The Delaware Court of Chancery’s recent opinion in Cygnus Opportunity Fund LLC et al. v. Washington Prime Group LLC et al. presents a veritable grab bag of potential blog posts, from a suggestion that an officer of an Limited Liability Company could be contractually bound by an LLC Agreement he never signed to the interesting interplay (and potential conflict) between an officer’s duty of obedience to the LLC’s board and the officer’s duty of disclosure to investors. The focus here — and we believe chief among the thorny issues addressed in Cygnus — is the Court of Chancery’s decision to sustain a claim for breach of the implied covenant of good faith and fair dealing with respect to an issue that the LLC Agreement expressly addressed. What makes it even more fascinating is the tone of the Opinion: Vice Chancellor Laster evidently came to an early conclusion that, taking the allegations as true for purposes of a pleading motion, there was some inherent unfairness in the Defendants’ conduct that needed to be set right. Left unclear is the impact of this decision, assuming it is not disturbed on appeal, on Delaware’s long-standing deference to parties’ agreements and, in particular, limitations of duties, in the LLC context. In any event, the Opinion should serve as a cautionary tale for companies considering converting to an LLC form through a non-consensual bankruptcy process.
The facts of Cygnus Opportunity Fund LLC are somewhat complex and revolve around four separate but related transactions: (1) the acquisition of senior notes by a new holder that precipitated a bankruptcy the court seemed to believe was early and potentially unnecessary; (2) the post-bankruptcy conversion of Washington Prime Group, LLC (the “Company”) from a publicly traded corporation to an LLC in which that senior noteholder became an 87% holder of the company’s equity (the “Majority Holder”); (3) the tender offer made by the Majority Holder a few weeks after the emergence from bankruptcy; and (4) the “squeeze-out” merger where the Minority Unitholders alleged their units were “dramatically undervalued.”
There are two important narrative elements that color the entire Opinion. The first is that, when the Company emerged from bankruptcy as an LLC and with the Majority Holder owning 87% of its shares, it came with a new governing document, an LLC Agreement. The LLC Agreement provided strictures on the Company’s governance structure, limits on the Majority Holder’s ability to acquire additional shares without “Specified Approval,” and a provision, Section 11.1(b), that specified the information the Minority Unitholders had a right to receive. The Court of Chancery seemed to be deeply suspicious of what it might believe was an unnecessary transition from a publicly traded corporation where the shareholders had certain protections to an LLC where they are largely without, particularly so given the structure of the LLC, which the Court describes as a “corporate analogy.”
This leads into the next and likely most significant underpinning of the entire case: the Court’s suspicion that something profoundly unfair occurred without the typical features of consent of the parties to an LLC Agreement. This is not subtle. At one point, the Court writes that the Majority Holder “acquired a majority of their corporation’s Senior Notes, engineered a Chapter 11 filing without the Company ever defaulting . . . , and pushed through a plan under which the Company emerged [as an LLC].” For whatever legal arguments the Defendants made, at least at the pleading stage, they could not escape this overhang of perceived unfairness and absence of traditional indicia of consent to the terms of the LLC Agreement.
Throwing (Implied Covenant) Caution to the Wind
There are three steps that made up the Court of Chancery’s holding that the implied covenant of good faith and fair dealing (the “implied covenant”) could be used to imply a greater disclosure obligation than that which was provided in the LLC Agreement: (1) the Court’s determination that the context of this matter — that the Minority Unitholders originally had invested in a Delaware corporation, but suddenly found themselves in an LLC — meant that the usual caution around using the implied covenant in alternative entities did not apply; (2) its subsequent decision to allow for a gap filler requiring additional/better disclosures in an LLC Agreement that explicitly contemplated the issue of disclosures; and, finally, (3) broadening Delaware Supreme Court precedent addressing the implied covenant in the context of disclosure obligations.
The Court of Chancery first set forth a careful analysis of the “cautious enterprise” of the implied covenant, acknowledging that it is not an “equitable remedy” to employ when a party’s interests are adversely, unexpectedly, affected. Even further, as the Court notes, there should be “particular caution” when it comes to “alternative entity agreements” such as LLCs, because the parties “accept[ed] the risks associated with a purely contractual relationship.”
