Supreme Court Underscores Non-Waivable Contractual Duty of Good Faith and Fair Dealing Regardless of Presumptions in Agreement

Gerber v. Enterprise Products Holdings, LLC, Del. Supr., No. 46, 2012 (June 10, 2013).

Issue Presented:  This seminal Delaware Supreme Court decision addresses the important, nuanced issue of whether a contract provision that presumes good faith can preclude a claim for a breach of the implied covenant of good faith and fair dealing.

Short Answer:  No. The concept of good faith described in the agreement in this case is different from the concept found in the statutorily implied covenant of good faith and fair dealing.  The contractual waiver in an LP agreement of the fiduciary duty of good faith, and the substitute of a new contractual definition for good faith, is not consistent with the same concept of good faith contained in the implied covenant.

Practice Note: This Delaware Supreme Court opinion needs to be distinguished from a recent Delaware Supreme Court decision in Brinckerhoff v. Enbridge Energy Company, Inc., a decision of last month highlighted on these pages here, which also dealt with a presumption of good faith in a limited partnership agreement, but importantly, the Delaware high court in that decision did not address the effectiveness of that conclusive presumption because the ruling relied on a separate holding that the complaint failed to allege facts suggesting bad faith.

Therefore, it remains noteworthy that this is the first Delaware Supreme Court decision that directly addresses the important, nuanced aspect of the presumption of good faith in limited partnership agreements to the extent it compares that contractual presumption, specifically, with the implied covenant of good faith and fair dealing.  Recent Chancery decisions involving similar issues might need to be revisited in light of this opinion.

Background

The first ten-pages or so of the opinion refer to the labrynthine transactions involving multiple related entities.  In order for the focus of this short overview to remain on the legal principles announced, I will not belabor the confusing overlapping entities which Delaware’s high court used three separate charts to outline in order to avoid confusion.

In addition, there is a related case that the court refers to as Gerber I, reported at Gerber v. EPE Holdings, LLC, 2011 WL 4538087 (Del. Ch. Sept. 29, 2011).  The Chancery decision that was appealed from in this case is styled as Gerber v. Enterprise Products Holdings, LLC, 2012 WL 34442 (Del. Ch. Jan. 6, 2012) (“Gerber II”).

Claims Made

The complaint in this case alleged breaches of express contractual duties, as well as the implied covenant of good faith and fair dealing, and tortious interference.  In a January 2012 decision, the Court of Chancery granted a motion to dismiss.

Applicable Statute and Contract Terms

The Court of Chancery relied on Section 17-1101(d) of the Delaware Revised Uniform Limited Partnership Act (DRULPA), that allows for a general partner’s duties, including fiduciary duties, to be expanded or restricted or eliminated except that the agreement may not eliminate the implied contractual covenant of good faith and fair dealing.  The Vice Chancellor determined that Section 1101(d) was used in the partnership agreement to supplant the fiduciary duties to which the general partner and other fiduciaries would have been subject.  The agreement expressly provided for the conduct to be in good faith, which was defined as a “belief that the determination or other action is in the best interest of the partnership.”

The partnership agreement also created two separate layers of protection to insulate from judicial review whether the contractual duty was satisfied.  The first layer covered conflict of interest transactions and provided safe harbors.

The second layer of insulation from judicial review was afforded by Section 7.10(b), which was not limited to conflict of interest transactions and created “a conclusive presumption” that the general partner did act in good faith when enumerated conditions were satisfied.  Those conditions included relying on opinions of experts, and such reliance would be conclusively presumed to have been done in good faith.

Trial Court Ruling
The Court of Chancery determined that the defendants had satisfied the conditions in the agreement that provided insulation from claims, and held that the presumption of good faith protected those who were parties to the agreement.

The trial court also held that the implied covenant claim only bound the parties to the partnership contract.

Supreme Court Analysis

The Delaware Supreme Court found fault with that aspect of the Chancery opinion that determined that Morgan Stanley had opined on the fairness of the 2009 Sale, but Delaware’s high court read Morgan Stanley’s opinion to refer to the total consideration for a combined 2009 Sale as well as a separate sale, as opposed to the consideration allocable to the 2009 Sale only.

Delaware’s high court distinguished its recent opinion in Norton v. K-Sea Transportation Partners LP, highlighted here on these pages, because in that case the banker’s opinion indirectly addressed the fairness of consideration at issue and the plaintiffs conceded fair consideration.  In contrast, the Morgan Stanley 2009 opinion in this case did not address the consideration that the limited partners received in the 2009 Sale separately, but instead addressed two separate transactions together as a whole.  See footnote 29.

At footnote 31, Delaware’s high court explains why it rejected the reasoning of the Court of Chancery in its dismissal of the claim based on a breach of the implied covenant of good faith and fair dealing in connection with Section 17-1101(d).

