Recent Developments on the Implied Covenant of Good Faith and Fair Dealing and Their Implications for Connecticut Law

Investors in a limited liability company (LLC), in which fiduciary obligations of controlling principals can be contractually waived, often find themselves in predicaments where the controlling principals take one or more actions that the investors find unfair or to be taken in bad faith. But with no ability to make breach of fiduciary duty claims, and assuming no contractual protections that specifically prohibit the unwanted actions, investors may find that their only possible remedy is to claim breach of the implied covenant of good faith and fair dealing (the “Implied Covenant”).

But how much certainty can either the investor or the controlling principal(s) take from the Implied Covenant when almost by definition it is both so broad and so vague in scope? A trio of Delaware cases applying the Implied Covenant, written by three different members of the Chancery Court and published within the last two years, shed both some light and some intellectual boundaries around the use of the Implied Covenant. Using these decisions as a foundation, this article examines how these decisions have refined the Implied Covenant and how similar issues may be approached under Connecticut law.

The Implied Covenant

First, what is the Implied Covenant? The Delaware Supreme Court has summarised the Implied Covenant as follows:

“The implied covenant is inherent in all contracts and is used to infer contract terms to handle developments or contractual gaps that […] neither party anticipated. It applies when the party asserting the implied covenant proves that the other party has acted arbitrarily or unreasonably, thereby frustrating the fruits of the bargain that the asserting party reasonably expected. The reasonable expectations of the contracting parties are assessed at the time of contracting.”

As a gap-filler, the Implied Covenant has broad application, “attach[ing] to every contract” that is subject to Delaware law ‒ as Vice Chancellor Laster wrote in Calumet, “[a]s a matter of black-letter law, every contract imposes upon each party a duty of good faith and fair dealing in its performance and its enforcement.”

Fair enough. So, what can a trio of recent cases tell us about that broad application to contractual arrangements, and ‒ importantly – what courts may or may not view as “gaps” that are actually eligible to be filled by the Implied Covenant?

The Independent Legal Significance Doctrine

Looming large over the first two cases is the Independent Legal Significance Doctrine. As described by the Delaware Supreme Court, this doctrine stands for the premise “that action taken in accordance with different sections of [Delaware statutory] law are acts of independent legal significance even though the end result may be the same under different sections.” That is to say, for example, what can be accomplished via a statutory conversion may also be accomplished by a statutory merger (or vice versa, or via any other statutorily-enabled action) without having to comply with the requirements of both actions, “the mere fact that the result of actions taken under one [statutory] section may be the same as the result of action taken under another [statutory] section does not require that the legality of the result must be tested by the requirements of the second section.”

Delaware courts have similarly applied the doctrine not only to competing statutory provisions, but also in instances where an entity’s governing documents may “compete” with, but fail to address, statutory realities – ie, statutorily-enabled actions exist independently of any contractual provision between private parties that fails to address the treatment of such actions specifically. As the court in 2002’s seminal Benchmark Cap. Partners IV, L.P. v Vague succinctly put it within the context of a corporate charter being amended via statutory merger to the detriment of certain preferred stockholders:

“[T]o the extent that the merger adversely affects the rights, preferences and privileges of [certain stockholders], those consequences are the product of a merger, a corporate event which the drafters of the protective provision could have addressed, but did not.”

So, in remaining silent, drafters will, as it were, memorialise the bedrock independence of these statutorily-enabled actions, leaving them free to be deployed by a counterparty in whatever creative ways may serve their purposes.

But at the intersection of the Implied Covenant with the Doctrine of Independent Legal Significance lies the question made famous by the fictitious Dr Ian Malcolm of Jurassic Park fame: “Yeah, but your [expert legal practitioners] were so preoccupied with whether or not they could, they didn't stop to think if they should.” The application of Dr Malcolm’s question is better framed here as this: just because the Independent Legal Significance Doctrine says that a party can use a token statutory mechanism to circumvent a counterparty’s otherwise bargained-for rights, should such an act be permitted given the equitable purpose of the Implied Covenant? The outcomes from the collision of these two prominent doctrines may seem counter-intuitive at surface, but likely unsurprising to those who have followed the blunt application of the Independent Legal Significance Doctrine in Delaware case law through the years.

