Traditionally, the Delaware Court of Chancery has been reluctant to apply the implied covenant of good faith and fair dealing to hold contracting parties liable for conduct that is not explicitly prohibited by the plain language of their contract.  In Whitestone REIT Operating Partnership, L.P. v. Pillarstone Capital REIT, however, the Court recently found that the Defendant breached the implied covenant of good faith and fair dealing by adopting a shareholder rights plan that interfered with the Plaintiff’s redemption rights under the parties’ Amended and Restated Agreement of Limited Partnership (the “LP Agreement”).

In September 2016, the Plaintiff, a real estate operations business, entered into the LP Agreement with the Defendant to form Pillarstone Capital REIT Operating Partnership L.P. (the “Partnership”). As consideration for entering the Partnership, the Plaintiff agreed to contribute 14 commercial properties in exchange for Class A Units in the Partnership. The LP Agreement gave Plaintiff the right to redeem its Units by delivering a Notice of Redemption to the Partnership. Upon receipt of a Notice of Redemption, the Defendant had discretionary authority to redeem the Plaintiff’s Units in the form of either cash or by issuing common shares of the Defendant’s equity to the Plaintiff.

Approximately four years later, the Plaintiff and Defendant began negotiating the Plaintiff’s exit from the Partnership. When the Defendant learned that the Plaintiff intended to redeem its Partnership Units, the Defendant’s board adopted a Shareholders Rights Plan (the “Rights Plan”) under which Defendant’s equity would dilute when an “Acquiring Person” possesses 5% or more of Defendant’s common shares. Since delivery of a Notice of Redemption would trigger the Rights Plan, the Plaintiff filed a complaint to enforce its redemption rights under the LP Agreement.

After trial, the Court ruled that the plain terms of the LP Agreement implied that neither party could act to impede the other’s rights under the contract, including the Plaintiff’s redemption option. Under this implied covenant, each contracting party is required to act in good faith when enforcing the terms of an agreement. The Court uses this covenant to imply the terms of a contract when there are “unanticipated developments” or to fill gaps between a contract’s explicit terms. While the implied covenant of good faith and fair dealing exists in every contract under Delaware law, Vice Chancellor Lori W. Will emphasized that the implied covenant provides a “limited and extraordinary legal remedy” that must be used sparingly. To ensure that this remedy is not abused, the Court requires parties to prove that the implied terms of the contract reasonably correspond with the existing terms of the contract. In doing so, the Court prevents contracting parties from arguing that the implied term they seek exists in any one of the contract’s terms.

In determining whether the Defendant breached the implied covenant by adopting the Rights Plan, the Court noted that such a claim is contractual in nature. As such, the Court applied the elements of a breach of contract claim to the Plaintiff’s claim under the implied covenant. First, the Court found that the plain meaning of the LP Agreement implied that the Defendant was precluded from frustrating the Plaintiff’s redemption rights. Second, the Defendant breached the implied terms of the LP Agreement when it adopted the Rights Plan for the purpose of discouraging the Plaintiff from exercising its redemption option. Lastly, the Court ruled that Defendant, by adopting the Rights Plan, deprived the Plaintiff of what it bargained for in the LP Agreement — a largely unrestricted right to redeem its Units in exchange for contributing 14 commercial properties to the Partnership.  Therefore, the Court concluded that the Rights Plan was unenforceable under the implied terms of the LP Agreement.