Supreme Court Approach to the Core Issues

The Supreme Court distilled the plethora of legal disputes and focused on two core issues as being dispositive of the appeal.  The first is whether the claims of liability are precluded by the “conclusive presumption of good faith” in Section 7.10(b) of the agreement.  If that section does not bar a claim under the implied covenant, then that provision does not preclude judicial review.

Because the Delaware Supreme Court determined that the “conclusive presumption” does not bar those claims, the second issue was described as follows:  whether the complaint adequately pled the breach of the implied covenant of good faith and fair dealing.  The Delaware Supreme Court concluded independently that both the 2009 Sale and the 2010 Merger were subject to a well pled breach of the implied covenant.

Due to the Supreme Court finding that the foregoing claims should not have been dismissed, on remand a third set of issues that the trial court did not raise were ordered to be addressed on remand:  which defendants, if any, other than the general partner are subject to secondary liability for tortious interference or for aiding and abetting a breach of contract.

Standard of Review

The standard of review on appeal of the dismissal of a complaint under Court of Chancery Rule 12(b)(6) is de novo.

Appellate Reasoning

The opinion explained why the presumption of good faith in the agreement did not bar a claim for breach of the implied covenant of good faith and fair dealing.

The high court found that the:

“flaw in the [trial] court’s reasoning stems from a decision by the LPA’s drafters to define a contractual fiduciary duty in terms of “good faith” – - a term that is also and separately a component of the “implied covenant of good faith and fair dealing.”

Although that term is common, the LPA’s contractual fiduciary duty describes a concept of “good faith” very different from the good faith addressed by the implied covenant.

The court adopted the explanation in a separate Chancery ruling that explained the difference between the common law fiduciary duty concept or a contractual fiduciary duty concept, as it differs from the implied covenant of good faith and fair dealing.  See Slip op. at 32-34 and footnote 47.  The block quote of almost two pages explains the importance of the temporal distinction between the contractual fiduciary duty and the implied covenant.

The focus of a fiduciary duty analysis is the action at the time that the wrong took place.  By contrast, the focus of an analysis under the implied covenant, is what the intent of the parties was at the time that the contract was formed, which is often many years prior to the alleged wrong.  See footnote 48.

Footnote 48 also explains that a contractual provision of any type could never properly eliminate the implied covenant, contrary to what was implied by the Court of Chancery in this matter.  The Supreme Court emphasized that there could be no elimination of the implied covenant, even on a de facto basis through a conclusive presumption, and nothing in the Supreme Court’s opinion of Nemec v. Shrader should be interpreted differently.

The high court provided several hypothetical examples of why the implied covenant cannot be “contracted away,” and that no provision in an agreement could bar a claim for arbitrary and unreasonable use of discretion that would be a breach of the implied covenant.

The high court did note, however, that it is well settled in Delaware that the implied covenant cannot apply to non-parties to a contract.  See footnote 53.

The high court also held that an implied covenant claim can still be stated even where, as here, the defendant allegedly attempted to satisfy its contractual obligations, within a conclusive presumption provision, by relying on a fairness opinion that did not value the consideration that was actually received by the LP unitholders.

In this case, the court reasoned that it could “confidently conclude” that had the parties addressed the issue at the time of contracting, they would have agreed that any fairness opinion must address whether the consideration actually received was fair in order to satisfy the contractually defined duty, which was the good faith component of the contractual fiduciary duty defined in Section 7.9(b).  The court reasoned that relying on an unresponsive fairness opinion to engage in a manifestly unfair transaction in a manner that would be conclusively presumed to satisfy a contractual standard, is “the type of arbitrary, unreasonable conduct that the implied covenant prohibits.”  (Compare: Norton v. K-Sea Transportation Partners L.P. which did not involve claims that the fairness opinion did not state that the merger was fair, nor did that plaintiff allege that the fairness opinion was flawed.)

The court also reasoned that the implied covenant supported the view that the parties:

“would certainly have agreed, at the time of contracting, that any fairness opinion contemplated by that provision [Section 7.10(b)] would address the value of derivative claims where (as here) terminating those claims was a principal purpose of a merger.  Therefore, Gerber has sufficiently pled that Enterprise Products GP breached the implied covenant in the course of taking advantage of Section 7.10(b)’s conclusive presumption.”

The court also independently determined, based on the allegations in the complaint, that in connection with the 2010 Merger, although the agreement does not expressly forbid the general partner from acting in the way that it did when effecting a merger, the court reasoned that it “is reasonably inferable that, had the parties focused on that question at the time of contracting, they would have proscribed such conduct.”  Thus, the court remanded.