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Court Rejects Use of the Implied Covenant of Good Faith and Fair Dealing to Preserve LLC Members’ Exit Sale Rights
The implied covenant of good faith and fair dealing inheres in all contracts governed by Delaware law. In some circumstances, the implied covenant may apply to fill “gaps” in an agreement consistent with the parties’ reasonable expectations at the time of contracting. Delaware courts have held, however, that implying terms in this manner should be a cautious enterprise.
The Delaware Supreme Court’s recent decision in Oxbow Carbon & Minerals Holdings v. Crestview-Oxbow Acquisition, __ A.3d __, 2019 WL 237360 (Del. Jan. 17, 2019) emphasizes that implying terms as a “gap filler” is “a limited and extraordinary remedy” that does not protect sophisticated parties from the harsh operation of contract provisions in circumstances the parties could have anticipated. Specifically, the Supreme Court held that minority members of a limited liability company had no recourse to the implied covenant when the admission of new members reset certain capital return requirements that had to be satisfied before the minority members had the right to liquidate their investments through a sale of the company. The Supreme Court did so notwithstanding the Delaware Court of Chancery’s finding that, had the issue been identified and addressed at the time the new members were admitted, the minority members would not have agreed to that result.
Oxbow Carbon LLC (the company or Oxbow) is a Delaware limited liability company that is the leading third-party provider of marketing and logistics services to the global petcoke market. At all pertinent times, a majority of the company’s membership interests, which took the form of units, were owned by William I. Koch and his affiliates (the Koch parties). Minority members Crestview Partners, L.P. and Load Line Capital (together, the minority members) invested in 2007 and received roughly 33 percent of the company’s membership interests.
Oxbow’s governing limited liability company agreement (the LLC agreement) permitted the members to exit their investment after seven years via a “put” right. If a member’s units were not redeemed in full, the member had the right to trigger a process for the sale of the whole company (an exit sale). An important condition to the exit sale right was that any such transaction had to result in the members receiving proceeds that, together with past distributions, totaled at least 1.5 times each member’s capital contributions (the 1.5x clause).
In 2011, the company issued additional units comprising 1.4 percent of Oxbow’s membership interests to Koch’s family members and executives of a business the company had acquired (together, the small holders). The issuance was approved unanimously by the company’s board of directors (the board), including the minority members’ representatives. The issuance did not, however, comply with the LLC agreement’s pre-emptive rights provisions, nor did it receive a required special approval as a related party transaction. While the resolutions approving the issuance did not specify the rights associated with the units, the new unitholders became parties to the LLC agreement. The parties’ subsequent course of dealing confirmed that everyone understood them to be members.
By the time the small holders became members, all of the other members had already received distributions sufficient to satisfy the 1.5x clause. Neither the small holders or the other members considered, however, whether any future exit sale would also have to satisfy the 1.5x clause for the newly admitted small holders.
Litigation ensued after the minority members sought to trigger an exit sale and the Koch parties delayed and obstructed that process. During that process, a third-party acquirer offered to purchase the company, but the proceeds to the small holders would not satisfy the 1.5x clause. Arguing before the Court of Chancery, the Koch parties contended inter alia that the 1.5x clause had not been satisfied for the small holders, so the minority members had no right to an exit sale. In its post-trial decision rejecting that argument, the Court of Chancery reasoned among other things that the LLC agreement contemplated that the board would determine the rights, powers and duties of new members at the time of their admission. The board failed to do so, however, and accordingly the board did not address whether the small holders would have the right to invoke the 1.5x clause to prevent an exit sale. Invoking the implied covenant of good faith and fair dealing to fill this “gap,” the Court of Chancery reasoned that the minority members, who had the right to block the small holders’ admission as members, would not have agreed to admit them if they thought they could prevent an exit sale. After reviewing the parties’ course of dealing in detail, the Court of Chancery found that, had the issue been raised, the parties most likely would have agreed that the minority members could satisfy the 1.5x clause by “topping off” the small holders via additional payments from their own proceeds in any exit sale. The court accordingly held the minority members had the right to trigger an exit sale and “top off” the small holders, and that the Koch parties were in breach for obstructing the exit sale. The Koch parties appealed.
The Supreme Court’s Decision
The Delaware Supreme Court, sitting en banc, affirmed the Court of Chancery’s interpretation of the LLC agreement’s plain language, including the Court of Chancery’s ruling that the exit sale provisions expressly required the 1.5x clause to be satisfied for all members. The Supreme Court reversed, however, the Court of Chancery’s ruling that the board’s failure to specify the rights of the small holders upon their admission left a “gap” for the implied covenant to fill.
Reviewing the questions of contract interpretation de novo, the Supreme Court reasoned that “the LLC agreement delegates responsibility to the Board to determine the terms of admission and permits—but does not require—the board to issue units with different rights or classes.” The LLC agreement defined “members” to include persons subsequently admitted as such. Absent a board decision imposing different rights for newly-issued units, the Supreme Court reasoned, new members, like the small holders, would have the same rights as existing members.
The Supreme Court further reasoned that the LLC agreement’s grant of authority to the board to impose such different rights did not create a “gap” for the Court of Chancery to fill. Nor did the parties’ “sloppiness and failure to consider the implications of the small holders’ investments.” Stated somewhat differently, “whatever mistake the parties subjectively made about the implications of admitting new members does not create a contractual gap.”
The Supreme Court continued to reason that its decision was consonant with limitations on the use of the implied covenant, which is not a general equitable remedy “for rebalancing economic interests after events that could have been anticipated, but were not, that later adversely affected one party to the contract.” Similarly, the Supreme Court reasoned that the implied covenant should not be used to imply a contractual protection when, in the circumstances, sophisticated parties readily could have provided expressly for it.
The Supreme Court accordingly reversed the Court of Chancery’s judgment in favor of the minority members, concluding the litigation in favor of the Koch parties. As a result, and at bottom, by agreeing to the admission of new members, the minority members inadvertently lost the ability to exercise important, bargained for liquidity rights.
The Oxbow Carbon decision illustrates the Supreme Court’s analysis of an attempt by sophisticated parties to invoke the implied covenant as a “gap filler.” Where contracting parties could have anticipated an issue and proceeded accordingly, Delaware courts may be reluctant to invoke the implied covenant—even to avoid an unfair outcome, or one to which the parties likely would not have agreed. Oxbow Carbonthus squarely puts the onus on each party to protect itself at the time of contracting.
The context in Oxbow Carbon may also have been important. The parties were working in an area of corporate governance where precision is key: reaching and clearly memorializing agreements about the rights of equity holders. Both the Supreme Court and the Court of Chancery were faced with the result of the parties’ insufficient efforts to consider, determine and document the small holders’ rights and the intended effect of their investments on the existing members. Admitting equity holders and reaching agreement on their rights vis-à-vis one another are fundamental issues in the governance of a business entity. On such key issues, to which every entity must attend with care, a reviewing court may be chary to accept requests to fill “gaps” in the parties’ contracts, so as to incentivize parties to be as thorough and precise as possible when contracting.