Private Equity

When a contractual provision vests in a person the right to make a contractual determination, is the making of that determination bounded by an obligation to exercise the granted right in “good faith?” A recent Delaware Supreme Court decision, Baldwin v. New Wood Resources LLC, 2022 WL 3364169 (Del. Aug. 16, 2022), answered that question in the affirmative, at least in the specific context of a right to indemnification under the specific terms of an LLC agreement. But the case raises questions about how the decision may have turned out differently in other contexts, with different contractual language, or in a different jurisdiction.

New Wood Resources involved the interpretation of a provision in an LLC agreement that granted indemnification to the Members, Managers, Board members or officers of the LLC, to the “fullest extent permitted by the [Delaware Limited Liability Company],” as long as the entitled person was determined to have “acted in good faith and in a manner that he or she reasonably believed to be in or not opposed to the best interests of the Company.” But the LLC agreement went on to specifically vest in “the holders a Majority of the then outstanding Units,” the right to make the determination as to whether the entitled person had met the required standard of conduct. The holders of the majority of the Units made such a determination respecting a request for indemnification from a Manager of the LLC; and the determination was that the Manager who had requested indemnification from the LLC had not met the required standard of conduct.

But the Manager claimed that the holders of the majority of then outstanding units had made their determination in bad faith, solely based upon a desire to avoid paying the indemnification claim, not because there had been any actual effort to determine whether the Manager had in fact acted in good faith. And, based upon the fact that the LLC agreement clearly vested in the majority of the outstanding units the right to make the standard of conduct determination, the Superior Court ruled that the Manager could not challenge the basis for that determination by implying a requirement that such a determination must have been made in “good faith.”

On appeal, the Delaware Supreme Court reversed the Superior Court, and held that the implied covenant of good faith and fair dealing actually imposed a good faith obligation on the majority of unit holders in making the required standard of conduct determination. According to the Delaware Supreme Court, if there was no such implied obligation, the required standard of conduct to which the Manager was expected to comply (i.e., that the Manager “acted in good faith and in a manner that he or she reasonably believed to be in or not opposed to the best interests of the Company)” would be rendered meaningless. In other words, if there really was no required standard of conduct, but instead the idea was that the majority of unit holders could deny indemnification for any reason or no reason at all, then the LLC agreement could have so provided. But, by requiring that the determination of whether to provide indemnification be a determination of whether a required standard of conduct had been met, the necessary implication was that such a determination would not be made arbitrarily in bad faith. Our English colleagues may recognize this holding as having some resemblance to the so-called “Braganza” duty: “in the absence of very clear language to the contrary, a contractual discretion must be exercised in good faith and not arbitrarily or capriciously. This will normally mean that it must be exercised consistently with its contractual purpose.”^[1]

Ah, some might say, wouldn’t this result have been different if the LLC agreement had vested the determination as to whether the standard of conduct had been met “in the sole and absolute discretion” of the majority unit holders. Indeed, some commentators have suggested that the use of “sole and absolute” as a modifier to the exercise of a party’s discretionary determination actually may have the effect of eliminating any good faith requirement in connection with the exercise of that discretion, at least in New York.^[2] But a closer examination of the cases seems to suggest that adding “sole and absolute” to contract language granting one party the right to make a particular determination may do very little to eliminate a requirement that any such determination be made in good faith, unless there is additional language making clear that the determination can be made for “any reason or no reason.”

Indeed, in Southern Telecom Inc. v. ThreeSixty Brands Group, LLC, 520 F.Supp.3d 497 (S.D.N.Y. 2021), the court noted that cases that have been cited in New York for the proposition that the use of “sole and absolute discretion” relieves a party vested with such discretion from exercising it in good faith, do not in fact stand for that proposition. Even with determinations vested in a party’s “sole and absolute discretion,” the question remains what is the determination that is required to be made. If the determination is whether a particular standard of conduct had been met, whether a particular party is credit worthy or has adequately performed, whether particular products are consistent with certain specified standards, or any other determination that requires consideration of facts by the person holding that discretion, the caselaw appears to require the determination actually be made honestly, in consideration of the facts, and not on some pretextual basis. In other words, the exercise of discretionary decision making (even “sole and absolute discretion”) by a party “mandates that an action authorized to be taken for a particular reason actually be taken for that reason.”^[3] According to Southern Telecom court:

Courts presume that parties do not make empty promises. When the implication of a duty of good faith and fair dealing would be inconsistent with the language of a provision of a contract and is not necessary to make the agreement meaningful, the court will not invoke the covenant. But where, by contrast, it is necessary to read an obligation of good faith in order to avoid rendering a contract promise illusory—in the words of the cases, where necessary so as not to deprive a contracting party of the “fruits of the contract”—the courts will not hesitate to infer an obligation to act in good faith. A licensee granted the exclusive rights to sell the licensor’s products, for example, cannot automatically relieve itself of the obligation to exercise that contractual right in good faith by the simple expedient of adding the language “sole discretion,” if the failure to act in good faith would render the contract illusory. That is what was meant when Judge Cardozo long ago spoke of a contract right as being “instinct with an obligation.” No magic words can ipso facto and without review of the contract as a whole relieve a contracting party of that obligation.^[4]

But the words “sole and absolute discretion” do have a benefit. As long as the party vested with that type of decision making authority actually considers the required facts, the resulting decision based upon a consideration of those facts apparently is not challengeable by the affected party based upon whether the resulting decision was fair or reasonable; instead, the party vested with sole and absolute discretion is simply prohibited from basing its decision on some pretextual reason unrelated to an actual consideration of the required factual determination.^[5] 

A party who desires truly sole and absolute discretion to make a determination needs to make clear that there is no standard against which that discretion is being measured. In the absence of such a standard there is nothing on which the covenant of good faith and fair dealing can operate to ensure that the affected party is not deprived of the fruits of the contract—i.e., the fruits of the contract are that the party holding the discretion can utilize that discretion in whatever manner it desires: “Where a contract allows one party to terminate the contract in ‘its sole discretion’ for ‘any reason whatsoever,’ the covenant of good faith and fair dealing cannot serve to negate that provision.”^[6]

It would seem, therefore, that even in an LLC agreement, where Delaware law specifically prohibits any provision that “limit[s] or eliminate[s] liability for any act or omission that constitutes a bad faith violation of the implied contractual covenant of good faith and fair dealing,”^[7] a discretionary decision that is contractually agreed to be determined in a party’s “sole and absolute discretion” “for any reason or no reason,” may be devoid of anything upon which the covenant of good faith and fair dealing can act to render the resulting decision in bad faith. But there are vagaries in the caselaw and differences in jurisdictions, so be aware and draft with care.