Chancery Defines Good Faith for Purposes of Contract Law

Policemen’s Annuity and Benefit Fund of Chicago v. DV Realty Advisors LLC, C.A. No. 7204-VCN (Del. Ch. Aug. 16, 2012).

Issue Addressed: How to define “good faith” for purposes of a limited partnership agreement that required a good faith determination for removal of a general partner.
Short Answer: The Court compared the common law definitions of good faith in the fiduciary context as compared to contract law, and also referred to the definition in the Uniform Commercial Code.  See Slip op. at 33 and 34, and footnote 101.

Background

This Delaware Court of Chancery opinion involved the governing document of a limited partnership which was styled as the Third Amended and Restated Agreement of Limited Partnership (the “LPA”).  The LPA provided a mechanism by which the limited partners could remove the two co-general partners without cause.  The limited partners in this case sought a declaration that their removal of the managing partner/general partner was valid.

Legal Analysis

The Court begins its analysis by observing that in a declaratory judgment action, the plaintiff has the burden of proof.  The Court collects and discusses a useful number of important cases involving those situations when the Court will impose an implied obligation of reasonableness to temper the discretion that an agreement may give to a party to make a decision or perform an action pursuant to the terms of an agreement–when that discretion is not already clearly defined.  See Slip op. at 28 to 31.

The parts of this 56-page opinion that are likely to be of the most wide-ranging interest for most readers, include the discussions regarding the common law definitions of good faith in the context of both contract law and fiduciary duty law.  See Slip op. at 33 to 34.

For purposes of contract law, the Court referred to the definition in the UCC found at 6 Del. C. Section 1-201(20), which applies to contracts involving “goods” and defines good faith as follows:  “Except as otherwise provided in Article 5 [which deals with letters of credit], [good faith] means honesty in fact and the observance of reasonable commercial standards of fair dealing.”  See Slip op. at 35.

In this case, the contract did not define good faith and thus the Court presumed that the parties intended to adopt the common law definition of good faith as applied to contracts, which the Court described as “primarily subjective, but there is likely some conduct which is so unreasonable that this Court will necessarily determine that it could not have been undertaken in good faith.  That may be because the common law definition of good faith as applied to contracts contains an objective element or it may be that, regardless of the evidence presented as to subjective intent, the Court will necessarily (almost always) find that certain conduct cannot possibly have been undertaken in good faith.  Articulating with precision what specific conduct will fall into this category is not possible.  Context matters – - what is utterly unreasonable in one setting may be perfectly acceptable in another.”  See footnote 105 and accompanying text. 

The Court found that the conduct of the limited partners in this case did not approach the sort of unreasonable conduct that is necessarily undertaken in bad faith.  The Court also recognized that some test is required and conduct must be analyzed under some rubric, and for that purpose the Court referred to the aforementioned UCC definition, which the limited partners in this case satisfied.

The Court described in extensive detail why it found that the limited partners satisfied the standard of good faith in their decision to remove the managing partner/general partner of the limited partnership without cause.  The Court explained that the continuous failure of the managing partner to provide the audited financial statements by the deadline required in the agreement was sufficient to provide the limited partners with a good faith belief that the managing partner/general partner needed to be removed for the best interest of the limited partnership.