The Implied Contractual Covenant of Good Faith and Fair Dealing Under the Delaware LLC Act
Steven D. Goldberg, Esq. Wilmington, DE
sgoldberg@stevendgoldberg.com
http://www.stevendgoldberg.com
Contact me if you need assistance in forming/organizing a Delaware business entity or any matter of Delaware law. Delaware Forms and Publications are available at http://www.delawarellclaw.com
Sections 18-1101 of the Delaware Act provides in (c) and (e) that under a company agreement that fiduciary duties of a member, manager or other person bound by the agreement “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.” (emphasis added) In this post I will not address what fiduciary duties may exist or whether in fact there are default fiduciary duties, that must wait for another post. As a result of conflicting decisions out of the Court of Chancery the question of whether there are default fiduciary duties is not yet settled, though I have my personal beliefs where the outcome should lie. You should understand that in this context when the courts speak about “fiduciary duties” in a LLC they are referring to the “duty of loyalty.” This post will be limited to the meaning of the implied contractual obligation of good faith and fair dealing.
Subsection (a) of 18-1101 states “The rule that statutes in derogation of the common law are to be strictly construed shall have no application to this chapter” and (b) states “It is the policy of this chapter to give the maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements.”
It was not casually that the Delaware Legislature selected the terms “implied contractual covenant”. By using those terms the Legislature was instructing the Courts that the must look to contract law and not corporate law in analyzing the relationship among the members and other bound by the agreement. The use of the terms emphasizes that corporate concepts of “good faith” and “fair dealing” are in apposite and as is review under the corporate concept of “entire fairness”.
The implied contractual covenant of good faith and fair dealing (the “contractual covenant”) is well understood in Delaware jurisprudence. The contractual covenant applies only to performance and enforcement after the contract has been formed and not to pre-contract negotiations. The Restatement (Second) of Contracts, Sec. 205 (1981) provides “Every contract imposes upon each party a duty of good faith and fair dealing in its performance and enforcement.” “The phrase good faith is used in a variety of contexts, and its meaning varies somewhat with [its use]. Good faith performance or enforcement of a contract emphasizes faithfulness to an agreed common purpose and consistency with the justified expectations of the other party, it excludes a variety of types of conduct characterized as involving ‘bad faith’ because they violate the community standards of decency, fairness or reasonableness.”
The implied contractual covenant of good faith and fair dealing establishes a minimum floor of conduct which cannot be waived by the parties. However in at least one occasion the Delaware courts have refused to over ride an express contractual term on that basis reasoning that the “implied” duty will not come into play if the subject is expressly covered by the contract.
Numerous Delaware cases have filled in the missing terms in a contract to determine exactly what is the contractual covenant in a specific transaction. Courts look at the language used by the parties and from there the courts extrapolate the “probable intent” of the parties from that language. The Court of Chancery has stated that in determining whether the contractual covenant has been breached “requires a court to extrapolate the ‘spirit’ of the contract from its express terms, and ‘determine the terms the parties would have bargained for to govern the dispute had they foreseen the circumstances under which their dispute arose.'”
Just what is “good faith and fair dealing”? Delaware courts which have addressed the contractual covenant have developed concepts of interpretation however they have not established one bright line rule. Courts look for culpability and intent in determining whether the line has been crossed. Courts have precluded parties from “arbitrary or unreasonable conduct which has the effect of preventing the other party to the contract from receiving the fruits of the contract.” It has been held that the contractual covenant will “prevent one party from unfairly taking advantage of the other party”, additionally the contractual covenant “requires a party to avoid hindering or preventing the other party’s performance.”
Thus, the implied contractual covenant of good faith and fair dealing requires conduct by the parties in the enforcement and performance of the contract which “excludes a variety of types of conduct characterized as involving ‘bad faith’ because they violate the community standards of decency, fairness or reasonableness,” “arbitrary or unreasonable conduct,” and conduct which would “prevent one party from unfairly taking advantage of the other party”.
I have an active Delaware business practice as well as a practice in Delaware’s State and Federal courts. If you or your client have a business matter or a matter which you wish to litigate in Delaware or has a matter pending in Delaware, we would appreciate the opportunity to consult with you regarding our representation. Please remember that we do not accept representation without a written engagement letter.
