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March 19, 2018 Practice Points

Delaware Chancery Court Rejects Minority Members’ Use of Implied Covenant to Seek Higher Transaction Price in Sale of LLC

The implied covenant of good faith and fair dealing cannot be used to rewrite contractual agreements to appease unhappy parties

by Travis S. Hunter

Numerous jurisdictions recognize that contracts contain an implied covenant of good faith and fair dealing (the implied covenant). Courts have described the implied covenant as “a judicial convention designed to protect the spirit of an agreement when, without violating an express term of the agreement, one side uses oppressive or underhanded tactics to deny the other side the fruits of the parties’ bargain.” Chamison v. Healthtrust, Inc- Hosp. Co., 735 A.2d 912, 920-22 (Del. Ch. 1999). The implied covenant should not be used to “rewrite [a] contract to appease a party who later wishes to rewrite a contract [it] now believes to have been a bad deal.” Nemec v. Shrader, 991 A.2d 1120, 1126 (Del. 2010). “[O]ne generally cannot base a claim for breach of the implied covenant on conduct authorized by the agreement.” Id. at 1125–26.

These principles were recently reinforced in Miller v. HCP & Co., 2018 WL 656378 (Del. Ch. 2018). Miller arose in connection with the sale of Trumpet Search LLC. The defendants, HCP & Co. and its affiliates (collectively, the HCP entities), were the largest holders of membership units in Trumpet. Under Trumpet’s operating agreement, the HCP entities were entitled to appoint four of the seven managers on Trumpet’s board. Trumpet’s operating agreement also explicitly waived fiduciary duties and contained a “waterfall provision” for determining members’ returns on their capital investment in the event of “a sale or otherwise.” Id. at *2–3. Holders of Class E and D membership units, which the HCP entities held, were entitled to first priority in proportion to their capital contribution until they received 200 percent of their respective contributions. Only after the Class E and D unitholders received distributions could other unitholders receive distributions.

According to the plaintiffs, the waterfall provision created a perverse incentive. If the HCP-dominated board decided to sell Trumpet, approximately 90 percent of the first $30 million would go to the HCP entities. In other words, the HCP-dominated board would have an incentive to negotiate any sale price up to approximately $30 million but little incentive to negotiate further.

This played out in 2016 when Trumpet’s board began to contemplate a sale. The potential buyer initially offered $31 million. The HCP-allied majority of managers elected not to run an open sales process and gave the non-affiliated managers little time to find alternate buyers. Although Trumpet was eventually sold to the potential buyer for $43 million, the plaintiffs argued that an open auction process would have led to a higher purchase price and brought a claim against the defendants for breach of the implied covenant. According to the plaintiffs, the implied covenant required an open-market sale or auction to maximize value for all members.

The court rejected this argument and concluded that the operating agreement left no gap for the implied covenant to fill. Specifically, the operating agreement eliminated fiduciary duties and vested the board with sole discretion to conduct a sale. Although the court acknowledged that “[w]hen a contract confers discretion on one party, the implied covenant requires the discretion to be used reasonably and in good faith,” it found that maxim inapplicable because the operating agreement vested the board with sole discretion to determine how to conduct a sales process and “if the scope of discretion is specified, there is no gap in the contract as to the scope of the discretion, and there is no reason for the Court to look to the implied covenant to determine how the discretion should be exercised.” Miller, 2018 WL 656378, at *11.

In sum, the court found that the practical effect of the waterfall provision was obvious from the operating agreement, and the implied covenant could not be used to alter the parties’ bargain, particularly when “[a]pplying the implied covenant is a ‘cautious enterprise,’ and the doctrine is ‘rarely invoked successfully.’” Id. at *9 (citation omitted). “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.” Id. at *10 (citation omitted).

Although implied covenant claims are often brought alongside breach of contract claims, Miller highlights that the implied covenant is no substitute for contractual terms. When drafting contracts, including LP or LLC agreements, parties should secure important provisions at the bargaining table because courts will not rewrite contracts to appease unhappy parties seeking a higher transaction price. This is particularly true where there is a negotiated, mutual waiver of fiduciary duties.

Travis S. Hunter is with Richards Layton & Finger, P.A., in Wilmington, Delaware.

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