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LLC Member Duties: The New Implied Covenant of Good Faith and Fair Dealing, Part 2

In Part 1 of this discussion we examined the (relatively) new Alabama LLC Law and its provisions allowing parties to waive fiduciary duties. See LLC Member Duties: The New Implied Contractual Duty of Good Faith and Fair Dealing, Part 1 at https://www.clarklawfirm.com/llc-member-duties-the-new-implied-contractual-duty-of-good-faith-and-fair-dealing-part-1/. We noted that the new law would not allow parties to waive “the implied contractual covenant of good faith and fair dealing” or the duty “not disclose or otherwise use information of the [LLC] to the detriment of the [LLC] or the other members.” Ala. Code § 10A-5A-4.08(g)(1). This entry discusses that new “implied contractual covenant of good faith and fair dealing” by reviewing Delaware cases addressing the issue.

In Miller v. HCP & Co., 2018 Del. Ch. LEXIS 40 at *22 (Del. Ch. 2018), the Delaware Chancery Court discussed the implied covenant of good faith and fair dealing in the context of a limited liability company. The Delaware courts have also addressed the covenant involving other contract-based entities, such as limited partnerships. See Gerber v. Enter. Prods. Holdings, LLC, 67 A.3d 400 (Dec. 2013), overruled on other grounds by Winshall v. Viacom Int’l, Inc., 76 A.3d 808 (Dec. 2013); Lonergan v. EPE Holdings LLC, 5 A.3d 1008 (Del. Ch. 2010).

The Miller court held that “the implied covenant inheres in every contract governed by Delaware law.” “Because a claim for breach of the implied covenant is contractual, the elements of an implied covenant claim are those of a breach of contract claim: a specific implied contractual obligation, a breach of that obligation by the defendant, and resulting damage to the plaintiff.”

The Delaware Chancery Court further held in Miller that “[a]pplying the implied covenant is a cautious enterprise, and the doctrine is rarely invoked successfully. The implied covenant applies only when one party proves that the other party has acted arbitrarily or unreasonably, thereby frustrating the fruits of the bargain that the asserting party reasonably expected. A party’s reasonable expectations are measured as of the time of contracting, and any implied terms must address developments or contractual gaps that the asserting party pleads neither party anticipated. The Court will not rewrite a contract simply because a party now wishes it had gotten a better deal. And the implied covenant does not establish a free-floating requirement that a party act in some morally commendable sense. Instead, ‘good faith’ in the implied covenant context entails faithfulness to the scope, purpose, and terms of the parties’ contract. Similarly, ‘fair dealing’ here does not imply equitable behavior. The term ‘fair’ is something of a misnomer here; it simply means actions consonant ‘with the terms of the parties’ agreement and its purpose. Put differently, any implied obligation must be consistent with the terms of the agreement as a whole.”

So, “the first step in evaluating an implied covenant claim is to determine whether the contract in fact contains a gap that must be filled. That is because the implied covenant applies only if the contract is silent as to the subject at issue. If the contract directly addresses the matter at hand, ‘existing contract terms control such that implied good faith cannot be used to circumvent the parties’ bargain. If, on the other hand, the express terms of the contract do not address the subject at issue, the Court must then consider whether implied contractual terms fill the gap. The Court conducts that inquiry by asking ‘whether it is clear from what was expressly agreed upon that the parties who negotiated the express terms of the contract would have agreed to proscribe the act later complained of as a breach of the implied covenant of good faith—had they thought to negotiate with respect to that matter.’ The Court does not derive implied obligations from its own notions of justice or fairness. Instead, it asks what the parties themselves would have agreed to ‘had they considered the issue in their original bargaining positions at the time of contracting.’ The implied covenant therefore ‘operates only in that narrow band of cases where the contract as a whole speaks sufficiently to suggest an obligation and point to a result, but does not speak directly enough to provide an explicit answer.’”

“When an LP or LLC agreement eliminates fiduciary duties as part of a detailed contractual governance scheme, Delaware courts should be all the more hesitant to resort to the implied covenant. The reason is that an alternative entity agreement that waives all fiduciary duties implies an agreement that losses should remain where they fall rather than being shifted after the fact through fiduciary duty review.

