Delaware Court of Chancery Confirms That The Implied Covenant of Good Faith and Fair Dealing is Not a Substitute For Fiduciary Duties

Steven D. Goldberg, Esq.
Wilmington, DE
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On October 11, 2010, Vice Chancellor Laster of the Delaware Court of Chancery handed down an important case dealing with the Implied Covenant of Good Faith and Fair Dealing. Lonergan v. EPR Holdings LLC, et al.Opinion ].  The case involved a LP agreement which eliminated all fiduciary duties as permitted under 17-1101 of the Delaware Revised Uniform Limited Partnership Act (DRULPA).  Section 17-1101 is identical to 18-1101 of the Delaware Limited Liability Company Act so that this decision will have equal application for LLC’s. The Plaintiff recognizing that they had no claim for violating fiduciary duties attempted to characterize the claim as a breach if the implied covenant. The Court held that the implied covenant is not a substitute for fiduciary duties and declined to substitute the Court’s judgment for the parties to create a basis for a breach of implied duty claim.

The limited partnership is a publicly traded master limited partnership (mlp). Two sections of the agreement eliminate fiduciary duties (not just reduce or modify the duties).

Section 7.9(e) provides: 
Except as expressly set forth in this Agreement, neither [Holdings GP] nor any other Indemnitee shall have any duties or liabilities, including fiduciary duties, to the Partnership or any Limited Partner and the provisions of this Agreement, to the extent that they restrict or otherwise modify the duties and liabilities, including fiduciary duties, of [Holdings GP] or any other Indemnitee otherwise existing at law or in equity, are agreed by the Partners to replace such other duties and liabilities of [Holdings GP] or such other Indemnitee
Section 7.10(d) provides:
Any standard of care and duty imposed by this Agreement or under the Delaware Act or any applicable law, rule or regulation shall be modified, waived or limited, to the extent permitted by law, as required to permit [Holdings GP] to act under this Agreement and to make any decision pursuant to the authority prescribed in this Agreement, so long as such action is reasonably believed by [Holdings GP] to be in, or not inconsistent with, the best interests of [Holdings].

When Section 17-1101(d) [which is identical to 18-1101(d)] was drafted the drafting committee was careful to make sure that Delaware law was not subverted in a way that removed all protections from member but also in a way that does not create an alternative form of fiduciary duty. The drafting committee included in the section the phrase “provided that the partnership agreement may not eliminate the implied contractual covenant of good faith and fair dealing.” The use of the terms “contractual covenant” were carefully selected to differentiate the concept of good faith and fair dealing from any equitable concept of fiduciary duties. At the time that 1101(d) was being drafted the Court of Chancery was using corporate concepts to interpret LP and LLC law. The drafters wanted to clearly differentiate contractual terms from equitable concepts of fiduciary duties.

In defining the implied covenant the Court stated:

The implied covenant is not a substitute for fiduciary duty analysis. “The covenant is ‘best understood as a way of implying terms in the agreement’ . . . . Existing contract terms control, however, such that implied good faith cannot be used to circumvent the parties’ bargain, or to create a free-floating duty unattached to the underlying legal documents.”…The Court must focus on “what the parties likely would have done if they had considered the issues involved.” … It must be “clear from what was expressly agreed upon that the parties who negotiated the express
terms of the contract would have agreed to proscribe the act later complained of . . . had they thought to negotiate with respect to that matter.” “The doctrine thus 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.” [Citations omitted].

The Court further stated:
Respecting the elimination of fiduciary duties requires that courts not bend an alternative and less powerful tool into a fiduciary substitute. The nature of the implied covenant of good faith and fair dealing is “quite different from the congeries of duties that are assumed by a fiduciary.” … “Delaware’s implied duty of good faith and fair dealing is not an equitable remedy for rebalancing economic
interests after events that could have been anticipated, but were not . . . .”…To use the implied covenant to replicate fiduciary review “would vitiate the limited reach of the concept of the implied duty of good faith and fair dealing.” … To the extent the complaint seeks to re-introduce fiduciary review through the backdoor
of the implied covenant, it fails to state a colorable claim.

The Court declined to substitute its own analysis for the missing term thereby giving full effect to the elimination of fiduciary duties. This case has well defined the difference between fiduciary duties and the implied covenant. The result of this case is to provide additional certainty to the drafters of Delaware LLC and LP agreements. This certainty of outcome is a keystone of Delaware entity law.

In his decision Vice Chancellor Laster also reviewed the duties that a corporate officer has to the stockholders in a merger transaction. This case will also serve as a starting point for future analysis of corporate duties.

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