A recent Delaware Chancery Court opinion highlights the flexibility of alternative entities such as limited liability companies, the court’s focus on enforcing contracts as written, and the limited circumstances in which the implied covenant of good faith and fair dealing applies.
The case, Christopher Miller, et al. v. HCP & Company, et al., involves a dispute between the co-founder of Trumpet Search, a company offering clinical services to persons with autism and developmental disabilities, and entities affiliated with Trumpet’s private equity investor, HCP & Company, as well as managers appointed to Trumpet’s board of managers by HCP. Through various financings, the HCP entities collectively were the largest holder of membership units in Trumpet, including holding units with a “first-in-line” liquidation preference that entitled them to substantially all of the first $30 million of proceeds from any sale of Trumpet. The plaintiffs owned junior classes of units that required the liquidation preference of the Class E and Class D units to be satisfied before receiving any proceeds from a sale of the company. These junior classes of units, in turn, had a liquidation preference that would need to be satisfied before the HCP entities would share in any additional sale proceeds received above their liquidation preference. This capital structure created a situation in which it was beneficial to HCP to engage a transaction up to $30 million or at a much higher value in which it would receive additional proceeds after satisfaction of the junior liquidation preference, but HCP had no incentive to drive value from a sale in the range between $30 million and the higher valuation at which it would participate in receiving additional sale proceeds.
Less than a year after Trumpet’s applicable operating agreement was adopted, MTS Health Partners offered to purchase Trumpet for $31 million. After receiving MTS’ offer, the company’s board of managers chose not to run a fulsome sale process and gave the non-HCP affiliated managers little time to find other potential buyers. The limited sale process produced a letter of intent to purchase Trumpet for a price “in the $36 million range,” which caused MTS to increase its offer to $41 million, and an indication of interest that valued Trumpet between $50 million and $60 million. That indication of interest, however, apparently did not progress further and caused MTS to threaten suit against Trumpet for failing to comply with an obligation in the MTS letter of intent to “work in good faith to complete due diligence and execute definitive documentation.” MTS ultimately increased its offer to the final transaction price of approximately $43 million, which resulted in the plaintiffs receiving negligible or no consideration for their junior classes of units.
In connection with Trumpet’s Series E financing, the company’s members entered into an operating agreement that contains several standard provisions for private equity investments, including:
- Providing HCP the right to appoint a majority of managers of Trumpet’s board
- The members waiving all fiduciary duties with respect to each other and from the managers to the members
- A drag-along right allowing HCP to cause the members to sell their interests in connection with a sale of the company to an unaffiliated third party
The company’s operating agreement also provides that “the Board shall determine in its sole discretion the manner in which [a sale of all Trumpet membership units to an independent third party] shall occur.”
The plaintiffs alleged that the defendants breached the implied covenant of good faith and fair dealing by not conducting an auction or open-sale process in connection with the sale of Trumpet that might have maximized the company’s value for all members. The defendants moved to dismiss the plaintiffs’ claim for failure to state a claim.
In an opinion authored by Vice Chancellor Glasscock, the court’s analysis focused on the applicable rights and obligations under Trumpet’s operating agreement and the narrow circumstances in which the implied covenant of good faith and fair dealing applies. The court noted that the members waived any fiduciary duties of the managers, which otherwise would have applied if Trumpet was organized as a Delaware corporation and where the ability to waive fiduciary duties is much more limited. In the corporate context, the court would have reviewed the transaction with a heightened level of scrutiny under the entire fairness standard given the presence of a controlling equity holder that received greater consideration for its equity interests than the minority equity holders. However, in the absence of any fiduciary duty due to the operating agreement, the plaintiffs had to search for an alternative basis for their claim, which they attempted to find in the form of a breach of the implied covenant of good faith and fair dealing.
In analyzing the claim, the court highlighted that the amounts payable to the various classes of members, including the liquidation preferences of the Class D and Class E units, and the incentives that this capital structure created with respect to approving sales of the company at difference prices, were clear on the face of the operating agreement. Because an implied covenant must address “developments or contractual gaps that the asserting party pleads neither party anticipated” and the amount each class of units would receive was clear in the operating agreement, the court found that no gap existed or unanticipated development occurred for the implied covenant to apply. In fact, the provision providing that the Board would determine in its sole discretion the manner in which a sale would occur directly addressed who would control a sale process and how such a process could be conducted. The plaintiffs’ claim for breach of the implied covenant therefore failed.
The court further supported its decision by noting that “an alternative entity agreement that waives all fiduciary duties ‘implies an agreement that losses should remain where they fall.’” In the absence of any fiduciary duties, the court characterized plaintiffs’ claims as an attempt to “re-introduce fiduciary duty review” through the backdoor of the implied covenant of good faith and fair dealing. Although the implied covenant is an obligation that cannot be contractually eliminated under Delaware law, the court refused to open a backdoor for the plaintiffs’ claims when the contract clearly locked the front door by expressly disclaiming fiduciary duties.
Why It Matters
While the result in this case is not surprising based on the facts, the decision is a helpful reminder of the following aspects of Delaware law:
- Limited liability companies provide significant flexibility. Alternative entities like limited liability companies provide significant flexibility in structuring relationships among parties. The ability to disclaim fiduciary duties in the limited liability company context can drive differing results than if a corporate entity is involved.
- Specify members’ obligations to protect yourself. If the members of a limited liability company disclaim fiduciary duties, each holder needs to carefully consider what obligations each member and the company’s managers and officers should have and explicitly provide for those obligations in the applicable agreement among the members. Delaware courts will seek to enforce agreements as written, such as in this case when the operating agreement expressly provided the Board the discretion to determine the manner in which to sell the company. If the agreement provides certain rights to a person, Delaware courts will respect the grant of those rights.
- Implied covenant breaches will be scrutinized closely. Delaware courts will apply the implied covenant of good faith and fair dealing cautiously. Although the implied covenant cannot be contractually eliminated, it is rarely invoked successfully and requires more than an undesirable outcome for the party asserting the claim or a result that might seem unfair to a third party. The court was not willing to provide the plaintiffs protection that they had not bargained for in the absence of any deception or conduct that, although only in the best interests of the private equity firm, was not reasonably foreseeable. The importance of specifying parties’ obligations to each other as clearly as possible therefore is critical because the implied covenant will not be available as a general savings provision for circumstances or results that were foreseeable when an agreement was entered into.