June 26, 2013
Edward M. McNally
Delaware Business Court Insider

The Delaware Supreme Court on June 10 brought back to life claims alleging liability for a general partner's failure to act in good faith and to deal fairly with limited partners. Until the court's decision in Gerber v. Enterprise Products Holdings, 2013 LEXIS ____ (June 10, 2013), the Court of Chancery permitted general partners to almost escape liability to the limited partners by adopting sweeping exculpation language in limited partnership agreements. Gerberhas now limited the protection such language was thought to provide.

The background to Gerber helps explain its potential significance. The Delaware Revised Uniform Limited Partnership Act (and the Delaware Limited Liability Company Act as well) permits the partners or members to set the terms of their relationship in their partnership agreement. Freedom of contract is king. The DRULPA even permits the partner by their agreement to eliminate the traditional fiduciary duty partners owe to one another. But, there is one exception to that freedom of contract.

Section 17-1101(d) of the DRULPA mandates that a "partnership agreement may not eliminate the implied contractual covenant of good faith and fair dealing." Of course, that "covenant" is pretty vague and often hard to define in practice. It generally is held to be a "gap filler" that applies to circumstances that the partners failed to expressly address in their agreement and that is necessary to permit the parties to obtain the benefit of their bargain. A frequent example of the covenant is when a contract obligates a buyer to pay for goods that pass his inspection. A buyer cannot avoid the obligation to pay by refusing to inspect. If the parties do not cover that point in their contract, the "covenant" of good faith and fair dealing requires that the buyer inspect the goods delivered to him. For if the parties had focused on that issue when they contracted, they surely would have provided for a mandatory duty to inspect delivered goods.

Faced with this uncertain duty and, as always, trying to avoid liabilities, general partners have for years tried to limit this covenant of fair dealing that the DRULPA imposes on them. Prior to Gerber, the apparent solution was to rely on the freedom of contract to define "good faith and fair dealing" in such a way as to virtually make the covenant meaningless. If "good faith" could be defined to mean "whatever I think is best," the general partners had no real exposure for even self-dealing. While few drafters of limited partnership agreements (or limited liability agreements) would go that far, they came close.

The Gerber decision illustrates this effort to avoid potential exposure to claims alleging a failure to act in good faith. The LLP agreement there basically stated that if the general partner acted "in reliance upon the opinion" of an investment banker, he was "conclusively presumed to have [acted] in good faith." Thus, even if the banker was misled or issued a plainly erroneous opinion, that opinion would have exculpated the general partner. That is just too much to accept. The Gerber decision holds that notwithstanding the broad contractual language, the covenant of good faith and fair dealing still has meaning. There still may be liability when the broad exculpatory language is not relied on in good faith and is used to deal unfairly.

So where does this all leave us? Are the broad exculpation clauses so popular in limited liability and limited partnership agreements now useless after Gerber? The brief answer is that well-drafted exculpation clauses will still work just fine. But blanket provisions easily subject to being used to abuse investors are now ineffective. What, then, is a well-drafted provision?

The starting point is to remember what the covenant of good faith and fair dealing is designed to protect. It exists to ensure the contracting parties get the benefit of what they bargained for and are not deprived of their reasonable expectations by conduct no one anticipated or would have agreed to in advance. This is illustrated by considering the most common problem exculpation clauses are designed to address — self-dealing transactions by controllers. An exculpation clause that says "we can do whatever we feel is right" is useless. No one would agree in advance that such a clause insulates bad conduct. Under Gerber, such a clause would be subject to a duty to be applied fairly and in good faith. In short, it would not accomplish much.

On the other hand, if the agreement provides that limited partners may not object when clear, real safeguards are followed to try to reach a fair result, that provision will be respected by the courts. Providing for truly independent transaction approvals with the power to say no and with limited partners' approval rights, will certainly insulate general partners from liability in almost every deal short of flat-out fraud. Even provisions less protective will pass muster under Gerber if they are followed fairly. After all, one of the key facts in Gerber is that the banker's opinion was plainly inadequate to address the actual transaction that hurt the limited partners' interests.

In short, the Gerber decision requires greater care in drafting and applying exculpation clauses in limited partnership and limited liability company agreements. Those clauses can work, but only if applied reasonably.