Delaware Court of Chancery Examines Nuances of Implied Covenant of Good Faith

In re: El Paso Pipeline Partners, L.P. Derivative Litigation, C.A. No. 7141-VCL (Del. Ch. June 12, 2014).

Key Issue Addressed:  This Delaware Court of Chancery opinion examines in 51-pages the nuances of the implied covenant of good faith in the context of claims made in connection with a challenged transaction involving limited partnerships, as well as related principles.

Although the copious factual background in the opinion is integral to a complete understanding of the reasoning of the court in this case, for present purposes, and for the most likely usefulness to the reader, I will highlight the legal principles, shorn of their factual adornments, that would have the most widespread applicability.

Highlights of Principles Recited in Opinion

● The court examined the subjective good faith contractual standard used in the Limited Partnership Agreement.  This opinion refers to prior Delaware decisions applying similar contractual standards of good faith – - as distinct from the implied covenant of good faith.

● The court explained that when analyzing the subjective belief of directors in connection with a subjective good faith contractual standard, the Delaware Supreme Court has stated that trial judges should not replace actual directors with hypothetical reasonable people.

● In this opinion, the Court of Chancery reasoned that “because science has not yet developed a reliable method of reading minds, objective facts are logically and legally relevant to the extent they permit inferences that the defendants lack the necessary subjective belief.” Slip op. at page 25.

● Citing to the Supreme Court decision in Encore Energy, 72 A.3d at 107, the Court of Chancery explained that some actions are so unreasonable they are inexplicable on grounds other than subjective bad faith.

● The court emphasized that contractually defined good faith standards are not the same as the standard of good faith in the implied covenant of good faith and fair dealing.  See footnotes 3 and 4.

● The court underscored that the implied covenant is a doctrine by which Delaware law “cautiously supplies implied terms to fill gaps in the expressed provisions of an agreement.  Contractual gaps always exist because human negotiators and drafters lack perfect foresight, operate with limited resources and practice their craft using the imprecise tool of language.”

● The court explained that “it would be impractical to raise, negotiate and address every conceivable situation in the express terms of even the most prolix agreement.”  See footnote 5.

● Gaps in agreements exist for several reasons.  For example, some aspects of a deal are so obvious, the parties do not feel a need to address them.  Other understandings or expectations between the parties are so fundamental that they did not need to be negotiated.

● Moreover:  “Precisely because gaps always exist, the implied covenant is a mandatory, non-waivable aspect of every contract governed by Delaware law.”  See footnotes 4 and 5.

Implied Covenant Analysis

● The first step in the analysis of the implied covenant is: “the process of contract construction, which is distinct from the process of contract interpretation.  Interpretation is the process by which a court resolves ambiguity in the express terms of a contract . . ..  By contrast, construction is the process by which a court determines the scope and legal effect of those terms.”

● The second step is:  “If a contractual gap exists, then the court must determine whether the implied covenant should be used to supply a term to fill the gap.  Not all gaps should be filled.”  See Slip op. at page 38.

● The court must determine whether the language of the contract expressly covers a particular issue, in which case the implied covenant will not apply, or whether the contract is silent on the subject, revealing a gap that the implied covenant might fill.  Id. at page 38.

● Examples of gaps that need to be filled and which may exist in a contract include the following:  (1) where the parties simply fail to perceive a need for the term and never considered to include it; (2) when the parties felt the issue was too unimportant or too remote to warrant negotiations or inclusion; and (3) the term was too obvious to articulate.

● The court explained that:  “Terms are to be implied in a contract not because they are reasonable but because they are necessarily involved in a contractual relationship so that the parties must have intended them and have only failed to express them because they are too obvious to need expression.”  Id. at page 40.

Comparison Between Implied Covenant and Fiduciary Duty

● The court emphasized that the implied covenant is not a substitute for fiduciary duty analysis.

● The limited partnership agreement in this case eliminated all fiduciary obligations.

● The court found that the implied covenant alone “cannot support a generalized duty to disclose all material information reasonably available.”