When Can the Covenant of Good Faith and Fair Dealing Be Invoked?

Delaware is a contractarian state, which allows parties the freedom to contract as they see fit and leaves to the parties the ordering of their affairs. Even with the freedom to include (or exclude) terms in a contract, there is one term (a covenant, really) that need not be negotiated or expressly stated in the agreement—that is the implied covenant of good faith and fair dealing. The implied covenant has been described as a “cautious endeavor” that should rarely be invoked. This is because the covenant is used to protect the parties’ benefit of the bargain and not as a quasi-equitable rebalancing of rights. It cannot be invoked if the issue is already covered by the terms of the agreement. Rather, the job of the covenant is to imply those terms that the parties did not negotiate but that they would have included in their agreement if they had thought to do so. Thus, a party asserting the covenant must identify a gap in the contract for the covenant to fill. Parties may not use the covenant to obtain benefits or protections that they did not obtain at the negotiating table. It is not a free-floating duty unattached to the written contract, and it is not the court’s role to impose terms on the parties to which they did not agree.

No matter how thoroughly parties negotiate their agreement, there may be “nooks and crannies” in the contours of the agreement that are left unnegotiated. As such, there are some terms that are too obvious to be negotiated—and thus, a gap exists. For example, the implied covenant barred a general partner from seeking the benefit of a safe harbor provision in a limited partnership (LP) agreement where he had used deceptive and misleading tactics; had the parties thought to negotiate that obvious term, they would have provided that the general partner could not use such deceptive devices.

But a gap in the written agreement is not the only circumstance where the covenant may be applied. In the ordering of their affairs, parties may grant a party the authority to exercise its discretion in making decisions under the contract. While parties are free to set parameters on the exercise of discretion or include a standard by which the exercise of discretion is to be measured, when parties do not spell out the contours of the ability to exercise the discretion granted in the agreement, the implied covenant will imply that discretion must be exercised in good faith.

The covenant requires a contract counterparty to refrain from arbitrary or unreasonable conduct that has the effect of preventing the other party to the contract from receiving the fruits of the bargain. What is arbitrary or unreasonable is not, however, judged at the time of the alleged wrongful act. Rather, the court will look to the parties’ intent at the time they entered into the contract to determine the parties’ reasonable expectations.

The covenant is implied in every contract. Sometimes the covenant can be confused with contract terms providing for “good faith.” This is often seen in the limited liability company context. Limited liability companies are an attractive vehicle for a variety of investment opportunities, including private equity and hedge fund investments. LLCs (and limited partnerships) provide structural flexibility. It is the policy of the Delaware Limited Liability Company Act (the “Act”), for example, to give maximum effect to the principle of freedom of contract and to the enforceability of LLC agreements.

Thus, LLC agreements often confer very broad authority on the managers or directors and provide for a safe harbor for their decisions. Indeed, the Act permits the elimination of fiduciary duties. However, the LLC agreement may not eliminate the covenant of good faith and fair dealing.

So, what does “good faith” in the covenant mean in these various contexts? An LLC agreement may define “good faith” as being what the manager believes to be in the best interest of the LLC (a subjective standard), or what the manager reasonably believed to be in the best interest of the LLC (an objective standard), or provide that certain actions are conclusively presumed to constitute good faith. These concepts are not to be confused with “good faith” under the covenant, which entails faithfulness to the scope, purpose, and terms of the parties’ contract.

Understanding the implied covenant and how it differs from express contractual “good faith” standards is important in drafting contracts to obtain the intended objective, usually of limiting the right to challenge a decision or a liability-limiting provision for making self-interested decisions. It is also important to understand the distinction and how each operates in developing litigation strategies. These concepts should be fully explored at the outset of drafting or litigation.