Contractual Imperfection: When the Law Steps In
Nobody is perfect. Not everyone does the right thing all of the time, nor does everyone act with an eye on the future in their present day decision-making. Multimillion dollar businesses and the men and women that represent them are no different. As a result, there are times when the court must act as if it were present in the boardroom when a contractual relationship was both formed and spelled out. The court acts in this manner in order to align the contracting parties’ decisions, as memorialized in contract, with all of their intentions, many of which might not have made it into a written document.
In re El Paso Pipeline Partners, L.P. , the Delaware Chancery court was required to step in and interpret a contractual relationship. In March of 2010, El Paso Corporation (“El Paso”) sold a 51% interest in Southern LNG Company, LLC. (“Southern”) and a 51% interest in El Paso Elba Express Company, LLC. (“Elba”), two companies that it solely owned, to El Paso Pipeline Partners, L.P. (“El Paso MLP”). The remaining 49% interest in both companies was also eventually acquired by El Paso MLP in November of the same year.
In February of 2010, one month before the above-mentioned transactions occurred, El Paso offered El Paso MLP a 51% interest in Southern and Elba for $900 million plus the assumption of $153 million in debt. At the time the sale was approved, domestic production of shale gas was increasing, thereby weakening the market for imported shale gas, El Paso and El Paso MLP’s primary business. Ultimately, the plaintiffs believed that due to the weakened domestic market for imported shale gas, El Paso faced a substantial risk that their clients would be inclined to breach their Service Agreements, leaving the newly-acquired Southern and Elba with a potential 20% drop in revenue. The plaintiffs argued that through the sale of Southern and Elba, El Paso sought to unload its now risky assets onto El Paso MLP at a grossly inflated price.
When proceeding to the sale of Southern and Elba, El Paso and El Paso MLP created a “Conflicts Committee” that would be able to approve the sale if a majority of the committee’s members approved and acted in good faith. Over a period of 6 weeks, the Conflicts Committee met five times to review the sale. These meetings included presentations, overviews of the proposed transaction, discussions of due diligence, valuation, etc. Regardless of the Conflict Committee’s actions, the plaintiffs filed suit, alleging a breach of both contractual obligations and the implied covenant of good faith and fair dealing.
Under Delaware law, “the ultimate inquiry must focus on the subjective belief of the specific directors accused of wrongful conduct.” Furthermore, trial judges must avoid “replacing the actual directors with a hypothetical reasonable person,” when assessing the decision-making of a company’s directors.
The plaintiffs argued that the Conflicts Committee failed to appreciate how simple it would be for El Paso and El Paso MLP’s clients to walk away from the Service Agreements that they entered into together, thereby exposing El Paso and eventually El Paso MLP to substantial financial losses down the road.
El Paso Pipeline Partners turned on the issue of the implied covenant of good faith and fair dealing in an effort to fill in the gaps of the express provisions of the contractual agreement between El Paso and El Paso MLP. As the court acknowledged, “[c]ontractual gaps always exist because the human negotiators and drafters lack perfect foresight, operate with limited resources, and practice their craft using the imprecise tool of language.” Furthermore, gaps also exist because some aspects of the deal are so “obvious to the participants that they never think, or see no need, to address them.” As a result, the implied covenant of good faith and fair dealing is a “mandatory, nonwaivable aspect of every contract governed by Delaware law.” This concept is also echoed in the laws of both Pennsylvania and New Jersey alike.
The Delaware Chancery court provides a two-step analysis to determine whether the implied covenant is needed. First, the court looks to the process of “contractual construction,” which is the process by which a court determines the scope and legal effect of the terms of the agreement. By doing this, the court determines whether the language of a contract expressly covers a specific issue, thereby omitting the need for the implied covenant to apply, or whether the contract is silent on a particular issue, thereby revealing a gap that the implied covenant may fill.
Second, once a contractual gap is found to exist, the court must determine whether or not the implied covenant should be used to fill the gap, as not all gaps should be filled. This is a critical step because a court “must not use the implied covenant to ‘rewrite the contract.”’ “The implied covenant seeks to enforce the parties’ contractual bargain by implying only those terms that the parties would have agreed to during their original negotiations if they had thought to address them.”
The court gave three examples of gaps that would need to be filled with the implied covenant: (1) where the parties fail to perceive a need and fail to include it; (2) when the parties felt an issue was too unimportant to warrant inclusion in a written agreement; and (3) where a term would be considered too obvious to articulate.
In El Paso Pipeline Partners, the implied covenant was needed for situation (1) above. The plaintiffs argued that there was an affirmative duty on El Paso when selling its holdings to El Paso MLP to disclose material information to the Conflicts Committee, an issue the agreement was silent on. The court applied the implied covenant of good faith and fair dealing after finding that this gap did exist in the contractual relationship and ruled that the parties and drafters of the agreement between the two companies would not have imposed this affirmative duty on El Paso, citing five examples from the contractual relationship in support of this conclusion. As such, the court found that El Paso, El Paso MLP, and the Conflicts Committee appointed to work on the sale all acted in good faith in the transition of El Paso’s holdings to El Paso MLP.
The law applied in El Paso Pipeline Partners, although that of the State of Delaware, is relatively mirrored in both Pennsylvania and New Jersey. Both Pennsylvania and New Jersey have the implied covenant and use it when needed to fill in gaps found in contractual relationships. Even though Pennsylvania and New Jersey have yet to explain the full nuances of their own implied covenant laws, it would be expected that they would fall closely in line with those of Delaware.
The courts acknowledge that no person, group, or company is perfect. Even when parties get together to form a contractual relationship, taking all the care required to ensure their rights are protected, gaps always exist. The implied covenant of good faith and fair dealing is used not to control or change a contractual relationship, but rather to assist the court in making a determination of what the parties intended or would have intended be part of the contract and what was intended to be left out.
This feature of the law can be greatly beneficial but can also potentially harm a party it seeks to assist. Regardless of the outcome, the implied covenant still takes the power out of the hands of the contracting parties and places it firmly in the hands of the court to make the determination of what it thinks the parties intended. Although perfection cannot be expected, it is important to do your due diligence and ensure that your contractual relationship spells out as much as possible, thereby leaving as little as possible for the courts to interpret.