Campus Eye ‒ independent legal significance of a Section 18-209(f) merger

Vice Chancellor Will’s opinion in Campus Eye Management Holdings v Didonato, issued in August 2024, arose from the sale by an optometrist of a majority stake in his practice to a private equity fund. As part of the sale, the optometrist had the contractual right in the LLC Agreement to appoint one of three managers of the holding company LLC that now owned his business. However, contrary to the optometrist’s protective provisions, the private equity fund unilaterally amended the LLC Agreement to convert it from manager-managed to member-managed without the optometrist’s consent, thereby eliminating his right to be a manager. 

The optometrist challenged this amendment in court and was granted summary judgment that the private equity fund could not independently amend the LLC agreement because, unsurprisingly, the LLC Agreement specifically provided that the optometrist had to consent to any such amendment. 

Undeterred, and relying on Benchmark, the private equity fund shifted tactics. Instead of a direct amendment of the LLC Agreement, the fund caused the LLC to be merged with and into another newly formed LLC. The LLC agreement of this newly formed LLC placed the business solely under the control of the private equity fund and eliminated the optometrist’s prior rights to share control of the entity. The optometrist then claimed that causing this merger with the intended result of eliminating his contract rights violated the private equity fund’s Implied Covenant.

In her decision, Vice Chancellor Will began by laying out the general principles of the Implied Covenant, namely that “[t]he doctrine ‘ensures parties to not ‘frustrat[e] the fruits of the bargain’ by acting ‘arbitrarily or unreasonably.’” But, importantly:

“‘The application of the implied covenant of good faith and fair dealing [...] [sic] is limited to filling contractual gaps that neither party anticipated.’ It can fill a gap only if ‘it is clear from the contract that the parties would have agreed to that term had they thought to negotiate the matter.’”

After having sketched out the purpose and bounds of the Implied Covenant, Vice Chancellor Will turned to its application to the private equity fund’s amendment:

“[The optometrist] asserts that, when the parties signed the […] LLC Agreement, it was unforeseeable that [the private equity fund] might use a merger to [indirectly] effect an amendment [that it could not effect directly]. But Section 18-209(f) of the LLC Act contemplates this very situation. It sanctions an amendment or adoption of a new LLC agreement ‘notwithstanding any provision of the limited liability company agreement relating to amendment or adoption of a new limited liability company agreement.’” 

And so, since the private equity fund took an act that statutory law specifically allowed it to take, there was not a contractual gap that the optometrist could not have anticipated, and thus the Implied Covenant simply did not apply. Vice Chancellor Will concluded this portion of her opinion by also noting that the challenged actions did not “frustrate the ‘overarching purpose’” of the transaction, as the optometrist got his contracted USD14 million for 65% of his business and only lost claimed contract rights for which he had not actually negotiated adequate protection.

Gunderson ‒ independent legal significance of a reincorporation

The second case in the triumvirate was Gunderson v The Trade Desk, Inc., decided by Vice Chancellor Fioravanti in November of 2024. In Gunderson, the facts were very similar to those of Campus Eye. An investor challenged The Trade Desk, Inc.’s (Delaware) reincorporation as a Nevada corporation. As a result of this reincorporation, charter provisions that required a two-thirds vote for the elimination of certain protective provisions were “disappeared” in the new certificate of incorporation of the newly reincorporated Nevada entity.

Notwithstanding that the reincorporation in plain language had the effect of repealing the two-thirds voting requirement without having first obtained such charter-mandated two-thirds vote, Vice Chancellor Fioravanti comprehensively and easily dealt with the investor’s principal argument under the banner of the Independent Legal Significance Doctrine (as detailed by Benchmark and its related cases), holding that:

• the elimination of these provisions by means of reincorporation was no different than doing so by means of merger;
• reincorporation was specifically authorised by statute just like mergers; and
• if the investors counting on the two-thirds requirement wanted to be protected from its elimination by means of reincorporation, they needed to protect themselves by insisting on similar Benchmark-prescribed language as that negotiated by those wanting to protect their rights from token mergers.

Having introduced the Independent Legal Significance Doctrine to the analysis, Vice Chancellor Fioravanti then made short shrift of its interaction with the Implied Covenant, summarily dismissing the covenant’s application in such an instance: “Plaintiff’s implied covenant argument has been addressed statutorily.”

