The implied covenant of good faith and fair dealing is a notoriously misunderstood doctrine. It can be invoked much less often than most people think, and its application is highly state-specific. A recent ruling from the Delaware Court of Chancery offers a good example of when the implied covenant is actionable under Delaware law.
First, some basics. The implied covenant of good faith and fair dealing is inherent in all contracts under Delaware law, but it seldom applies in practice. The covenant is a “gap-filling” device, meaning it works by implying contractual terms that are not found in the text. However, adding terms to a contract goes against general Delaware practice. As a result, Delaware courts view the implied covenant as a “limited and extraordinary” remedy. For it to apply, a contract cannot speak directly to the contested issue. At the same time, the contract must speak clearly enough to suggest an obligation and point to a result.
That brings us to the Jan. 25, 2024, decision in Whitestone REIT Operating Partnership, L.P. v. Pillarstone Capital REIT. The parties created a limited partnership in which the plaintiff had an express and unilateral right to exit its investment by tendering a redemption notice. But when the defendant/general partner learned that the plaintiff might redeem its investment, the defendant adopted a “shareholder rights plan,” triggered by the plaintiff’s redemption, which gave the defendant’s shareholders the ability to purchase additional common shares, thus diluting the plaintiff’s interest and strongly disincentivizing redemption.
The Court of Chancery held that adoption of the shareholder rights plan — which it termed a “poison pill” — breached the implied covenant of good faith and fair dealing. Although the plan did not violate an express term of the partnership agreement, the court found that the plaintiff’s unilateral and largely unrestricted redemption right implied an obligation on the defendant not to frustrate that right. And because the evidence showed that the defendant adopted the shareholder rights plan to impede the plaintiff’s right to redeem, doing so violated the implied covenant.
This decision shows that the implied covenant of good faith and fair dealing is a powerful (if elusive) tool in contract disputes. In practice, breaches of the implied covenant are alleged much more often than they are upheld. Still, litigants need to understand the scope of the implied covenant, which varies by state, and evaluate its implications in any contractual dispute. For more information, please contact the authors.