LLC managers often enjoy wide latitude and unrestricted “discretion” under the LLC’s operating agreement. At the same time, all contracts — including LLC operating agreements — are subject to the implied covenant of good faith and fair dealing, which applies to prevent one party from acting arbitrarily or unreasonably to frustrate the other party’s reasonably expected “fruits of the bargain.”
The LLC Jungle has covered several cases exploring the intersection of managerial discretion and the implied covenant of good faith and fair dealing. See here, here, here, and here.
An opinion recently issued by the Delaware Court of Chancery — Cygnus Opportunity Fund, LLC v. Washington Prime Group, LLC — hits the same theme.
Facts: LLC manager exercises discretion in obtaining “independent” approval for merger; minority owners sue
Washington Prime, LLC is a REIT that owns, develops, and manages shopping centers. Strategic Value Partners, LLC (“SVP”) owned 87% of the membership interest in Washington Prime. Plaintiffs were the minority interest owners.
The operating agreement imposed restrictions on SVP’s ability to acquire additional shares without either direct approval by the minority owners or approval by the “Minority Approved Independent Manager,” who would supposedly represent the interests of the minority owners. Martin Reid was identified as the initial Minority Approved Independent Manager. The operating agreement contained no mechanism for the minority owners to remove or replace any manager, including the Minority Approved Independent Manager. Only SVP had that authority.
SVP then launched a “squeeze-out merger” designed to acquire 100% ownership of the company. The company issued a disclosure statement — consisting of a “three-page cover letter and a skeletal, five-page information statement” — informing the minority owners that their membership units had been converted into the right to receive $27.25 per unit in cash, without interest and with no right to an appraisal. The disclosure said that Reid — the Minority Approved Independent Manager — had obtained a “fairness opinion” from Jones Lang LaSalle Securities LLC, but the disclosure documents did not include the opinion or summarize its contents.
The minority owners tried multiple times to obtain information about the merger, but were stonewalled each time.
The lawsuit: minority owners challenge the squeeze-out merger, including a claim based on good faith and fair dealing
The minority owners sued, alleging a variety of claims challenging the squeeze-out merger. The minority owners alleged that the squeeze-out merger dramatically undervalued their membership units at $27.25, when in reality they were worth between $60 and $120 per unit depending on which valuation metric was used, and sought damages equal to the fair value of their units.
Among many other claims, the minority owners included a claim based on the implied covenant of good faith and fair dealing. The minority owners pointed to the lack of meaningful disclosures surrounding the merger, Reid’s apparent conflicting interests and allegiances to SVP that prevented him from acting independently from SVP, and family connections between SVP and Jones Lang LaSalle.
SVP filed a motion to dismiss the claims on the pleadings.
Court of Chancery: minority owners adequately alleged claim for breach of implied covenant of good faith and fair dealing
The court held that plaintiffs alleged a valid claim based on the implied covenant of good faith and fair dealing, and refused to dismiss the claim at the pleading stage.
The court confirmed that the covenant of good faith and fair dealing applies to an exercise of LLC managerial discretion: “this means that the exercise of discretionary authority must fall within the range of what the parties would have agreed upon during their original negotiations, if they had thought to address the issue.” The court continued:
[The covenant of good faith and fair dealing] operates with special force when a contract confers discretion on a party. At a minimum, the implied covenant requires that the party empowered with the discretion use good faith in making that determination. Terms that enhance the level of discretion, such as ‘sole discretion,’ do not eliminate the implied duty. When a party has sole discretion to make a decision, that setting provides more reason for the implied covenant to apply, not less.
(Citations omitted.) The phrase “good faith” means “faithfulness to the scope, purpose, and terms of the parties’ contract.” And “fair dealing” means acting “consistently with the terms of the parties’ agreement and its purpose.”
Addressing the squeeze-out merger, it was clear that under the operating agreement the LLC managers had discretion to either obtain direct minority owner approval or obtain the approval of Reid as the Minority Approved Independent Manager. However, the allegations made clear that the minority owners never would have agreed to allow Reid to approve a merger on their behalf when Reid had acted in unison with management in withholding information and adequate disclosures from the minority owners and had demonstrated substantial conflicts of interest through his allegiance with SVP, especially in light of the glaringly inadequate merger price.
The court concluded: “It is reasonably conceivable that in the original bargaining position, the parties would not have agreed that Manager Approval could be used under those circumstances.”
The Cygnus Opportunities Fund opinion is the latest in a long string of cases holding that while LLC managers might have broad discretion under the operating agreement, the implied covenant of good faith and fair dealing imposes limits on the exercise of that discretion.