Chancery Rejects Implied Covenant Claim for Failure to Prove that, Had the Issue Been Negotiated, Both Parties Would Have Agreed
Roundpoint Mortgage Servicing Corp. v. Freedom Mortgage Corp., C.A. No. 2020-0161-SG (Del. Ch. July 22, 2020)
To establish an implied contractual obligation pursuant to the implied covenant of good faith and fair dealing, a party must prove that, even though the contract does not state the term at issue, the parties would have agreed to it had they thought to negotiate it at the time of contracting. Here, the Court of Chancery post-trial denied an acquirer’s implied covenant claim even though the result arguably resulted in unfairness from a financial point of view to the acquirer. As illustrated by this case, unfairness alone to one party does not necessarily prove that both parties would have agreed to the implied term had they thought to negotiate about it.
This case arose out of the acquisition by merger of plaintiff (“Seller”) by defendant (“Buyer”). The parties’ merger agreement contained customary restrictions between signing and closing on the Seller incurring indebtedness or selling assets. Yet it was anticipated that in that time period the Seller might face margin calls on a credit facility secured by certain assets and that, due to the restrictions on selling assets between signing and closing, the Seller might not be able to pay margin calls. The solution was to permit the Seller to borrow from its controlling stockholder. The Merger Agreement authorized such borrowing, but required as a condition to closing that Seller “shall have repaid, all amounts outstanding under the [new] Facility.”
Between signing and closing, the Seller obtained a credit facility from the controller totaling $123 million. Prior to closing, the controlling stockholder forgave all but $1.0 million without requiring repayment. It was in the controller’s interest to do so, because the merger consideration to the Seller was based on its net asset value plus a 7.5% premium. The forgiveness of indebtedness resulted in a relatively higher net asset value as compared with a scenario where the Seller had to part with cash or other assets to repay the debt. As the Court recognized, “[e]very dollar that [Seller] is no longer obligated to repay increases the book value of [Seller] by one dollar”, whereas the use of a dollar of assets to extinguish debt has a neutral impact on book value. As a practical matter, due to the 7.5% premium over book value, the controlling stockholder “benefits (almost) 7.5 cents per dollar of debt it forgives.” On the other side, “each such [forgiven] dollar requires the [Buyer] to come up with an additional dollar (plus premium) in cash at closing[.]” When Buyer would not close on the ground that Seller had not satisfied the condition (in its view) to have repaid all amounts borrowed, Seller brought suit.
The Court reached the Buyer’s implied covenant issue after first agreeing with Seller that the Merger Agreement did not expressly prohibit the controlling stockholder from forgiving the indebtedness. In addressing the implied covenant claim, the Court recognized that it was in the Buyer’s financial interest to prohibit forgiveness. The Court declined to imply a “no forgiveness” term, however, because Buyer had failed to meet its burden to prove that the parties would have agreed to prohibit forgiveness had they thought to negotiate about it. Considering the parties’ circumstances, the structure of the agreement and the negotiating history, the Court found that the Seller for non-bad-faith reasons may have preferred flexibility in repaying the credit facility. The Court concluded that, had the issue been discussed, the parties may have reached a compromise on something other than a “no forgiveness” provision. While the Court had no doubt that Buyer would have agreed to the no forgiveness term, the Buyer failed to carry its burden to prove that Seller also would have agreed to that term. Hence, the Court denied the Buyer’s implied covenant claim.