Delaware LLC Agreements: Beware Relying on the Implied Contractual Covenant of Good Faith and Fair Dealing

June 25, 2018

Delaware has long been the jurisdiction of choice when forming a limited liability company (LLC). One reason is flexibility, with members themselves having the power to define their preferred relationship within their LLC agreement. Indeed, section 18-1101(c) of the Delaware Limited Liability Company Act (the Act) allows members to waive any fiduciary or other duty that would otherwise apply to an LLC member or manager:

"To the extent that, at law or in equity, a member or manager or other person has duties (including fiduciary duties) to a limited liability company or to another member or manager or to another person that is a party to or is otherwise bound by a limited liability company agreement, the member’s or manager’s or other person’s duties may be expanded or restricted or eliminated by provisions in the limited liability company agreement; provided, that the limited liability company agreement may not eliminate the implied contractual covenant of good faith and fair dealing.”

The italicized section of this excerpt from the Act specifies that an LLC may not, when waiving duties, eliminate the implied contractual covenant of good faith and fair dealing, which applies to all contracts under Delaware law.

The implied covenant in practice

This implied covenant is central to an important 2018 Delaware Court of Chancery case, Miller v. HCP & Company. The case arose out of a fairly typical LLC agreement which, among other provisions, stipulated that the board had sole discretion as to the manner of any sale of the LLC to an unaffiliated third party, including a drag-along clause. The LLC agreement also included an explicit waiver of fiduciary duties.

The LLC’s board was controlled by a private equity investor with a preferred equity interest in the company. The board accepted a buyout that would completely pay off the private equity investor. However, minority investors, who were in line to receive substantially less, claimed breach of the implied covenant of good faith and fair dealing – because the board refused to pursue a sales process designed to achieve the highest value reasonably available for all LLC members. Instead, the minority investors alleged, the defendants pushed through a below-market sale of the LLC that gave the private equity investor a quick exit and a 200% return.

The court ruled in favor of the defendants, saying it "…will not rewrite a contract simply because a party now wishes it had gotten a better deal.” The court further noted that the implied covenant addressed only “developments or contractual gaps that […] neither party anticipated” as of the time of contracting. The court concluded that the members "eschewed fiduciary duties, and gave the board sole discretion to approve the manner of the sale, subject to a single protection for the minority, that the sale be to an unaffiliated third party. It thus appears that the parties to the [LLC agreement] did consider the conditions under which a contractually permissible sale could take place.”

The implied covenant was also relevant in a second 2018 Delaware Court of Chancery case. In MHS Capital v. Goggin, an LLC’s minority members accused the company’s manager of self-dealing. The court recited the rule that the implied covenant may only be applied to “developments or contractual gaps that […] neither party anticipated” as of the time of contracting. To come to its decision, the court cited a different clause in the LLC agreement: “[t]he Manager shall discharge his […] duties in good faith, with the care an ordinarily prudent person in a like position would exercise under similar circumstances, and in a manner [he] reasonably believes to be in the best interests of the Company.” Because this express term already covered the issue at hand, the court rejected the implied covenant claim.

What this could mean for you

The Miller and MHS Capital cases are instructive for parties negotiating a Delaware LLC agreement. Besides often being lengthy and cumbersome, LLC agreements are sometimes rushed – parties may seek to quickly finish the process so they can advance the closing of an investment. Controlling and minority members need to carefully consider the implications of “boilerplate” management provisions within standard LLC agreements, because Delaware courts will enforce such terms as written. Delaware courts will not bail out an investor for making a bad deal. Citing the implied covenant when express terms in the LLC agreement already address an issue is not a winning strategy; it’s better to negotiate express terms before signing the LLC agreement.

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