October 22, 2018

October 19, 2018

Subscribe to Latest Legal News and Analysis

Court of Chancery Holds There Must be a Gap in Agreement for an Implied Covenant of Good Faith and Fair Dealing

In Christopher Miller, et al., v. HCP & Company, et al., memorandum opinion 180201, the Court of Chancery granted a motion to dismiss because the underlying Limited Liability Company Agreement did not contain a “gap” for an implied covenant of good faith and fair dealing to fill. Rather, the Court of Chancery held that the Limited Liability Company Agreement contained negotiated investor favorable provisions regarding good faith and fair dealing, thus undercutting any argument that the Court of Chancery should read an implied covenant into the operating agreement.

Trumpet Search, LLC (the “Company”) had various members invested in differing classes of units that each had unique payment rights under the operating agreement’s waterfall provision. For example, Class E unitholders received a first in line payment of 200% of the holder’s investment. Similarly, the Class D unitholders were entitled to a 200% payment after the Class E unitholder’s payment. One group of investors held the majority of Class E and Class D units through a number of separate entities (the “HCP Entities”). The HCP Entities held 78.5% of the Class E units representing a capital investment of $1,963,354 and 87.7% of the Class D units representing a capital investment of $12,000,000, meaning the HCP Entities were entitled to the first $27,926,708 of any sale.

Under the operating agreement, the HCP Entities were entitled to appoint a majority of the Company’s board. The Limited Liability Company Agreement also gave the Company’s board sole discretion as to the manner of any sale, except that the sale had to be to an unaffiliated third party. Further, all of the members of the Company waived all fiduciary duties to one another and from the managers to the members.

The HCP Entities initially championed a sale of the Company to an unaffiliated third party for a purchase price of $31,000,000. However, other unitholders felt this offer undervalued the Company by a significant margin. Ultimately, the Company was able to increase the offer to $43,000,000. Even with the increase in purchase price some unitholders were unhappy with the sale because the HCP Entities received the lion’s share of the purchase price.

Some of the unhappy unitholders (the “Plaintiffs”) brought a lawsuit against the HCP Entities (the “Defendants”) claiming the Defendants breached an implied covenant of good faith and fair dealing, along with various derivative claims stemming from the alleged breach. Plaintiffs argued that even though Defendants eschewed their fiduciary duties via the Limited Liability Company Agreement the Court of Chancery should nonetheless read an implied covenant of good faith and fair dealing into the operating agreement. Then based on Defendants’ duties under the implied covenants the Defendants should have held an open-market process to determine a fair price for all the unitholders of the Company.

The Defendants contended that the Company’s Limited Liability Company Agreement explicitly addressed the issues of fiduciary duties and also how the Company could be sold. They argued that because the Limited Liability Company Agreement had language waiving fiduciary duties and also detailing that the board had sole discretion in determining the manner in which the Company was sold, as long as it was to an unaffiliated third party, the Court of Chancery should not replace the parties’ negotiated bargain with an implied covenant.

The Court of Chancery found the Defendants’ arguments compelling. The Delaware Limited Liability Company Act allows for members or managers to waive fiduciary duties that would otherwise restrict certain behavior. This reflects Delaware’s policy of giving maximum effect to the principle of the freedom to contract. However, in this case the Court of Chancery found that the Company Limited Liability Company Agreement directly addressed the issued raised by the Plaintiffs. Therefore, the Court of Chancery held that there was no “gap” for an implied covenant to fill. The Court of Chancery highlighted that parties have the “right to enter into good and bad contracts; the law enforces both.”

Christopher Miller, et al., v. HCP & Company, et al., memorandum opinion 180201

Copyright 2018 K & L Gates

TRENDING LEGAL ANALYSIS


About this Author

Scott Waxman, Limited Liability Companies, Corporate, Attorney, KL Gates Law FIrm
Administrative Partner

Scott Waxman is a founding partner in the firm’s Wilmington, Delaware office and a member of the firm’s global Management Committee. His practice focuses on organizational and operational issues related to limited liability companies, limited and general partnerships, statutory trusts, and special purpose corporations, as well as general commercial and financial transactions, including structured financings, securitizations, mergers and acquisitions, joint ventures, private equity and hedge funds, preferred securities transactions, insurance premium financing transactions, life settlement...

302-416-7070
Douglas A. Logan, KL Gates, Chancery Arbitration Lawyer, Corporate Litigation Attorney
Associate

Douglas Logan is an associate in the firm’s Seattle office.

Mr. Logan was previously a judicial extern to the Honorable Ricardo S. Martinez of the United States District Court for the Western District of Washington. He was also a K&L Gates summer associate in 2014. Prior to law school, Mr. Logan worked for the Department of Justice Antitrust Division as a paralegal specialist in Washington, D.C.

206-370-8096