Leap of Faith: Determining the Standard of Faith Needed to Violate the Implied Covenant of Good Faith and Fair Dealing for Delaware Limited Liability Companies

By Andriola, Pat | Boston College Law Review, January 1, 2016 | Go to article overview

Leap of Faith: Determining the Standard of Faith Needed to Violate the Implied Covenant of Good Faith and Fair Dealing for Delaware Limited Liability Companies


Andriola, Pat, Boston College Law Review


Introduction

Delaware courts have long respected the right to contract in Delaware, and possibly no entity is afforded more privileges to set the boundaries of its corporate form than the Delaware Limited Liability Company ("LLC"). Unlike nearly every other state, Delaware permits LLCs to not only abolish the duty of care in their operating agreements, but also the duty of loyalty.1 Thus, if their operating agreement so allows, directors of Delaware LLCs are immune from claims such as self-dealing, clandestine profit engorgement, and nepotism, among others. However, Delaware law expressly forbids eliminating lia© bility for "any act or omission that constitutes a bad faith violation of the implied contractual covenant of good faith and fair dealing."2

The problem with the phrase "bad faith violation" is that, when referencing a breach of the implied covenant of good faith and fair dealing, it implies that there exists a non-bad faith violation of the covenant. For example, what is a "good faith" breach of the implied covenant of good faith and fair dealing? This essay acknowledges that in order to find a violation of the implied covenant, "bad faith," and not something akin to "neutral faith," must be found. However, it also recognizes that Delaware courts have not expressed a coherent policy rationale for why bad faith must be found. This essay recommends that Delaware courts consider that while Delaware LLCs are permitted to contract around the fiduciary duties of care and loyalty, the fact that the implied covenant is never permitted to be contracted out means the Delaware legislature expects it to be taken incredibly seriously. Thus, the weight of available authority on the subject indicates that the covenant cannot be violated except in bad faith.

I. The Implied Covenant of Good Faith and Fair Dealing

Although it has a reputation as a generic catchall, the implied covenant isn't a blanket opposition to anything seemingly done in bad faith. "General allegations of bad faith conduct are not sufficient" to state a claim, despite the claim's frequent (and frequently unsuccessful) use as a last resort by parties who are otherwise disappointed with where their contracts have brought them.3

In order to assert this claim, one must allege "a specific implied contractual obligation, a breach of that obligation . . . and resulting damage."4 Courts will look at what the parties hoped to receive from the contract at the point when they entered it, and determine if the actions under scrutiny were (or should have been) reasonably considered ex ante. "When applying the implied covenant of good faith and fair dealing, the temporal focus is critical . . . . The implied covenant looks to the past, and seeks to enforce terms that the parties would have agreed to themselves had they considered the issue in their original bargaining positions at the time of contracting."5 Judges will "not rewrite the contract to appease a party who later wishes to rewrite a contract he now believes to have been a bad deal."6 Rather, the covenant asks whether one party is frustrating the purpose of the contract through some "loophole" not expressly outlined in the contract.

Because Delaware courts show utmost consideration to the four corners of a voluntary agreement, they consider use of the covenant to be a "rare and fact-intensive exercise" saved only for a "narrow band of cases."7 Parties alleging a violation of the covenant may not base their claims "on conduct authorized by the terms of the agreement."8 The difficulty of stating a claim for violation of the covenant means that parties rarely invoke it successfully.9

II. Good Faith and Bad Faith

Bad faith is a very specific term of art in Delaware. In distinguishing the phrase from "fraud," the Delaware Supreme Court has relied on Black's Law Dictionary to find that

[The] term "bad faith" is not simply bad judgment or negligence, but rather it implies the conscious doing of a wrong because of dishonest purpose or moral obliquity; it is different from the negative idea of negligence in that it contemplates a state of mind affirmatively operating with furtive design or ill will. …

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