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Implied Contractual Covenant of Good Faith and Fair Dealing - Kelly v. Blum, Kuroda v. SPJS Holdings, L.L.C. and Nemec v. Shrader

April 26, 2010

The implied contractual covenant of good faith and fair dealing is becoming more relevant in analyzing issues in the alternative entity context.  Three recent cases shed light on how courts are interpreting this very important concept.

In Kelly v. Blum, CA No. 4516-VCP (Del. Ch. Feb. 24, 2010), the Court of Chancery granted defendants' motion to dismiss a claim alleging breach of the implied contractual covenant of good faith and fair dealing.  Thomas Kelly and MBC Investment, L.P. ("MBC Investment") were investors in and members of Marconi Broadcasting Company, LLC, a Delaware limited liability company (the "LLC").  Within two years of the LLC's formation, additional members (all of whom were affiliated with MBC Investment) were admitted to the LLC in an attempt to increase the LLC's cash flow.  Pursuant to its limited liability company agreement (the "LLC Agreement"), the LLC was managed by its four managers, of which plaintiff Kelly was one.  The remaining three managers were affiliated with MBC Investment and its parent. 

The LLC Agreement precluded the LLC's entry into a merger without first obtaining the consent of the LLC's Class A Member or Managers and its Class C Member or Managers.  Kelly was none of these.  The Class A and Class C Members eventually approved and effected the merger of a newly formed entity with and into the LLC, pursuant to which Kelly ceased to be a member and manager of the LLC.  Soon thereafter, Kelly filed suit, claiming, inter alia, a breach of the implied covenant of good faith and fair dealing.

The court noted that the implied covenant applies to all contracts "and requires that contracting parties refrain from arbitrary or unreasonable conduct which has the effect of preventing the other party from receiving the fruits of the contract."  The court found that Kelly had not alleged the presence of a specific implied contractual obligation, how the defendants breached such implied obligation or what his damages were, each of which must be alleged to maintain a claim for a breach of the implied covenant of good faith and fair dealing.  Furthermore, the court found that the LLC Agreement specifically addressed the authority and role of the LLC's managers as well as "the ability of [the LLC] to enter into affiliated and self-interested transactions."  The court stated that a court's use of the implied covenant "should be rare."  The court therefore held that Kelly had no claim for breach of the implied covenant of good faith and fair dealing and granted defendants' motion to dismiss such claim. 

In Kuroda v. SPJS Holdings, L.L.C., CA No. 4030-CC (Del. Ch. Mar. 16, 2010), the Court of Chancery considered whether the implied covenant of good faith and fair dealing could be used to imply a confidentiality obligation under a limited liability company agreement.  Applying an analysis similar to the court in Kelly, the court refused to use the implied covenant to override the express terms of the limited liability company agreement.  "[R]ather than constituting a free floating duty imposed on a contracting party, the implied covenant can only be used conservatively 'to ensure the parties' "reasonable expectations" are fulfilled.'"

While not an alternative entity case, the Delaware Supreme Court recently addressed the implied covenant of good faith and fair dealing in the corporate context.  In Nemec v. Shrader, CA Nos. 3878 and 3934 (Del. 2010), a divided Delaware Supreme Court upheld a Court of Chancery decision granting defendants' motion to dismiss a claim for breach of the implied covenant of good faith and fair dealing brought against them.  Plaintiffs Joseph Nemec and Gerd Witkemper were former officers and stockholders of Booz, Allen & Hamilton Inc., a Delaware corporation ("Booz Allen").  As parties to the Booz Allen stock rights plan, Nemec and Witkemper could have required Booz Allen to purchase their Booz Allen stock at book value for a period of two years beginning at the time of their retirement from Booz Allen.  Subsequent to that two-year period, Booz Allen had the right to acquire Nemec's and Witkemper's stock at any time at book value.  Both Nemec and Witkemper retired from Booz Allen.  During the subsequent two-year period, Nemec did not require Booz Allen to purchase any of his stock; Witkemper retained some of his stock but required Booz Allen to purchase the remainder. 

During the two-year period following Nemec's and Witkemper's retirement, Booz Allen's board of directors decided to sell part of its business to a third party pursuant to a merger (the "Merger"), which the parties expected to occur prior to the expiration of Nemec's and Witkemper's put rights.  The Merger did not occur, however, until four months after their put rights expired.  Prior to the Merger closing, Booz Allen exercised its rights to acquire all of Nemec's and Witkemper's stock at book value, resulting in Nemec and Witkemper receiving $60 million less than they would have received had they retained their stock until the closing of the Merger.  Nemec and Witkemper filed suit alleging, inter alia, that Booz Allen breached the implied covenant of good faith and fair dealing contained in the Booz Allen stock rights plan by acquiring their stock, rather than allowing them to retain it until the Merger closed. 

In stating that the implied contractual covenant of good faith and fair dealing "only applies to developments that could not be anticipated [at the time the contract was made], not developments that the parties simply failed to consider," and "requires a party in a contractual relationship to refrain from arbitrary or unreasonable conduct which has the effect of preventing the other party to the contract from receiving the fruits of the bargain," the court held that Booz Allen had not breached the implied covenant contained in the Booz Allen stock rights plan.  A key issue was whether, at the time of contracting, Nemec and Witkemper had a reasonable expectation of participating in the Merger.  The court found no facts pled that would allow it to conclude that had the parties specifically contemplated the issue at hand at the time the contract was made, they would have agreed to allow Nemec and Witkemper to retain their stock until the Merger closed. 

In addressing the requirement that Booz Allen's exercise of its contractual rights must "further a legitimate interest of [Booz Allen]," the court found that while Booz Allen was not directly affected by the purchase of Nemec's and Witkemper's stock, failure to exercise its call rights may have subjected Booz Allen and its directors to a lawsuit by the remaining Booz Allen stockholders for favoring retired stockholders at the expense of working stockholders.  Similar to the courts in Kelly and Kuroda, the court stated that "the covenant is a limited and extraordinary remedy."  The court found that Nemec and Witkemper "got the benefit of their actual bargain," and therefore affirmed the Court of Chancery's dismissal of the plaintiffs' claim for breach of the implied covenant of good faith and fair dealing. 

The dissent in the case vigorously disagreed with the majority, especially in light of the procedural context of the decision, namely, a motion to dismiss.  The dissent felt the complaint had stated a claim for breach of the implied covenant because of allegations that Booz Allen's acquisition of the shares harmed Nemec and Witkemper and served no legitimate interest of Booz Allen.  "[A] contracting party, even where expressly empowered to act, can breach the implied covenant if it exercises that contractual power arbitrarily or unreasonably."