Originally published in ALM's Delaware Business Court Insider
Delaware permits the elimination of fiduciary duties in limited liability company agreements. Notwithstanding, and just like in any other contract, parties to a limited liability company agreement are still subject to the implied covenant of good faith and fair dealing. This is because, under Delaware law, there is a difference between a fiduciary’s duty of good faith and a contracting party’s duty of good faith. The former requires a fiduciary to act fairly in its dealings with the company and its members; the latter requires a contracting party to act in good faith in regard to the terms and purpose of the contract.
As the Court of Chancery’s decision in Khan v. Warburg Pincus, C.A. No. 2024-0523-LWW demonstrates, because a fiduciary’s and a contracting party’s duties of good faith are distinct, and because Delaware respects the elimination of fiduciary duties in alternative entities, Delaware courts will not allow the implied covenant of good faith and fair dealing to stand in as a substitute for fiduciary duties, where a limited liability company agreement explicitly waives those duties.
Background and the Court of Chancery’s Decision
The plaintiffs were the two co-founders of an urgent care business formed as a Delaware limited liability company. Following an investment from the defendants (a private equity firm), the plaintiffs became the minority members and defendants became the majority members. In turn, the parties amended the limited liability company agreement to reflect two classes of units, Class A units for the majority members and Class B for the minority members. Holders of Class B units were given tag-along rights to participate on equal pro-rata terms with the Class A unit holders in a sale of the company. The tag-along rights were subject to amendment by a majority vote of the Class B unit holders. Finally, and as relevant here, the amended limited liability company agreement expressly waived the Class A unit holders’ (the private equity firm defendants) fiduciary duties and permitted them to act exclusively in their own interests.
When the opportunity to sell the company presented itself again through a merger, the private equity firm defendants sought to further amend the limited liability company agreement to eliminate the Class B unit holders’ tag-along rights. As alleged, the defendants represented that if the Class B unit holders—including the two co-founder plaintiffs—wanted to participate in the merger, they had to vote to approve the amendment. The Class B unit holder— again, including the two co-founder plaintiffs—approved the amendment and the merger went through, with the Class A unit holders receiving disparate consideration: all cash, versus a mix of cash and equity for Class B.
Ultimately, the merged company revealed a large goodwill impairment which, in the view of the two-cofounder plaintiffs, negatively impacted the equity they had received in the merger. The two co-founder plaintiffs then sued the private equity firm defendants alleging, among other things, that the defendants breached the implied covenant of good faith and fair dealing in connection with the amendment of tag-along rights and their subsequent receipt of disparate merger consideration.
On the defendants’ motion to dismiss, the court approached the implied covenant claim looking first to see whether there was any gap in the limited liability company agreement for the covenant to fill. The court determined that the alleged implied term—here, to not amend the limited liability company agreement in way that would result in the disparate treatment of Class B units—directly contradicted an express term of the agreement. On the contrary, and as the court reasoned, the parties agreed they could amend the tag-along rights.
The court next considered the plaintiffs’ argument that the private equity firm defendants had “coerced” the Class B unit holders into approving the amendment by its purportedly rushed and crammed-down presentation. Here, the Court of Chancery noted the distinction between a fiduciary’s duty of good faith, which looks to the fiduciary’s dealings with its beneficiaries and a contracting party’s good faith, which looks to fairness to the terms and purpose of the contract. The Court found that the “good faith” invoked by the “coercion” theory was a fiduciary, not contractual duty of good faith. Because the parties had expressly waived the private equity firm defendants’ fiduciary duties, the Court determined it would not permit plaintiffs to “disguise” a breach of fiduciary duty claim as a breach of the implied covenant of good faith and fair dealing. Accordingly, the Court of Chancery dismissed the plaintiffs’ claims.
Key Takeaways
In Delaware, the implied covenant of good faith and fair dealing is a narrow doctrine. Its principal use is to fill in gaps in parties’ contracts, where the applicable contract is truly silent and where one of the contracting party’s actions are not in keeping with the terms and purpose of the agreement. But as the Court of Chancery in Khan reaffirmed, the implied covenant of good faith and fair dealing is not a substitute for fiduciary duties. And where parties to a limited liability company agreement expressly waive fiduciary duties, the Court of Chancery will not permit a party to pursue breach of fiduciary duty claims under the guise of the implied covenant.