Calumet capital ‒ acting with sole discretion

Turning to Calumet, Vice Chancellor Laster dealt with a motion to dismiss that involved an alternative investment broker (“Investor”) that entered into a number of agreements with a litigation financier (the “Lender”) engaged in the business of lending money to law firms. Under the arrangements, the Investor would have preferential access to new loan opportunities for two years, during which time the Investor and its affiliates would have a right of first offer on funding the Lender’s litigation loans. In turn, the Lender would administer and service the funded loans and receive certain economic incentives as the loans were satisfied.

However, the Lender alleged that after the business plan had proven to be lucrative, the Investor plotted to take away the Lender’s business for itself using both contractual and extra-contractual means to circumvent the Lender from the finding, placement and funding model. 

After disposing of other claims, Vice Chancellor Laster sided with the Lender and refused the Investor’s motion to dismiss the Lender’s claims that Investor violated the Implied Covenant by using a contractual right of first offer to draw out the loan placement process for the bad faith purpose of interfering with the Lender’s ability to offer the opportunity to third parties. Vice Chancellor Laster engaged in a very detailed discussion of when the Implied Covenant is and is not violated. While the Implied Covenant arises to infer contract terms that were not and could not have been anticipated, Vice Chancellor Laster makes clear that you cannot read the requirement that circumstances “could not have been anticipated” literally, as anything, especially in hindsight, could be reasonably anticipated. 

Rather, Vice Chancellor Laster makes clear that the Implied Covenant comes into play “[w]hen parties could not have realistically addressed a gap – either because of the circumstances they faced or their implicit understanding […].” The fact that a party has the ability to exercise a right in its sole discretion, he explains, does not eliminate the Implied Covenant. Rather, it remains implicit that the “sole discretion” contractual right be exercised in good faith ‒ not “loyalty to the contractual counterparty [which would be reading in a fiduciary obligation] but rather faithfulness to the scope, purpose and terms of the parties’ contract.” The key takeaway is that even sole discretion “must be exercised ‘consistently with what reasonable parties would have agreed to at signing.’”

Connecticut’s applications

Connecticut also believes in the Implied Covenant, though with apparently fewer examples and detail than Delaware (and without the Independent Significance Doctrine coming into play, though that does not necessarily mean that Connecticut would or would not give it the broad deference that Delaware does).

In what may be the seminal Connecticut case of De La Concha of Hartford, Inc. v Aetna Life Insurance Co., the Connecticut Supreme Court upheld a lower court decision that found no violation of the Implied Covenant. The basic facts were not extraordinary within the world of commercial real estate: a landlord who owned a shopping mall (that was part of the Hartford Civic Center complex) would not renew the lease of a defaulting tenant, and the defaulting tenant wanted the landlord to spend more money promoting the Civic Center complex (though the landlord spent far more on promotion than was required under the lease).

While acknowledging the existence of the Implied Covenant (“the [landlord] was obligated to conduct itself in good faith and in a manner consistent with the reasonable expectations of the parties in view of the provisions of the lease” and could not engage “in purposeful conduct that is inimical to the material terms of the lease”), the Court noted that, under Connecticut law, there must be an element of bad faith involved in the actions of the party being accused of violating the Implied Covenant ‒ merely acting in a manner that tries to achieve the legitimate, predictable interests of the party (in this case, trying to make money on the property it owns within the bounds of the contract) will not be sufficient.

Similarly, in both Renaissance Management Co. v Connecticut Housing Finance Authority and Capstone Building Corp. v American Motorists Insurance Co. (although not as clear in this latter case as the court seemed to go back and forth between the Implied Covenant and bad faith conduct as if they were synonymous), the Court failed to overturn lower court rulings that found no violations of the Implied Covenant where the charged party was using contractually delegated discretion (as in Calumet) without an element of bad faith.

So, what do the recent Delaware cases tell us about what Connecticut might do with similar cases? With regard to Delaware’s apparent overriding position (not expressed this way) that the Independent Legal Significance Doctrine will save actions that might otherwise be candidates for violations of the Implied Covenant, Connecticut has yet to confront a case with similar facts. That said, one can easily argue that eliminating contractually agreed-to minority protective provisions by some type of reorganisational sleight of hand is exactly what the Implied Covenant should be protecting against. Otherwise, while the stated tests are far from identical, Connecticut might very well be influenced by a decision such as Calumet, as both Delaware and Connecticut seem to require some type of bad faith ‒ an effort to undermine the agreed-upon mutual arrangement as opposed to simply maximising one party’s benefit from it.