First, Ruminations is not expanding its coverage to all that would be considered “contract law.” It’s just that leases, mortgages, and all of the other documents we encounter on a daily basis are just a subset of the broader category of contracts, ones dealing with real property. Second, although we mostly write about memorializing agreements, from time to time we bring up the topic of how people act once their agreements are executed. Today is such a day.
So, today, Ruminations will be focusing on some post-contract behavior we read about in a January 20, 2017 decision from the Supreme Court of Delaware. For readers who don’t already know this, here’s a valuable piece of information. The Delaware Supreme Court is held in extremely high regard by courts of other states – it is “persuasive.” And, when it overrules the very highly regarded Court of Chancery of the State of Delaware, ears should perk up.
Here’s the story.
The general partner of a limited partnership thought it would be a good idea if that limited partnership was acquired by way of merger into another limited partnership in which the general partner or persons related to the general partner also had an interest. Though, under the limited partnership agreement, the general partner had almost unlimited powers, where exercise of those powers would constitute a conflict of interest (as here), approval required satisfying one of two alternate procedures.
One allowed such a “conflicted” transaction to take place if a “Special Approval” was obtained from an independent “Conflicts Committee.” The alternate procedure was to obtain approval from limited partners who were not affiliated with the acquiring limited partnership.
To translate, “Special Approval typically means that a Conflicts Committee composed of members independent of the sponsor and its affiliates reviewed the transaction and made a recommendation to the partnership board whether to approve the transaction. Unaffiliated Unitholder (limited partner] Approval is typically just that—a majority of unitholders unaffiliated with the general partner and its affiliates approve the transaction.”
It wasn’t necessary that both types of approval be obtained, but the general partner sought and seemingly obtained both.
We say seemingly because although the way the general partner got those approvals followed the strict wording of the partnership agreement, some things seemed “a little off.” Before reading further, although some readers know this, those that don’t will better understand why hearing this “story” out of Delaware is especially informative. Basically, Delaware entity law (that for corporations, partnerships, limited liability companies, etc.) is extremely contractarian. The principle of “freedom of contract” is paramount in that state and Delaware courts are very protective of that singular principle. Basically, the rule for partners in Delaware is “partner beware.” Further, setting aside some nuances and avoiding a lot of highly technical arguments, readers would be safe in assuming that general partners have no fiduciary duties to limited partners if the partnership agreement states that to be the case.
With that as background, we should all be on the same page. As written, the limited partnership agreement did not require the general partners to treat the limited partners as it, the general partner, would want to have been treated (our very imprecise way to define what it means to have a fiduciary duty, one arising out of a relationship of trust). All it had to do was to follow the prescribed approval procedure in the way the words of the partnership agreement prescribed. Here, the general partner did so. It created a two person Conflicts Committee that included two individuals who, at the time the Committee began its review, clearly met the “unaffiliated” test. The Committee was advised by a major investment banker. The banker held no interest in any of the partnerships or partners. Technically, the Committee was “independent.” Even the well-respected Delaware Chancery Court thought so.
OK, we know that you know what we know. And what we both know is that being “technically” independent, meeting the words of the agreement, wasn’t going to be enough when viewed through the “lens” of the Delaware Supreme Court. So, now, to use Paul Harvey’s words, we’ll tell you “the rest of the story.”
One Committee member was a board member of the acquiring partnership until his resignation just days before the Conflict Committee first met. The day before the boards of each limited partnership began their merger discussions, he was appointed to the board of the general partner. While a member of both boards, he was consulted about the merger. After the first five days of negotiation, he resigned from both positions. A day later, he was appointed to the Conflicts Committee, he being no longer affiliated with the merging partnerships or the general partner. On the day after the merger took effect, he rejoined the acquirer’s board, filling the very same vacancy his earlier resignation had created.
On the day after the merger, the second member of that Conflicts Committee was appointed to the surviving partnership’s board.
What is more, is that the financial advisor was selected by an officer of the top-tier entity that controlled both limited partnerships, not by the Conflicts Committee. At the time, it was well-known that this executive would become the head of that top-tier entity. Consequently, there was a well-supported belief by some that the financial advisor would favor the top-tier entity, the one that, in fact, had engineered the merger transaction.
But, wait – even if the Conflicts Committee’s “Special Approval” wasn’t going to work, didn’t the unaffiliated limited partners approve the transaction? Why, yes they did.
How was that to work? According to the limited partnership agreement, the general partner needed to do no more than furnish the most bare-boned disclosure. All it needed to do was to abide by the partnership agreement’s express disclosure requirements. But, for whatever reason, it issued a 165-page proxy statement. That thick document covered every required item called for by the partnership agreement. It also assured the limited partners that the Conflict Committee had approved the transaction.
One of the limited partners cried foul. He argued, with the help of six lawyers and three law firms, that the covenant of good faith and fair dealing, implied in every contract, had been violated. Two challenges were raised. First, under the facts, the members of the Conflicts Committee weren’t really independent. [Readers can reach their own conclusion as to that point.] Second, the proxy statement should have revealed the “employment” history of the members of the Conflicts Committee. To succeed in upsetting the merger, the complaining limited partner needed to get the court to invalidate both “approvals” because either one, by itself, would have been enough to make the merger a legitimate one.
