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.”

Delaware Usury Rate and Post-Judgment Interest Rate Examined

Sequoia Presidential Yacht Group LLC v. FE Partners, LLC, C.A. No. 8270-VCG (Del. Ch. June 12, 2014).

Issue Addressed:  This letter ruling provides a useful review of the Delaware Usury Statute relating to the maximum interest rate permitted by law to be charged by a lender, as well as the maximum rate that may be charged by an unlicensed lender.  This Delaware Court of Chancery ruling also examines whether post-judgment interest rates are controlled by the statutory rate when it is different than the contractual rate of interest agreed to by the parties.  The court concludes in this decision that the contract between the parties in which they lawfully agreed to a post-judgment interest rate will control, as opposed to the statutory rate of post-judgment interest.

Prior Chancery decisions in this case were highlighted on these pages.

Supreme Court Reinstates Arbitration Award; Reverses Chancery

SPX Corp. v. Garda USA, Inc., Del. Supr., No. 332, 2013 (June 16, 2014).

Issue Presented: Whether the standard of ”manifest disregard of the law” was met such that an arbitration award should be vacated? Answer: Not in this case. Thus, a rare reversal of the Court of Chancery by this en banc panel of the Delaware Supreme Court, reinstated the arbitration award that Chancery had vacated.

Highlights

This succinct and compact opinion from Delaware’s high court reasoned that the arbitrator, in this post-closing purchase price adjustment dispute, interpreted the relevant contract provisions in a manner that may have been wrong, but it “was not without a basis in the contract and the parties’ submissions.” Therefore, under the “manifest disregard” standard, the award was not subject to vacatur.

The court observed that the review of an arbitration award is “one of the narrowest standards of judicial review in all of American jurisprudence.” See fn. 15. The court explained that: “As long as the arbitrator is even arguably construing or applying the contract and acting within the scope of his authority, that a court is convinced that he committed serious error does not suffice to overturn his decision.” See fn. 23.

The Delaware Arbitration Act at Section 5714 tracks the Federal Arbitration Act at Section 10(a)(4), and the Delaware courts often follow the federal cases construing the similar provision. The high threshold was not met in this case because the court found that there was a difference in interpretation of the contract as opposed to a refusal to apply a known principle.

Supreme Court Affirms Oral Resignation of Director

Biolase, Inc. v. Oracle Partners, L.P., Del. Supr., No. 270, 2014 (Del. Ch. June 12, 2014).

Issue Addressed:  Whether a director may resign by an oral statement alone, pursuant to DGCL Section 141(b).  Answer:  Yes.

Highlights
This decision is the result of an expedited appeal based on an expedited Chancery proceeding to determine the valid composition of the board of directors of Biolase, Inc. pursuant to 8 Del. C. § 225.

The key background facts include a board meeting that was held by telephone during which, as planned previously, two of the directors resigned orally.  Later that same day, the CEO was surprised to learn that the two new directors who took the place of the resigning directors were aligned with a faction that sought his ouster, and at that point the CEO began to question the validity of the oral resignation.

There were a few “problem facts” for the challengers of the oral resignation. For example, a Form 8-K that was filed with the SEC  stated, in essence, that the oral resignations were not effective–but one problem with that Form 8-K was that a press release was attached which stated, inconsistently, that the two board members had resigned. The Court of Chancery determined that one of the two oral resignations was effective.

Key Issues Addressed:  (1)  Whether DGCL Section 141(b) is a permissive statute that does not require a director to resign in writing; and (2) Whether the Court of Chancery abused its discretion by denying Oracle an award of attorneys’ fees even though Oracle never made the argument seeking the fee award in its trial briefs or post-trial arguments.

Highlights:

The court upheld the reasoning of the trial court even though the standard of review for legal determinations, including the interpretation of a statute, is de novo.

The statutory provision in Section 141(b) that “any director may resign at any time upon notice given in writing or by electronic transmission to the corporation,” was interpreted as permissive and not requiring written notification.  The court cited to a long list of prior decisions in which oral resignations were recognized.  See footnote 8.

One of the unsuccessful arguments was that because two directors were appointed to fill one vacancy, there was no logical way to determine which of the two directors the board intended to fill the one vacancy.  However, the Delaware Supreme Court determined that the trial court used an orderly and deductive reasoning process to determine that, based on the draft minutes of the board meeting, the vacancy was filled in the order that the names appeared in the minutes.

Lastly, regarding the issue of attorneys’ fees, the Delaware Supreme Court determined that the claim for attorneys’ fees needed to be included in pre-trial briefs and in post-trial arguments. Because the argument for attorneys’ fees was not included in the pre-trial or post-trial briefs, the argument was waived.  See footnote 16.  The court also rejected the supplemental argument that the issue of awarding attorneys’ fees should be done in piecemeal fashion and only addressed after the entry of a final judgment.

It remains noteworthy to mention that this expedited appeal, including this final written opinion from the Supreme Court, all transpired within a few short weeks.

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The Chancery decision appealed from was highlighted on these pages here.

Forum Selection Clauses in Bylaws

The Harvard Law School Corporate Governance Blog has a helpful post that collects court decisions outside of Delaware that have upheld forum selection clauses in corporate bylaws. Of course, we know that they have been upheld already in Delaware. The post also provides data on the increasing number of public companies that are including these provisions in their bylaws.

Chancery Reforms Contract to Insert Missing Terms

Miller v. National Land Partners, LLC, C.A. No. 7977-VCG (Del. Ch. June. 11, 2014).