According to the Court, however, “[i]n this case, the context is different.” This is because Plaintiffs had, in fact, bought shares in a public corporation with all the associated protections. It was only after what the Court apparently viewed as the Majority Holder’s machinations that the Minority Unitholders found themselves owning shares in an LLC without the corporate structure’s protections. This rationale is understandable, although it is interesting that, at this juncture, the Court did not mention that a group of preferred stockholders, including a subset of Plaintiffs, had challenged the bankruptcy plan through an ad hoc committee that “obtained some improvements.” So, although the plaintiff-investors were not the drivers of this change, and perhaps could not have stopped it, it appears that they did have at least some voice in the creation of the LLC.
More importantly, and as will be seen below, the Court of Chancery’s seeming disapproval of this process follows the Defendants throughout the Opinion and likely colors some of the Court’s determinations in its holdings.
- Wedging in a Filler Where There Is No Gap
Moving on, the Court then turned to the all-important questions for the implied covenant: is there a gap and, if so, should it be filled? The inquiry starts with a simple premise, that all contracts impose upon its signors a duty of good faith and fair dealing in both the contract’s performance and its enforcement. In order to utilize this standard, the plaintiff must prove “a specific implied contractual obligation, a breach of that obligation . . . and resulting damage to the plaintiff” (emphasis added). In making this determination, the court must consider a few things:
- Is there express Language in the Contract Covering the Issue? To determine whether such an implied obligation exists, the court reviews the provisions of the contract. If there is language that “expressly covers a particular issue,” the court should not find an implicit obligation, as the implied covenant cannot “infer language that contradicts a clear exercise of an express contractual right.” If there is not, that indicates there could potentially be a gap that the implied covenant could fill.
- If there is a gap, Should the Court Fill it? However, just because a gap exists, does not mean it should be filled. A gap could exist because “the parties negotiated over a term and rejected it,” in which case, it would be inappropriate for the implied covenant to contradict that intention. Gaps can be filled where a term was not considered by the parties because contracts cannot anticipate every possible situation, or where the parties “understanding or expectations . . . were so fundamental” that they did not believe they needed to negotiate over it.
- If the Gap is to be Filled, It Must be Filled in the Context of the Original Negotiations. If the court does decide that there is, in fact, a gap, and it is one that should be filled by the implied covenant, the court can do so by “implying only those terms that the parties would have agreed to during their original negotiations if they had though to address them.” The court cannot insert an implied covenant with the benefit of hindsight.
Although the Court nods to this standard for gap locating and filling, once it comes down to discussing the LLC Agreement and Section 11.1(b), it does not engage in much of an analysis. It does not acknowledge (or at least give much weight to the fact) that the LLC Agreement did contain an explicit provision on disclosure, Section 11.1(b), which would generally mean there is no gap to be filled. Nor does it address that the presence of this provision, and the fact that a group of preferred shareholders had some influence over the LLC’s creation, meant that the provision may have been negotiated. The lack of discussion on this point, particularly with so much build up legally, leaves a door open for future plaintiffs: Are there circumstances where the court can fill a gap that does not exist?
- The Expansion of Dieckman
Instead of more fully engaging with the precedent on gap filling, the Court of Chancery makes its determination on the implied covenant point through a comparison with Dieckman v. Regency GP LP, 155 A.3d 358 (2017). However, in doing so, it may have broadened the holding of Dieckman beyond the Delaware Supreme Court’s original intention.
- The Delaware Supreme Court’s Analysis in Dieckman
In Dieckman, the plaintiff was a limited partner/unitholder in a publicly traded, master limited partnership (the “MLP”). The General Partner (the “GP”) proposed that a different limited partnership in the MLP family should acquire the partnership, creating a conflict of interest. Similar to the “Specified Approval” in Cygnus, such transactions were to be approved through a “Special Approval,” which provided the transactors safe harbor. In making its disclosures to attain this Special Approval, the GP “failed to disclose the conflicts within the Conflicts Committee.” The plaintiff alleged that the GP failed the safe harbor because it “made false and misleading statements in the proxy statement to secure the approval.”
The GP moved to dismiss, arguing that it only needed to “satisfy what the partnership agreement expressly required” which included “follow[ing] the minimal disclosure requirements.” The operative agreement (the “LP Agreement”) required “a summary of, or copy of, the merger agreement.”
