Reprinted with permission from the December 30, 2016 issue of The Legal Intelligencer. (c) 2016 ALM Media Properties. Further duplication without permission is prohibited.
Historically, the courts of the Commonwealth of Pennsylvania have been loathe to blur the distinction between tort and contract. The gist of the action doctrine, well formed and frequently litigated, precludes recasting contract claims as tort claims or claims of negligent performance of contractual duties. The courts have specifically held that parties to business agreements such as partnership, shareholder or LLC operating agreements may contract away or severely limit fiduciary duties owed by partners, directors and managers. Notwithstanding these long standing and often contested principles of law, the Pennsylvania Supreme Court is set to address an emergent trend toward the expansion of duties imposed by contract through the implication of the duty of good faith and fair dealing in the context of business relationships. Specifically, the Court has granted allocator on the issue of whether “the implied covenant of good faith and fair dealing” applies to “all limited partnership agreements under Pennsylvania law.” Assuming the Court answers the question in the affirmative, as have the Courts in neighboring Delaware in a similar cases involving business governance agreements, the bright line between tort and contract will dim.
The case of Hanaway v. Parkersburg Group, L.P. 132 A.3d. 461 (Pa. Super. 2015) arises out of a limited partnership agreement for the development and sale of real estate. The complaint alleges various breaches of fiduciary duty, conversion and contract based on the general partner’s sale of real estate at below market value to a separate entity also controlled by the general partner and involving many of the same limited partners as had invested in the original limited partnership – to the exclusion of the plaintiffs. All tort claims based on breach of fiduciary duty were found to be time barred. Further, the trial court granted summary judgment on the contract claims. On appeal to the Superior Court, plaintiffs argued that the trial court erred in granting summary judgment on breach of contract claims by finding that the provisions of the limited partnership agreement granting the general partner exclusive right to manage the business affairs of the partnership negated the duty of good faith and fair dealing. Plaintiffs argued the covenant is implied in every contract and imposes on each party a duty of good faith and fair dealing in its performance and enforcement, notwithstanding the grant of exclusive management rights.
The Superior Court held that the implied covenant of good faith and fair dealing imposed the duty to exercise a contractual obligation, even a contractual obligation expressly conferring the exercise of discretion, must be exercised in good faith. “Good faith” was interpreted to mean “faithfulness to an agreed common purpose and consistency with the justified expectations of the other party; it excludes a variety of types of conduct characterized as involving bad faith because they violate community standards of decency, fairness or reasonableness”. The Court went on to describe the implied duty as requiring “honesty in fact in the conduct of the transaction concerned”. Thus, the Court concluded that the general partner’s sale of partnership assets at below market rate for its own benefit and the benefit of its like minded limited partners to the detriment of others may constitute a breach of the implied duty and an issue for trial which should not have been dismissed on summary judgment.
The Pennsylvania Supreme Court’s impending decision will undoubtedly be guided by precedent from the Delaware Supreme Court and the statutory preservation of the duty of good faith and fair dealing even in the face of the right to contract including the right to limit other duties- even fiduciary duties. Delaware has adopted both a Revised Uniform Limited Partnership Act and a Limited Liability Company Act which permit parties to business agreements within the scope of those Acts to limit fiduciary duties owed to each other and the business. The Limited Liability Company Act goes so far as to confirm the premise that managers in an LLC owe fiduciary duties to each other under law by default, but allows for modification of such duties in the operating agreement. The Revised Uniform Partnership Act, while allowing for a contractual waiver of fiduciary duties, specifically rejects waiver of the covenant of good faith and fair dealing. Accordingly, while the parties are free to modify the fiduciary relationship with regard to management of business entities traditionally governed by contract, the implied covenant of good faith and fair dealing remains. That premise was confirmed by the Delaware Supreme Court in Gerber v. Enterprise Products Holdings, LLC 67 A.3d 400 (Del. 2013). In Gerber, the Supreme Court explained that the implied covenant “seeks to enforce the parties’ contractual bargain by implying only those terms the parties would have agreed to during their original negotiations had they thought to address them”. Gerber, at 418.
The blending of tort and contract in the Pennsylvania Superior Court’s analysis in Hanaway is clearly evident by the Court’s summary conclusion that the breach of contract claims should have been preserved for the jury. Although directly addressing the breach of contract claim, the Court applied tort principles by finding that the evidence, if credited, could support a finding that the Defendant orchestrated the sale of partnership assets at a price below market value for its own benefit. The Court then concluded such sale could have constituted a breach of the contractual duty to exercise management of the limited partnership in “good faith”. Hanaway, 132 A.3d at 476.
A Supreme Court opinion which imposes the duty of good faith and fair dealing to all agreements governing business relationships will have far reaching implications. Clearly, if breach of contract can be successfully alleged in a business setting under circumstances described in Hanaway, the statute of limitations analysis is substantially modified. Owners of a minority business interest may no longer be limited to a two year statute. Business practitioners and drafters of organizational documents who once believed a disclaimer of fiduciary duty was sufficient must now reconsider the inclusion of a “good faith” definition. For litigators, the permissible theories of damage claims in business disputes concerning internal governance documents are expanded.
