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Is Duty of Good Faith and Fair Dealing Still Alive in Delaware?

Articles & Publications

August 14, 2013
Edward M. McNally
Delaware Business Court Insider

The Delaware Supreme Court recently issued several decisions that some argue  go a long way toward eliminating any duty by controllers of limited partnerships  or limited liability companies to act in good faith and to deal fairly. In  Norton v. K-Sea Transportation Partners L.P., 67 A.3d 354 (Del. 2013), and Brinckerhoff v. Enbridge Energy, 67 A.3d 69 (Del. 2013), both issued the  same day, the court held that a limited partnership agreement effectively  exculpated managers of limited partnerships in conflicted transactions.

More recently, in Allen v. Encore Energy Partners L.P., No. 534,  2012, 2013 Del. LEXIS 378 (Del. July 22, 2013), the Supreme Court may have gone  even further by sanctioning a limited partnership agreement's exculpation of  managers who subjectively believed their actions were in good faith, even if  objectively they acted unreasonably. Given the obvious difficulty of proving a  manager subjectively believed he or she was acting improperly, plaintiffs may  never be able to prevail in such cases despite evidence the managers favored the  controlling partners or members over the minority interest owners. While recent,  well-publicized verdicts show that some defendants will brag about their lack of  loyalty to investors, those cases shock us partly because they are so rare. Even  in the age of social media, frank confessions of wrongdoing by managers does not  happen often.

In light of these recent decisions, what is left of the duty of good faith  and fair dealing in the real world? After all, one should expect that the broad  exculpation clauses in Norton, Brinckerhoff and Encore  Energy will be adopted by the drafters of limited partnerships and limited  liability company agreements. Is this, then, the finish of the "race to the  bottom" to eliminate investor protections that some predict is what Delaware law  is all about?

I do not think so. I remain confident that Delaware law will protect the  rational investor's expectations. Nonetheless, I must start with some cautions.  In Delaware, limited partnerships, limited liability companies and other  entities that are alternatives to the Delaware corporation are largely creations  of contract. Investors are on notice that their legal rights are largely (but  not entirely) defined by the operating agreements for those types of entities.  What you get is what you bargain for and that may be little indeed. Moreover,  every one of these operating agreements is somewhat different. Hence, due  diligence on one's legal rights is required before investing. That may be the  reason why these alternative entities are not the most common form of entity for  publicly-traded investments. The large majority of publicly-traded companies are  still corporations, not alternative entities.

But having acknowledged that there is increased legal risk in these  alternative entities, I still believe Delaware law provides at least a minimal  level of investor protection from managers. Some history is helpful here.

Prior to 2000, there was considerable doubt about whether traditional  fiduciary duties owed by managers might be eliminated by provisions in a limited  partnership or limited liability company agreement. In part, that was because  the statutes governing those entities were not clear on that point. When the  Supreme Court eventually suggested that this issue of contractually eliminating  fiduciary duties be addressed legislatively, the Delaware General Assembly  responded by amending the law to make it clear that fiduciary duties could be  eliminated if the investors agreed to do so in the entity's operating agreement.  But (and this is a big "but"), the statutes explicitly prohibit eliminating the  "implied covenant of good faith and fair dealing" in an operating agreement.

At the same time it was issuing these decisions upholding broad exculpation  clauses, the Supreme Court also issued Gerber v. Enterprise Products Holdings  LLC, 67 A.3d 400 (Del. 2013). Gerber squarely upholds the force of  the implied covenant by reinstating a complaint that properly alleged the  covenant was violated. Gerber does so despite a very broad exculpation  clause. Nothing in the other recent Supreme Court decisions undermines Gerber. Indeed, the other decisions carefully note that for various  reasons they were not addressing implied covenant claims. For example, Encore  Energy Partners L.P. noted that the "implied covenant" claims were not before it  on appeal.

It only makes sense that Delaware will continue to uphold valid implied  covenant claims. Delaware lawyers and judges do not want Delaware law to permit  plainly abusive conduct toward investors, even those investors who should know  better. Those lawyers and judges who shape Delaware law know that if Delaware  permits bad conduct, that will invite corrective action, such as at the federal  level. Preserving Delaware's pre-eminence is more important over the long run  than attracting a few more entities to Delaware that will be "bad actors."

For whatever reason, the plaintiffs bar has not aggressively brought implied  covenant claims. Now that those claims have been upheld by Gerber and  most other claims barred by the recent Supreme Court decisions, that may well  change. More implied covenant claims should be the result. It is likely that  those claims will follow the lead of Gerber by focusing on how fairly the  controllers of an alternative entity carried out the process to resolve  conflicts-of-interest transactions provided by the operating agreement.

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