The Delaware Court of Chancery explains in this 42-page opinion why it granted reformation of a contract in order to insert terms that the Court found the parties intended to include in their written document, but which they inadvertently left out. The controlling legal standard was described in the opinion as follows:

This Court may reform a contract when a ‘written instrument fails to express the [parties'] real agreement or transaction.’ To achieve reformation, the movant must demonstrate either mutual mistake of the contracting parties, or a unilateral mistake by one contracting party and knowing silence by the other. In cases of mutual mistake, the movant must demonstrate, by clear and convincing evidence, that ‘the parties’ actual (oral) agreement was not accurately reflected in their executed written contract.’ To satisfy this burden, the movant ‘must persuade the Court of the precise, orally-agreed-to terms that it seeks to have judicially inserted into the contract.’ (footnotes 109-112 omitted).

This case exemplifies why the outcome of cases like these are not predictable even when the law is clear, because how the law is applied will depend on which witness(es) the court finds credible–or not, and which facts the court will find to be determinative.

Supreme Court Disallows Award of Fees in the Absence of Final Judgment

Crothall v. Zimmerman, C.A. No. 608, 2013 (Del. Ch. June 9, 2014).

This Delaware Supreme Court decision features a rare reversal of the Court of Chancery, and determined that the award of attorneys’ fees was improvidently granted because there was no corporate benefit in this derivative action.  There was no corporate benefit, the Delaware high court reasoned, because there was no final judgment.  Prior to a final judgment, the derivative plaintiff sold his shares, which led to the dismissal of the case.  This situation should be distinguished from other cases where the defendant took action to make the case moot before a prior judgment.  The Court of Chancery allowed the attorney for the former plaintiff to intervene in order to seek counsel fees.

However, the Supreme Court noted that, although it did not directly rule on the intervention, it was “odd” and “troubling” to permit a lawyer in a representative action to recover from the company in circumstances where the stockholder rendered his claim moot.

The rule announced in this decision that can be applied to future cases is that:  “A plaintiff who generates a favorable trial court decision on a closely contested issue of corporate governance but then abandons his claim, and renders the decision moot before it becomes final, has not created a corporate benefit, he has merely caused uncertainty.”

The reasoning of the court is that no corporate benefit was created because any benefit that might have been possible by continuing the suit to a final, appealable judgment, disappeared when the derivative plaintiff abandoned his lawsuit.  Therefore the former attorney for that plaintiff was not entitled to any fee award.  Nor did that counsel identify any cases in Delaware which held that a plaintiff’s attorneys are entitled to fees for creating a corporate benefit when the plaintiff (as opposed to the defendant) took action that mooted the claims, caused their dismissal, and prevented the entry of a final judgment.

See prior Chancery decisions summarized on this blog in this matter.

 

Supreme Court Addresses Rules for Confession of Judgment

Zimmerman v. Customers Bank, Del. Super., No. 668, 2013 (June 10, 2014).

This Delaware Supreme Court decision addresses the rules for confession of judgment in Delaware.  The Court determined that the requirement for an affidavit in Rule 58.1, is not needed to confess judgment against a non-resident after a hearing before the Superior Court based on Superior Court Rule 58.2.  See also 10 Del.C. § 2306(c).

 

Delaware Supreme Court Declines Appeal on Maintaining Confidentiality of Pleadings

Al Jazeera America, LLC v. AT&T Services, Inc., Del. Supr., No. 600, 2013, appeal dismissed (May 30, 2014). The Delaware Supreme Court in this short Order dismissed a pending interlocutory appeal on the issue of what documents filed with the court may be withheld from the public based on the confidentiality provisions and conditions in Court of Chancery Rule 5.1. The decision was promptly by a reported settlement of the underlying litigation between the parties, but the dispute is not finished.

On June 5, 2014, the Court of Chancery, as a follow up to the Supreme Court’s Order, allowed for a stay of the implementation of its earlier decision requiring disclosure of the pleadings already filed, pending its ruling on an anticipated motion by Al Jazeera to expunge the record in light of the settlement that the parties expect to finalize soon.

The Court of Chancery now must decide if its prior decision to require disclosure of most of the contents of the prior filings in this contractual dispute between the parties should be implemented in light of the settlement–or if the disclosure of pleadings already filed should be required despite the recent settlement. Frank Reynolds of Thomson Reuters provides a helpful overview of the case.

The Chancery decision and related developments in this case were highlighted on these pages.

Fiduciary Discretion

Professor Gordon Smith has co-authored an article on “Fiduciary Discretion” that addresses, for example, the gaps in contracts in which fiduciary duties apply. The good professor has a post about it that includes the following introduction to the article:

Discretion is an important feature of all contractual relationships. In this Article, we rely on incomplete contract theory to motivate our study of discretion, with particular attention to fiduciary relationships. We make two contributions to the substantial literature on fiduciary law. First, we describe the role of fiduciary law as “boundary enforcement,” and we urge courts to honor the appropriate exercise of discretion by fiduciaries, even when the beneficiary or the judge might perceive a preferable action after the fact. Second, we answer the question, how should a court define the boundaries of fiduciary discretion? We observe that courts often define these boundaries by reference to industry customs and social norms. We also defend this as the most sensible and coherent approach to boundary enforcement.

This is practical scholarship that has practical applicability especially for agreements governing alternative entities in which fiduciary duties apply by default unless expressly waived. The formal citation for the article is: D. Gordon Smith & Jordan C. Lee, Fiduciary Discretion, 75 Ohio St. L. J. 609 (2014)