Earlier this year, the Delaware Court of Chancery helped clarify the interplay between common law fiduciary duties and the contractual relationships that eliminate them. In Khan v WP Investors1, the Court of Chancery held that where a limited liability company agreement expressly waives fiduciary duties and provides a clear contractual framework for modifying the members' rights under the agreement, the implied covenant of good faith and fair dealing cannot be used to reintroduce fiduciary-like protections or override the parties' negotiated terms in the contract.
What you need to know
- The implied covenant of good faith and fair dealing is a narrow, gap-filling doctrine that only applies when a contract is truly silent on an issue that was not within the parties' contemplation at the time of contract formation. Delaware courts will not use the implied covenant of good faith and fair dealing as a substitute for fiduciary duties to infer language that challenges actions that are expressly permitted by a negotiated agreement, or to grant rights that were never bargained for between the parties.
- Private equity funds should seek to protect themselves with broad fiduciary duty waivers and clear contractual provisions that address all significant matters of economics, liquidity and governance.
- Non-controlling investors should be aware that if a limited liability company agreement or limited partnership agreement contains a broad fiduciary duty waiver, they should not rely on the implied covenant of good faith and fair dealing to protect their rights under the agreement. Instead, they must ensure that all meaningful rights are clearly protected through clear contractual provisions, with appropriate controls over amendments (including by merger) that could override their substantive rights.
Background
The case centers on WP CityMD TopCo LLC (the Company), a healthcare platform jointly owned by a private equity fund and a group of minority investors. The private equity fund owned 60% of the Company's equity through Class A units, with unaffiliated minority investors owning 17% through Class B units.
In 2022, the private equity fund negotiated a merger between the Company and Village Practice Management Company, LLC. Under the proposed merger terms, the private equity fund would receive all-cash consideration, while the minority investors would receive a mix of cash and equity in the acquirer.
The disparate consideration in the proposed merger structure conflicted with a tag-along right in the Company's limited liability company agreement, which gave minority members the right to participate in the merger on the same terms as the private equity fund.
The limited liability company agreement permitted amendments with the prior written consent of the majority of the affected class. The private equity fund was able to secure the required approval of the Class B members to amend the tag-along right provision to permit disparate consideration, and the merger closed in January 2023.
In March 2024, the acquirer recorded a $12.4 billion goodwill impairment, significantly reducing the value of the equity merger consideration received by the minority investors. The minority investors sued the private equity fund, alleging a breach of the implied covenant of good faith and fair dealing. They claimed that the private equity fund acted unfairly by structuring the deal to benefit itself and by persuading the minority investors to approve an amendment that ultimately harmed them.
Legal analysis
The Court of Chancery dismissed the case. It held that the Company's limited liability company agreement explicitly permitted the amendment process, which was followed appropriately. The Court held that the implied covenant of good faith and fair dealing "is a limited and extraordinary legal remedy" that "does not apply when the contract addresses the conduct at issue, but only when the contract is truly silent concerning the matter at hand".
Additionally, the Court held that the express waiver of fiduciary duties in the limited liability company agreement precluded the plaintiffs' argument that the private equity fund impermissibly "coerced" the minority investors by conditioning the benefits of the merger on their waiver of the tag-along right. The Court cited language in the agreement giving the private equity fund the right to "act exclusively in its own interest and without regard to the interest of any other Person", including in the event of a conflict of interest between it and the Company.
As a result, the Court of Chancery found no basis to invoke the implied covenant of good faith and fair dealing to override the parties' negotiated rights. Doing so, the Court reasoned, would contradict the express terms of the contract.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
