Delaware Business Court Insider

September 11, 2013

The Meaning of Contractual Good Faith

Joel Feuer and Benyamin Ross Delaware Business Court Insider

Since the Delaware General Background and the Court of Chancery presumed that the parties Assembly made it clear that de- Chancery Decision intended to adopt Delaware’s com- fault fiduciary duties apply to man- In Policemen’s Annuity, the lim- mon-law definition of good faith as agers and controlling members of ited partners (LPs) of a Delaware applied to contracts. The court ad- limited liability companies, the limited partnership sought a dec- opted the definition of good faith attention of the Delaware courts laration that their removal of the in Section 1-201(20) of the Dela- has returned to a set of related partnership’s general partner (GP) ware Uniform Commercial Code questions for both partnerships was valid. The partnership’s lim- (UCC), which defines good faith as and LLCs: ited partnership agreement (LPA) “honesty in fact and the observance • How are fiduciary duties dis- granted the GP broad discretion to of reasonable commercial standards claimed and how are they displaced? manage the everyday affairs of the of fair dealing.” The court reasoned • When fiduciary duties are partnership. The LPA required the that because the UCC definition is contractually displaced by other GP to distribute audited financial at least as broad as the definition of standards, how are those standards statements on a timely basis. The good faith applicable to contracts at to be interpreted? GP repeatedly failed to do so. common law, if the LPs could sat- • Who bears the burden of proof? The GP argued that the LPs did isfy the UCC definition, then the In DV Realty Advisors LLC v. not meet the express and implied LPs would necessarily satisfy the Policemen’s Annuity and Benefit requirements of the LPA govern- common-law definition. The court Fund of Chicago, 2013 Del. LEX- ing removal of the GP. The re- found that the GP’s continuous IS 430 (Del. August 26, 2013), moval provision provided that the failures to deliver timely financial the Delaware Supreme Court ad- LPs could remove the GP “without statements provided the LPs with a dressed the second question and cause by an affirmative vote ... of good-faith belief that the GP need- provided a standard for contrac- the LPs holding in excess of 75 ed to be removed, even under the tual “good faith” where that stan- percent of the partnership inter- more stringent UCC definition of dard has not been further defined ests; provided that consenting LPs good faith. in the partnership agreement. in good faith determine that such Policemen’s Annuity evidences the removal is necessary for the best The Delaware Supreme court’s preference to read con- interest of the ... partnership.” Court Decision tractual provisions in partnership The LPA did not define good The Delaware Supreme Court and LLC agreements through the faith. Because the LPA stated that rejected the application of the prism of common-law standards, it was “made pursuant to and [was UCC definition of good faith to the including concepts associated to] be governed by the laws of the LPA. Instead, the court reiterated with fiduciary duties. state of Delaware,” the Court of its obligation to construct the over- Delaware Business Court Insider September 11, 2013 all scheme of a partnership agree- removal provision had not speci- preference to apply corporate-law ment to determine the values that fied a good-faith standard at all, tests can cut either way: While the contractual duty of good faith then applying the reasoning of undefined “fair” might invoke the sought to protect. The court found a prior Court of Chancery case, seemingly higher standard of en- that the term good faith was used Wilmington Leasing v. Parrish tire fairness, undefined “good faith” in the context of ensuring the LPs Leasing, L.P., 1996 Del. Ch. LEX- might invoke a subjective test in did not arbitrarily or capriciously IS 123 (Del. Ch. Sept. 25, 1996), partnership and LLC agreements remove the general partner. the covenant of good faith and that is satisfied more easily than Explicitly employing Aristote- fair dealing would have applied. its counterpart standard applied in lian logic, the court defined good Under that test, the limited part- commercial contexts. Of course, to faith by reference to its opposite: ners’ removal of the GP would generally avoid confusion, ambigu- bad faith. Bad-faith conduct, in have been measured by whether ity and unintended consequences, this case, was measured against the removal was exercised rea- practitioners may explicitly specify the same formula describing con- sonably and in good faith (i.e., which form of “fairness” or “good duct that falls outside business applying an objective reasonable- faith” is applicable. judgment protection: an action so ness standard). Thus, one conse- far beyond the bounds of reason- quence of Policemen’s Annuity is Joel Feuer is a partner of Gibson, able judgment that it seems essen- that by specifying a good-faith Dunn & Crutcher. He has handled a tially inexplicable on any ground standard, a laxer subjective test broad range of complex business litigation, other than bad faith. The Dela- may be applied; by not specify- including securities litigation and claims ware Supreme Court described ing any standard, the covenant arising out of corporate transactions. this good-faith standard as purely of good faith and fair dealing may subjective, and rejected the Court be applied, potentially resulting Benyamin Ross is an associate of Chancery’s application of a in the stricter objective standard. with the firm. He advises companies, standard that included both sub- private equity and venture capital jective good faith — “honesty in firms, and individuals in mergers and fact” — and an element of objec- Other Considerations acquisitions, equity investments and Policemen’s Annuity should re- tivity — “reasonable commercial joint ventures. mind practitioners that contractual standards of fair dealing” — as standards in partnership and LLC provided in the UCC. agreements may be viewed through Applying this standard, the a lens that applies standard cor- Delaware Supreme Court affirmed porate-law tests. For example, an the Court of Chancery’s judgment, “arm’s length” or “fair transaction” finding that the GP’s continu- standard in such an agreement may ous failures to provide financial be interpreted as requiring satisfac- statements provided the LPs with tion of an entire fairness standard, a good-faith belief that the GP including both prongs of having a needed to be removed for the best fair process and a fair result. In Gatz interest of the partnership. Properties LLC v. Auriga Capital, 2012 Del. Lexis 577 (Del. Nov. 7, Contractual Good Faith and 2012), the Delaware Supreme Court the Covenant of Good Faith stated that to impose fiduciary stan- and Fair Dealing dards of conduct as a contractual The LPA’s use of “good faith” matter, there is no requirement in Reprinted with permission from the September 11, 2013 edition of DELAWARE BUSINESS COURT INSIDER in the removal provision resulted Delaware that an LLC agreement © 2013 ALM Media Properties, LLC. All rights reserved. in the application of an easily- use magic words, such as “entire Further duplication without permission is prohibited. For information, contact 877-257-3382 or [email protected]. # satisfied subjective test. If the fairness” or “fiduciary duties.” The 203-09-13-01