The Court of Chancery's holding in Bay Center Apartments Owner, LLC v. Emery Bay PKI, LLC, 2009 WL 1124451 (Del. Ch. Apr. 20, 2009) illustrates the application of the requirement that a party exercise discretion in good faith to protect the reasonable expectations of a member of a Delaware LLC. Bay Center brought an action against Emery Bay PKI (PKI) for, among other things, breach of the implied covenant of good faith and fair dealing in the Emery Bay LLC Agreement. Bay Center and PKI formed Emery Bay to develop a condominium project. The LLC agreement named PKI as the managing member. The LLC agreement allowed PKI to manage the affairs of the LLC, and it also contemplated that PKI would be responsible for the condominium project. PKI then designated an affiliate, Emery Bay ETI (ETI), as the development manager, which signed the development management agreement outlining the responsibilities for developing the project. Plaintiff alleged mismanagement and poor financial performance that injured the condominium development project.
Under the terms of the LLC agreement, PKI had the "power and authority" to: (1) cause the development manager to perform its obligations; (2) perform or cause to be performed Emery Bay's obligations under any agreement; and (3) "take all proper and necessary actions reasonably required" to cause Emery Bay to carry out the provisions of loan commitments or other contracts. Bay Center alleged that these provisions, in conjunction with the statement in the LLC agreement that PKI "shall manage" the affairs of the LLC, created an express obligation for PKI to meet the LLC's loan obligations and to ensure the development manager carried out its obligations if the development manager failed to perform. PKI argued that these provisions empowered but did not require PKI to take action. Alternatively, if the court found there was any ambiguity in PKI owing an express obligation, Bay Center claimed that the implied covenant of good faith and fair dealing required PKI to exercise discretion, its "power and authority," in good faith. PKI moved to dismiss the implied covenant claim, but not the express breach of contract claims.
Denying the motion to dismiss, the court found that where an LLC agreement grants a manager discretion, that discretion must be exercised in good faith. Analogizing to the corporate context, then Vice Chancellor, now Chancellor, Strine explained that "[p]art of corporate managers' proper performance of their contractual obligations is to use the discretion granted to them in the company's organizational documents in good faith." The court found that PKI was obligated to manage the LLC, and that it had discretion to ensure that the development manager performed its duties. PKI had to exercise this obligation and discretion in good faith. It could not take arbitrary or unreasonable action that prevented Bay Center from receiving the fruits of the bargain. In this case, Bay Center contributed the real estate in exchange for PKI's proper management of the enterprise. The court found that Bay Center had alleged that PKI failed to carry out this task. Furthermore, the court found that Bay Center had alleged that PKI had acted in bad faith, i.e., with an improper purpose, because the conduct at issue was self-interested. PKI misdirected loan funds to its advantage, and the decision not to enforce the development management agreement was conflicted because the same party controlled Emery Bay and the development manager. Accordingly, the court refused to dismiss the implied covenant claim.
The Nemec opinion casts doubt as to whether a court following its rationale would necessarily reach the same result in Bay Center. The agreement at issue in Nemec permitted rather than required the company to repurchase the former officer's shares. Accordingly, when the company authorized the repurchase of shares, the Booz Allen directors were arguably exercising the company's discretion under the contract to decide if and when to repurchase the former executive's shares. Consequently, the dissenting justices argued that the line of Delaware cases finding that discretion must be exercised in good faith should prevent the plaintiffs' claims from being dismissed. Rejecting this argument, the majority found that the discretion line of cases did not apply in Nemec because Booz Allen had a specific right to take the action it did, i.e., to repurchase the shares, and thus exercised no discretion. Disagreeing with that narrow understanding of "discretion," the dissenting justices explained: "The Company's decision whether or not to redeem was discretionary, in the sense that Booz Allen, as the right holder was not obligated to redeem the shares at the time it chose to do that. Exercising a contractual right under circumstances detrimental to the counterparty and where the right holder has nothing to gain, is arguably not in good faith, unless the contract expressly allows the exercise for any (or even no) reason." The facts of Nemec and the arguments raised by the Nemec dissent suggest that a majority of the Delaware Supreme Court would support using the implied covenant to limit managerial discretion only where discretion exercised by a manager could not be construed as an act that was expressly permitted.
Post-Nemec: Careful Drafting of LLC Agreements is Critical
In light of the Delaware Supreme Court's decision in Nemec and the limitations placed on the implied contractual covenant through prior caselaw, what protection does the implied covenant offer a member of an LLC, and conversely what risks does it present for a defendant manager or managing member of an LLC, where the parties in their LLC agreement have waived fiduciary duties and the contract provides the manager with discretion to carryout a designated act?
As noted above, under Delaware law, the implied covenant is, at best, a weak tool for plaintiffs. It cannot be used as an amorphous or free-floating duty detached from the contract itself. It cannot be used paternalistically to rewrite provisions that, in hindsight, advantage one party over the other. It cannot be used to prohibit acts that are expressly permitted by the parties' bargained for agreement. Furthermore, because Nemec makes clear that "[t]he implied covenant only applies to developments that could not be anticipated, not developments that the parties simply failed to consider," parties must be vigilant in negotiating express terms regarding any significant developments that could be anticipated at the time of contracting. Although much will turn on how future decisions interpret the above quoted language, developments like change of control transactions or the sale of a division of a company often can be anticipated, particularly by sophisticated parties, and parties proceed at their own risk if they do not reflect in their operating agreement the treatment they expect in the event of such developments.
In the LLC context specifically, it is well-settled that the implied covenant cannot revive fiduciary duties expressly waived in the operating agreement. Furthermore, although Bay Center and similar cases offer some comfort to members of LLCs that the implied covenant may protect them even when fiduciary duties have been waived, it is uncertain after Nemec whether the Delaware Supreme Court will permit a claim based on the implied covenant if the parties expressly bargained that management has sole discretion to determine how to operate the LLC. LLC agreements often are drafted that way, allowing discretion to carry out or delegate to others the company's ordinary operations with member majority approval only necessary for specified major transactions. One could argue based on Nemec that the parties negotiating an LLC agreement, particularly where they are sophisticated parties, are perfectly capable of determining what, if any, limitations to place on a manager's authority. Furthermore, extending the majority's logic in Nemec, one could argue that PKI in Bay Center had been contractually granted the "power and authority" to manage certain aspects of the condominium project and simply exercised its contractually granted right to determine if, when, and how to exercise that contractually granted "power and authority." Since a majority of the Delaware Supreme Court appears to have a narrow view of what is an exercise of discretion versus an expressly permitted act, counsel to members of LLC must be cautious in placing too much weight on the implied covenant to police manager misconduct based on discretionary acts.
In light of the uncertainty in the vitality of the discretion line of cases following the Delaware Supreme Court's apparent narrowing of the reach of the implied covenant in Nemec, careful drafting of LLC agreements is more critical than ever. Even under the pre-Nemec case law, plaintiffs rarely succeeded on implied covenant claims. In a post-Nemec world, stating a breach of the implied covenant claim likely will prove even more difficult. Parties and their counsel should carefully consider at the time of formation whether managers should owe fiduciary duties to account for the uncertainty of whether the implied covenant of good faith and fair dealing will rectify future wrongs that the parties did not expressly anticipate in their contract. Although parties may reflexively believe that it is better to agree in the LLC agreement that neither party owes the other fiduciary duties, such belief may prove short-sighted given the limitations on the implied covenant of good faith and fair dealing to remedy an alleged wrong. Based on Nemec, the question of what terms should be added to an agreement to govern potential misconduct could be called the $64 million question.