By: Allison M. Neff, Editor-in-Chief of the Delaware Journal of Corporate Law.
In the wake of the Delaware Supreme Court decision in Oxbow Carbon & Minerals Holdings, Inc. v. Crestview-Oxbow Acquisition, LLC,[1] the Court limited the use of the implied covenant of good faith and fair dealing by rejecting its use to satisfy an Exit Sale requirement. In this recent unanimous en banc decision, the Supreme Court of Delaware ruled that the Court of Chancery erred in applying the implied covenant of good faith and fair dealing by filling a gap in the operating agreement that simply wasn’t there.[2] The parties argued over whether minority shareholder members had a right to compel an Exit Sale under the terms of Oxbow Carbon’s LLC agreement. The operating agreement allowed minority members to block an Exit Sale if all members received the same rights and conditions and the sale price exceeded an agreed upon floor price.[3] The operating agreement was silent as to what payment conditions and terms were applicable upon an Exit Sale to the later added members, known as Small Holders, who could prevent the Exit Sale if the payment conditions were not met. The Court of Chancery utilized the implied covenant of good faith and fair dealing to allow minority shareholder members to force an Exit Sale by distributing funds to Small Holders in order for the payment floor provision to be met.[4] The Supreme Court of Delaware disagreed that there was a contractual gap in the operating agreement because the board of directors were given discretion to define the rights and terms of the Small Holders. The Court reasoned that the board of directors used their contractual discretion to admit the new Small members, and did so in good faith.[5]
The Court in Oxbow expressed two common situations in which the implied covenant of good faith and fair dealing is applied: (1) when a situation was unforeseen by the parties who entered into an agreement with express terms that do not cover the situation at hand; and (2) when a party who has contractual discretion on a specific topic is argued to have used that discretion in a way that is impliedly proscribed by the contract’s express terms.[6] The Court disagreed with the Court of Chancery’s “contractual gap” finding that the contract was not silent in regards to the Small Holders’ right to refuse sale of their units, and ultimately enforced the plain terms of the operating agreement. The Court stated that the implied covenant of good faith and fair dealing does not apply when the contract addresses the conduct at issue. The implied covenant applies when the contract is “truly silent concerning the matter at hand.”[7] Further, when the parties exercise contractual choice by expressly omitting terms that could easily have been drafted into the contract, the implied covenant should not be used to find a contractual gap and rewrite the terms of the contract. The Supreme Court echoed the Lyondell Chemical[8] Court in reinstating the significance of using the implied covenant of good faith and fair dealing as a legal remedy only available in situations that are extraordinary and limited. In the absence of contract language the trial court seemed to have come to its holding using an outcome determinative mentality. The Supreme Court logically bridged the gap as discretion being a contractual term in and of itself. If the directors used the Small Holders to circumvent the Exit Sale, the outcome of the case would have drastically changed and the rationale behind it would have affected broadened the use of the implied covenant of good faith and fair dealing beyond the Court’s intended use.
In conclusion, the Oxbow case continues to evolve the use and meaning of the implied covenant of good faith and fair dealing by making its application more restrictive and its use more narrowly construed. What makes Oxbow so unique is that the Court expressly warned against the liberal use of the implied covenant of good faith and fair dealing in interpreting contracts. The Court also gave instruction to limit its own power by invoking a ‘chary’[9] attitude for interpreting courts. This case illustrates the importance of reviewing operating agreements prior to contemplating significant transactions.
About the Author: Allison M. Neff is a fourth-year Extended Division student expected to graduate in May, 2020. Ms. Neff obtained a summer associate position with Winget, Spadafora, Schwartzberg in Philadelphia, specializing in securities litigation. Currently, Ms. Neff is working as a Judicial Clerk with the Honorable Meghan A. Adams in the New Castle County Superior Court of Delaware. Ms. Neff is the Editor-in-Chief of the Delaware Journal of Corporate Law and her law note, “A Reassessment of Vertical Mergers Within the Context of Antitrust Laws: The Time Warner and AT&T Merger” will be published in the 44th Volume. Ms. Neff is a Senior Staff Member of the Transactional Law Honor Society and is the Co-Vice President of the Alternative Dispute Resolution Society. She is also a member of the Richard S. Rodney Inn of Courts. Ms. Neff plans to work as a corporate litigator in Delaware upon graduation.
Footnotes:
[1] No. 536, 2018, 2019 WL 237360 (Del. Jan. 17, 2019).
[2] CLIENT ALERT: Delaware Supreme Court Reverses Oxbow Decision Deploying the Implied Covenant to Force an Exit Sale, (Jan. 17, 2009), http://www.potteranderson.com/newsroom-news-CLIENT-ALERT-Delaware-Supreme-Court-Reverses-Oxbow-Decision-Deploying-the-Implied-Covenant-to-Force-an-Exit-Sale.html.
[3] See Oxbow Carbon & Minerals Holdings, Inc. No. 536, 2018, 2019 WL 237360 at *2.
[4] Id. at 46 (n71).
[5] Id. at 37-38.
[6] Francis Pileggi, Supreme Court Explains the Implied Covenant of Good Faith and Fair Dealing, (Jan. 28, 2019), https://www.delawarelitigation.com/2019/01/articles/delaware-supreme-court-updates/supreme-court-explains-the-implied-covenant-of-good-faith-and-fair-dealing/.
[7] Oxbow Carbon & Minerals Holdings, Inc. Del. Supr. No. 536 at 43.
[8] Lyondell Chem. Co. v. Ryan, Del. Supr., No. 401, 2008 (Mar. 25, 2009, revised Apr. 16, 2009).
[9] Oxbow Carbon & Minerals Holdings, Inc. Del. Supr. No. 536 at 43(quoting Nationwide Emerging Managers, LLC v. Northpointe Holdings, LLC, 112 A.3d 878, 897 [Del. 2015])(quoting Allied Capital, 910 A.2d at 1035).