The last point is important because the proposed merger only required approval by one of the two possible procedures. So, the Chancery Division, where the dispute was first heard, focused on (and accepted) the partner approval test. That allowed it to overlook the Special Approval given by the Conflicts Committee.
At issue was whether, in the proxy statement, it was a breach of any obligation the general partner had to the limited partners when the general partner wrote that Special Approval had been given by the independent Conflicts Committee without also explaining the history of the Committee’s members. If it was, and the limited partners relied on that “information,” their approval of the proposed merger would have been tainted and would not qualify as approval.
As you read on, keep in mind that the Delaware Revised Uniform Limited Partnership Act gives “maximum effect to the principle of freedom of contract.” As a reminder:
One freedom often exercised in the [master limited partnership] context is eliminating any fiduciary duties a partner owes to others in the partnership structure. The act allows drafters of Delaware limited partnerships to modify or eliminate fiduciary-based principles of governance, and displace them with contractual terms.
In the Chancery Court’s view, how did that work to ignore the proxy statement’s announcement that the “independent” Conflicts Committee had approved the merger? [Keep in mind that the Chancery Court was overruled.] Well:
[t]he Court of Chancery side-stepped the Conflicts Committee safe harbor, but accepted the general partner’s argument that the Unaffiliated Unitholder [limited partner] Approval safe harbor required dismissal of the case. The court held that, even though the proxy statement might have contained materially misleading disclosures, fiduciary duty principles could not be used to impose disclosure obligations on the general partner beyond those in the partnership agreement, because the partnership agreement disclaimed fiduciary duties. Further, the court agreed with the defendants that the only express disclosure requirement of the agreement in the event of a merger—that the general partner simply provide either a summary of, or a copy of, the merger agreement—displaced any implied contractual duty to disclose in the proxy statement material facts about the conflicts within the Conflicts Committee.
Did the Chancery Court even mention the “Covenant of Good Faith and Fair Dealing”? Yes, once it said that the disclosure agreement, whatever else it might have included (truthful or not), certainly covered the minimum requirements, it did and here’s what it said:
given the express disclosure obligation, the implied covenant of good faith and fair dealing “has no work to do” because “the express waiver of fiduciary duties and the clearly defined disclosure requirement prevent the implied covenant from adding any additional disclosure obligations to the agreement.”
Today’s blog posting is getting a little long in the tooth, even for us. So, we’ll get to the point, that being you can follow the express rules in your agreement, and that means not just in a limited partnership agreement, but in a lease or mortgage as well, and still breach the agreement. The Delaware Limited Partnership Act expressly provides for the implied covenant of good faith and fair dealing, but the requirement that contracting parties abide by that covenant does not need to be written into any law. It is implied in every contract.
Here’s how the Delaware Supreme Court expresses and explains that:
The implied covenant is inherent in all contracts and is used to infer contract terms “to handle developments or contractual gaps that the asserting party pleads neither party anticipated.” It applies “when the party asserting the implied covenant proves that the other party has acted arbitrarily or unreasonably, thereby frustrating the fruits of the bargain that the asserting party reasonably expected.” The reasonable expectations of the contracting parties are assessed at the time of contracting. In a situation like this, [our] inquiry focuses on whether, based on a reading of the terms of the partnership agreement and consideration of the relationship it creates between the [limited partners and the general partner], the express terms of the agreement can be reasonably read to imply certain other conditions, or leave a gap, that would prescribe certain conduct, because it is necessary to vindicate the apparent intentions and reasonable expectations of the parties.
The Delaware Supreme Court held that the Chancery Court had focused too narrowly on the words of the agreement. [That’s the real point of today’s blog posting – how we mislead ourselves, by convincing ourselves that the words we seek to interpret in our favor have no context and are independent of any overriding principles.] Here is the key to today’s posting: According to the Delaware Supreme Court, the Chancery Division “should have focused on the language of the safe harbor (approval) process, and what its terms reasonably mean.” [We added the underlining.] The express terms of the limited partnership agreement “[n]ot surprisingly, … did not address, one way or another, whether the General Partner could use false and misleading statements to enable it to reach the safe harbors.” We need to keep the following words in mind the next time we want to reach a result we want even though it smells wrong.
We find that implied in the language of the [Partnership] Agreement’s conflict resolution provision is a requirement that the General Partner not act to undermine the protections afforded [limited partners] in the safe harbor process. Partnership agreement drafters, whether drafting on their own, or sitting across the table in a competitive negotiation, do not include obvious and provocative conditions in an agreement like “the General Partner will not mislead [the limited partners] when seeking … Approval” or “the General Partner will not subvert the Special Approval process by appointing conflicted members to the Conflicts Committee.” But the terms are easily implied because “the parties must have intended them and have only failed to express them because they are too obvious to need expression.” Stated another way, “some aspects of the deal are so obvious to the participants that they never think, or see no need, to address them.”
For readers who want to know more about the implied covenant of good faith and fair dealing as applied more direct to real property, visit (or revisit) our 2011 posting about the subject by clicking: HERE in application to a lease. For readers insistent on reading the court’s opinion themselves, just click: HERE.