Delaware Business Litigation Report

Guidance Provided to Evaluate the Implied Covenant of Good Faith and Fair Dealing

The Delaware Limited Liability Company Act’s policy is to give the maximum effect to the principle of freedom of contract in LLC operating agreements. While the act permits parties to eliminate fiduciary duties that members or managers would otherwise owe to one another, an operating agreement may not eliminate the implied covenant of good faith and fair dealing that inheres in every LLC operating agreement under Delaware law. The implied covenant operates to imply terms to address developments or contractual gaps that neither party anticipated in the operating agreement, but which are necessary to fill gaps essential to meeting the reasonable expectations of the parties as reflected in the express terms of the operating agreement.

The implied covenant is not, however, a “free-floating requirement” that a party act in some morally commendable sense. Instead, “good faith” in the implied covenant means faithfulness to the scope, purpose, and terms of the parties’ operating agreement. Similarly, “fair dealing” does not imply equitable behavior, but rather, actions consonant with the terms of the operating agreement and its purpose. The Delaware Court of Chancery has emphasized that parties may not use the implied covenant to override express terms or rewrite an operating agreement because one party wants a better deal than it agreed to at the time of contracting. In sum, any implied term must be consistent with the reasonable expectations of the parties as reflected in the express terms of the operating agreement as a whole.

In evaluating a claim for breach of the implied covenant of good faith and fair dealing, the first step is to determine whether the express terms of the operating agreement address the subject at issue, or in other words, whether the operating agreement is silent or contains a gap in the contractual terms. If the operating agreement does not address the issue, the second step is to evaluate whether implying terms to address the contractual gap is consonant with the reasonable expectations of the parties as reflected in the express terms of the operating agreement. The Court of Chancery has cautioned that when an LLC operating agreement eliminates fiduciary duties as part of a contractual corporate governance scheme, “Delaware courts should be all the more hesitant to resort to the implied covenant.” The reason lies in the act’s policy of freedom of contract: the waiver or elimination of default common-law fiduciary duties in an operating agreement “implies an agreement that losses should remain where they fall” in the agreement, rather than being shifted after the fact through fiduciary-duty review.

In its recent decision, Miller v. HCP & Company, C.A. No. 2017-0291-SG (Del. Ch. Feb. 1, 2018) (Glasscock, V.C.), the Court of Chancery held that plaintiffs failed to state a claim for breach of the implied covenant of good faith and fair dealing in connection with a controllers’ refusal to pursue an open-market or auction process to achieve the highest price in a sale of the LLC that would benefit all of its members. Pursuant to the LLC operating agreement, the controlling members were entitled to the bulk of the first $30 million in any sale of the LLC before any sale proceeds would be available to other members, who were then entitled to receive 100 percent of the next layer of additional sales proceeds if the sale price were higher than $30 million. But these other members would have to receive millions of dollars in additional sales proceeds before the controlling members were again entitled to share, pro rata, in any sales proceeds resulting from an even higher sales price. Therefore, the plaintiffs claimed that because the controlling members would likely receive 0 percent of additional sales proceeds from a sale of the LLC for more than $30 million, the controlling-member dominated board had little incentive to conduct an open-market process to negotiate for a sales price higher than $30 million that would benefit all of the members.

In its evaluation of whether the failure to conduct an open-market sales process to achieve a higher sales price breached the implied covenant of good faith and fair dealing, the court first determined that the operating agreement was not silent as to how the LLC could be marketed and sold. Relying in part on the parties’ waiver of fiduciary duties in the operating agreement, the court found that the express terms of the operating agreement vested the board with sole discretion as to the type and manner of the sale process subject only to the condition that the LLC be sold to an independent third party. While provisions providing unqualified sole discretion to a board require that such discretion be exercised reasonably and in good faith under the implied covenant, “if the scope of the discretion is specified, there is no gap in the contract as to the scope of the discretion, and there is no reason for the court to look to the implied covenant to determine how the discretion should be exercised.” Here, the operating agreement cabined the board’s discretion in the sale process by only permitting sales to unaffiliated third parties. The court reasoned that these terms, which prohibited a sale to an affiliate of the controlling members or an insider, indicated that the members had considered the implications of vesting discretion for a sale in a conflicted board, leaving no room or gap in the type or manner of the sale process for the implied covenant to fill.

Even if the operating agreement did contain a gap as to how the LLC could be sold, the court concluded that implying terms to require an open-market sales process was inconsistent with the reasonable expectations of the parties as reflected in the express terms of the operating agreement. The court reasoned that the express terms of the operating agreement actually contemplated that the LLC might be sold through private negotiation rather than an open-market process. The members had agreed to a sales process that enabled the controlling members to structure and time an exit at a very substantial premium to their investment in order to encourage the investment, but at the cost of fiduciary duties that may have protected prior investors from the controlling members seeking a quick pay out on their investment at the expense of other members. Therefore, adding an open-market or auction requirement to the sales process would frustrate the reasonable expectations of the parties in the deal that they had struck. In these circumstances, the Delaware Supreme Court has emphasized that the implied covenant of good faith and fair dealing is “not an equitable remedy for rebalancing economic interests after events that could have been anticipated, but were not, that later adversely affect one party to a contract.” Accordingly, the court ruled that plaintiffs had failed to state a claim for breach of the implied covenant of good faith and fair dealing, and dismissed the action.

Practice Point

To avoid a claim for breach of the implied covenant of good faith and fair dealing for conflict transactions in the alternate-entity context, the parties’ organizational agreement should eliminate fiduciary duties, cabin the discretion of the board in its evaluation and decision on the transaction, and most importantly, expressly set forth terms that clearly manifest the parties’ reasonable expectations in the transaction.

Delaware Business Court Insider l February 21, 2018

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