Although the Hanaway Superior Court decision is at odds with many traditional notions of separation between tort and contract, any Supreme Court determination that excludes the principal of good faith and fair dealing from business agreements would be at odds with the overarching and recognized principle that the duty is “implied in every contract”. Further, any such ruling would be at odds with recent precedent from the Supreme Court of Delaware.
Tom Donnelly is a Partner of the firm. His practice focuses primarily on commercial litigation and transactions, employment disputes and personal injury. To learn more about the firm or Tom Donnelly, visit www.ammlaw.com.
Those of us routinely asked to draft or review letters of intent (LOI), memorandum of understanding (MOU) and initial term sheets have a new challenge. The use of conventional text clearly stating “this is non-binding” to be sure a preliminary document memorializing negotiations does not give rise to the risk of unintended enforcement apparently is no longer sufficient. As a result of the Delaware Supreme Court’s decision in SIGA Technologies v. PharmAthene, Inc., No 314, 2012 2013 Del. LEXIS 265, 1-2 (Del. May 24, 2013), it is now suggested that counsel negotiating LOIs, MOUs and even term sheets designated as final include a specific negation of good faith. Text specifically stating the parties agree that neither party shall have a duty to negotiate in good faith is now considered appropriate. Getting both sides to agree to include such a forbidding sentence, however, is a significant challenge.
In SIGA Technologies, the court held that expectation or “benefit of the bargain” damages (and not just out of pocket, reliance damages) were appropriate where (1) the parties had a term sheet; (2) the parties expressly agreed to negotiate in good faith in a final transaction in accordance with those terms; and (3) but for the breaching party’s bad faith in trying to improve the terms, the parties would have consummated a definitive agreement with the terms set forth in the term sheet.
The SIGA Technologies decision might have been appropriate in light of the specific facts before the court but it leaves transactional lawyers at a loss. Business lawyers have been advising clients since the beginning of time that there is, and should be, a great difference between incomplete and preliminary letters, drafts and other communications clearly understood as non-binding (with the exception of specifically identified provisions, such as those relating to confidentiality and exclusivity) and final, mutually executed contracts with an integration clause. The former should have no legal effect other than as a basis to start the hard drafting process for definitive agreements. LOIs, MOUs and term sheets referring to the parties’ intent to finalize binding documents later are to be used as support for financing efforts and strategic planning and not evidence of a final oral or implied agreement between the parties. Exceptions to this rule were, until recently, very narrowly applied and usually only if the parties made an effort to carve out the intended exceptions with clear language (non-disclosure, exclusivity or no-shop provisions). Efforts by counsel for either party to impose a written duty of good faith and fair dealing on the other party are normally met with resistance with the better practice perceived to be silence on this point and text that allows either party to halt negotiations at any time for any reason as long as there is no breach of the binding confidentiality and/or exclusivity provisions. Termination fees are sometimes added to encourage good faith negotiations and cover out of pocket costs incurred as a cost of freedom to abandon those negotiations.
To avoid imposition of a SIGA Technologies penalty, many corporate advisors are now insisting the only safe course is to explicitly refute the presence of good faith. And yet, most clients do not want to suggest that they would ever negotiate in bad faith. Worse, most clients do not want to agree to allow the other party to the proposed transaction to abandon all pretenses of good faith and fair dealing. Who wants to go to the dance with a partner who asks for permission to humiliate you while there and tells you of his or her plan to possibly leave you without a ride home?
Bad faith in the midst of negotiations has historically been perceived as bad form but not an exception to the “non-binding” rule and certainly not the basis for expectation (lost profits) damages. To make this area even more challenging, a judicial determination of one company’s bad faith (e.g., trying to improve terms if the circumstances have become more favorable for the company) can easily be deemed by the shareholders/members of the same company to be the exercise of management’s fiduciary duty to maximize equity holders’ return. Failure to push for the best possible terms in the face of a non-binding term sheet could be found by another court to be a breach of that duty.
Whether bad faith should support an exception to the “non-binding” rule as a matter of law is an interesting question but the philosophy of law is rarely a topic businessmen and women wish to explore. Any number of things can make a deal that seemed attractive at a given point unacceptable some time later. Negotiations with respect to terms not included in the preliminary documents can be filled with real dispute; due diligence may reveal greater risks than anticipated; the industry-wide market may shift; or business may suddenly improve supporting more favorable terms for one party and less favorable terms for the other. Where the risk of the business enterprise does not begin to shift until after the execution of a definitive document, why should either party get the benefit of a preliminary bargain when the facts and circumstances supporting the transaction have changed?
While no one should be conducting negotiations in bad faith, the imposition of an implied duty of good faith and fair dealing in preliminary “non-binding” documents unless the parties specifically negate that obligation seems problematic. In contrast, once agreements are fully negotiated and signed, the covenant to act in good faith and engage in fair dealings is appropriate between business partners of all kinds. As found in other Delaware decisions, even where the contracting parties appear to have agreed to limit the scope of their common law and statutory fiduciary duties in a final document, good faith and fair dealing have an important role that should be implied and enforced by the courts. But, only after a final document is signed and sealed, however, should we be insisting a party trying to maximize their position “Did a bad, bad thing.”