For example, in Miller, the plaintiff objected to a sale of an LLC at a price which paid the most senior equity holders but left little or nothing for the remaining equity holders. The LLC operating agreement waived any fiduciary duties which the members or managers would otherwise have owed to each other. The LLC operating agreement further provided that the company’s board retained sole discretion to determine the manner in which a sale of the company or its assets could be consummated. The Miller court held that the operating agreement was not silent as to the issue of how a sale could take place and, instead, expressly contemplated that potential event. So long as the board abided by the terms negotiated by the parties in the operating agreement, “the implied covenant cannot be invoked to override the express terms of the contract.”

On the other hand, in Gerber v. Enter. Prods. Holdings, LLC, 67 A.3d 400 (Dec. 2013), overruled on other grounds by Winshall v. Viacom Int’l, Inc., 76 A.3d 808 (Dec. 2013), the Delaware Supreme Court found that the plaintiff stated a potential claim for a breach of the implied covenant of good faith and fair dealing. Similar to Miller, the partnership agreement in Gerber also waived any fiduciary duties which partners or the managers of the partnership might otherwise owe to one another. Gerber involved a complex sale of related entities within the limited partnership structure. The partnership agreement provided four “safe harbors” for potential sale or merger transactions. One such safe harbor was obtaining a “fairness opinion” from an independent party that the transaction was fair to the various involved parties. The fairness opinion in Gerber addressed the total consideration provided for two distinct transactions among the LP structure. The particular transaction made the subject of the complaint (which was one of the two transactions addressed by the fairness opinion) was undertaken specifically to avoid pending derivative lawsuits brought against the partnership by limited partners. But the fairness opinion failed to even attempt to value those claims when giving its opinion that the value received for the sale was “fair” to the limited partners.

The Gerber court found that the plaintiff “could not fairly be charged with having anticipated that [the general partner of the limited partnership] would merge [the limited partnership] for the purpose of eliminating [the limited partnership]’s derivative claims, but then rely on a fairness opinion that did not even consider those claims’ value. Although [the partnership agreement] does not explicitly so require, we conclude that the parties would certainly have agreed, at the time of contracting, that any fairness opinion contemplated by that provision [of the partnership agreement addressing the sale or merger of the limited partnership] would address the value of derivative claims where (as here) terminating those claims was a principal purpose of a merger. Therefore, [the plaintiff] has sufficiently pled that [the general partner] breached the implied covenant in the course of taking advantage of [the partnership agreement]’s conclusive presumption [of good faith].”

The Gerber court explained that “[t]he temporal focus is critical. Under a fiduciary duty or tort analysis, a court examines the parties as situated at the time of the wrong. The court determines whether the defendant owed the plaintiff a duty, considers the defendant’s obligations (if any) in light of that duty, and then evaluates whether the duty was breached. Temporally, each inquiry turns on the parties’ relationship as it existed at the time of the wrong. The nature of the parties’ relationship may turn on historical events, and past dealings necessarily will inform the court’s analysis, but liability depends on the parties’ relationship when the alleged breach occurred, not on the relationship as it existed in the past.”

“An implied covenant claim, by contrast, looks to the past. It is not a free-floating duty unattached to the underlying legal documents. It does not ask what duty the law should impose on the parties given their relationship at the time of the wrong, but rather what the parties would have agreed to themselves had they considered the issue in their original bargaining positions at the time of contracting.”

In short, while a fiduciary duty claim asks whether the actions of the parties at a specific time fell within the parties’ duties and obligations to each other at that time, an implied covenant claim asks whether the parties contemplated in their original contract the event which occurred at the specific time and whether the actions of those parties at that specific time met the contractual standards set forth by the parties in their original contract.

The difference appears slight, but shifts the burden of proof substantially in favor of company management or majority owners. This standard also encourages parties to conduct detailed and thorough negotiations of the documents governing the management of the company, and the rights of members/partners, on the front-end instead of litigating disputes on the back-end.