The Delaware Supreme Court found that the plaintiff had stated a claim for breach of the implied covenant. While the LP Agreement only required very minimal disclosures, to get Special Approval and safe harbor protection, the GP had to make additional disclosures. Thus, the GP had disseminated a 165-page proxy statement not required by the disclosure provision. This extraneous disclosure was important, because the Court determined that there was a gap to fill, not in the disclosure provision, but in the provision that allowed the GP to receive the benefit of the safe harbor. Filling the gap was appropriate because, “[n]ot surprisingly, the express terms of the LP Agreement did not address . . . whether the GP could use false or misleading statements to enable it to reach safe harbors.” Thus, “once [the GP] went beyond the minimal disclosure requirements of the LP Agreement . . . , implied in the language of the LP Agreement’s conflict resolution provision was an obligation to not mislead unitholders” (emphasis added).
- Application to Cygnus
With this in mind, the Court of Chancery’s characterization of Dieckman may be questioned. The Court notes that in Dieckman the limited partnership engaged in a squeeze-out merger after obtaining Special Approval. It further states that the limited partnership “issued an information statement in connection with the transaction.” It concludes that the Delaware Supreme Court held that “the implied covenant obligated the defendants to provide truthful and accurate disclosure of material information.”
This is accurate as far as it goes, but the Court omitted to discuss a few key elements of Dieckman, such as:
- The location of the gap-filler: in Dieckman the gap that the Supreme Court filled was in the agreement’s “conflict resolution” provision, not in the disclosure requirements;
- It was only when the Dieckman Limited Partner “went beyond the minimal disclosure requirements” that the implied covenant imposed these additional obligations;
- The focus of the Dieckman court was false and misleading disclosures, not a lack of disclosure.
Because the Court of Chancery did not address these factors, it did not have the chance to explain precisely how Dieckman dictated the result in Cygnus. Noticeably, the Court did not identify where the gap is located, whether it be in the provisions about Specified Approval, which would hewn more closely to Dieckman, or in the express disclosure provision of the LLC Agreement. Nor did it engage at all with Dieckman’s qualifier that it was only when those disclosures went beyond the minimal requirements that the implied covenant came into play.
Most important, the Cygnus court did not discuss how the issue in Dieckman, the dissemination of a false or misleading, non-required disclosure, should be tailored to apply to Cygnus, where the allegation is that Defendants “were under an implied obligation to disclose information about the Tender Offer and the Squeeze-Out Merger” beyond the minimum disclosures contemplated in the LLC Agreement, and not that the disclosures the investors received, no matter how paltry, were false or misleading. As the Court noted, the Majority Holder “did not obtain Specified Approval before proceeding with the Tender Offer. [The Majority Holder] also did not engage in the notice process contemplated by the Challenge Right.”
Indeed, although the Cygnus court is clear about the limited nature of the Defendants’ disclosures regarding the Tender Offer, both in number and completeness, it did not conclude that the disclosures were materially false or misleading.
Turning to the Squeeze-Out Merger, the Court noted that the disclosure informing the Minority Unitholders about the Squeeze-Out Merger “consisted of a three-page cover letter and a skeletal, five-page information statement.” Concluding that plaintiffs could pursue a claim based upon an implied duty to not make “misleading partial disclosures,” the Court determined that the disclosure explained “what the Squeeze-Out Merger was” but not “how the Company made this decision or why this was an appropriate course of action.” But again, the discussion is centered around how little was disclosed rather than the accuracy of what was or was not disclosed. In this vein, the Court seemingly was influenced by Plaintiffs’ allegations concerning various requests for information, all ignored aside from an “email [that] consisted of five sentences that did not answer [Plaintiff’s] questions and added nothing to the Disclosure Documents.”
The Cygnus court’s predominant reliance upon allegations of misleading omissions rather than misrepresentations thus may signal a change in approach to the implied covenant, at least in certain circumstances. By implying a duty to disclose specific information even in the presence of an agreement addressing what would be required, the Court seems to veer closely to the forbidden “equitable remedy” territory that examines the situation in hindsight. The Cygnus court thus seemingly expands a precedent that arose in the specific context of a non-required disclosure that was materially inaccurate and applies it to disclosures that were not alleged to have been inaccurate.
That said, what does this mean for those with non-corporate structures in Delaware? Does this change the general principles governing alternative organizational structures? Or will later application of Cygnus be limited to situations where the traditional indicia of consent to an alternative organizational structure did not exist? Generally, it is not likely that this represents a sea change, given Delaware’s long-standing deference to parties’ freedom to contract in the LLC context. Other cases (and perhaps ultimately an appeal of Cygnus) will provide the Delaware courts ample opportunities to expand, limit, and otherwise shape the law applicable to these alternative entities.
This post is as of the posting date stated above. Sidley Austin LLP assumes no duty to update this post or post about any subsequent developments having a bearing on this post.