The Delaware Supreme Court recently affirmed the dismissal of a co-founder’s claim that a private equity investor and its affiliated managers breached the implied covenant of good faith and fair dealing in connection with the sale of Trumpet Search, LLC. The Supreme Court’s decision, however, was significantly more limited in scope than the Chancery Court’s opinion, finding that the implied covenant of good faith and fair dealing applied in the context of the sale and noting that, if argued differently, the alleged breach of the implied covenant might have survived the defendants’ motion to dismiss.
The Chancery Court’s decision in Christopher Miller, et al. v. HCP & Company, et al. is summarized in this prior update. While the Delaware Supreme Court affirmed the Chancery Court’s decision, it did so on a notably different basis. The Chancery Court ruled that the implied covenant of good faith and fair dealing did not apply in this case in part because the operating agreement explicitly vested the board of managers with the “sole discretion” as to the manner in which a sale of the company was conducted. Based on that vesting of sole discretion, the Chancery Court found that implied covenant did not exist in the context of a sale of the company because the implied covenant “operates only in that narrow band of cases where the contract as a whole speaks sufficiently to suggest an obligation and point to a result, but does not speak directly enough to provide an explicit answer.” The Supreme Court, however, found that the mere vesting of such sole discretion did not relieve the board of its obligation to use that discretion consistently with the implied covenant in the absence of further language clarifying that such sole discretion could be exercised considering only those interests that the board desired or expressly disclaiming any obligation to consider the interests of any members or the company.
Finding that the implied covenant applied under the circumstances, the Supreme Court turned to the argument advanced by the plaintiffs, which was that implied covenant imposed a duty on the company’s board similar to Revlon duties applicable in the context of a sale of a Delaware corporation. Based on that limited argument, the Supreme Court agreed the disclaimer of fiduciary duties in the operating agreement precluded the application of Revlon duties through the implied covenant and affirmed dismissal of the defendants’ claims. The Supreme Court nonetheless noted that “there are aspects of the record here that arguably could have supported a more targeted claim of contractual impropriety, [but] the plaintiff did not attempt to advance targeted claims of that type below or before [the Supreme Court].”
The Supreme Court’s potential receptivity to different arguments from the plaintiffs also stands in contrast to the Chancery Court’s finding that the defendants’ actions did not frustrate the fruits of the bargain that the plaintiffs reasonably expected when they entered into the operating agreement. Noting various provisions of the operating agreement relating to drag along rights, the liquidation waterfall and the disclaimer of fiduciary duties, the Chancery Court emphasized the “cautious enterprise” of applying the implied covenant, which is a doctrine that is “rarely invoked successfully,” especially in the context where fiduciary duties are disclaimed implying “an agreement that losses should remain where they fall.” In addition to its greater willingness to find that the implied covenant applies, the Supreme Court also seemed to signal less hesitation than the Chancery Court to find that an assertion of a breach of the implied covenant could succeed (or at least survive a motion to dismiss).
Specifying obligations (or lack thereof) is critical. Unlike the Court of Chancery, the Supreme Court found that additional language beyond vesting “sole discretion” in the board to determine the manner for selling the company was necessary to eliminate the implied covenant of good faith and fair dealing in the sale context. The Supreme Court indicated that a provision further specifying that the board could “consider only such interests and factors as it desires, including its own interests” along with parallel language eliminating any duty to consider minority member interests could have been sufficient to eliminate the implied covenant rather than require the board to exercise its discretion in a manner consistent with the implied covenant. This is another reminder that when drafting operating agreements, it is critical to provide the maximum clarity on members’ and managers’ obligations (or lack thereof).
Criteria for satisfying the implied covenant in the sale context remain unclear. While implying that a viable claim for breach of the implied covenant of good faith and fair dealing might have existed, the Supreme Court did not, and did not need to, clarify which alleged fact or combination of facts “arguably” could have supported a successful claim. Based on the alleged facts from the complaint cited in the Chancery Court’s opinion, the implied covenant seemingly could require:
- An obligation not to take arbitrary or unreasonable actions intended to obstruct a higher sale price, similar to the application of the implied covenant in the context of certain earn-outs where the implied covenant exists.
- Actions short of those that would satisfy Revlon duties to seek to obtain at least a “fair” (if not maximum) price, which might not have been satisfied by the five-day period the board provided non-affiliated managers to find alternative buyers in the Trumpet case.
- An obligation for managers and officers to avoid communications with bidders not authorized by the board, such as unauthorized renewed negotiations with Trumpet’s buyer alleged to have occurred during the company’s sale process.
- Some combination of any or all of the foregoing.
Although the claimed breach of the implied covenant of good faith and fair dealing did not succeed in the Trumpet case, the Supreme Court’s decision raises the specter that a similar claim could successfully be asserted in the sale context where the governing operating agreement does not effectively directly answer the question of a how the sale process can or cannot be conducted and a plaintiff alleges yet undefined specific bad acts relating to the sale process that could breach the implied covenant. Managers of Delaware limited liability companies should take note that “sole discretion,” without further language, does not necessarily mean unfettered discretion. The courts therefore might scrutinize a sale process that does not maximize the sale price even in the absence of fiduciary duties, albeit at some level short of the enhanced scrutiny applicable in the corporate Revlon context.