Friday, July 16, 2010

Business to business fraud (Part IV): The obligation of good faith

In prior posts I considered some recurrent causes of business to business fraud and potential remedies (breach of fiduciary duty and fraudulent inducement) common in business litigation. In this post I discuss the obligation of good faith.

The obligation of good faith.
This is a tricky obligation. It is a duty engrafted onto every contract, including operating agreements of LLCs. But it won’t stand alone as a separate obligation to permit suit for breach of contract. For example, if one party has discretion pursuant to the agreement to do something, he or she must exercise that discretion in good faith; the party cannot act to deny the other party the anticipated benefits of the agreement. The obligation won’t be applied to overrule an explicit contract provision, however, which makes the obligation confusing and difficult for the courts to apply in contract breach cases.

Loan agreements as an example.

Banks have the right to declare defaults under most loan agreements, but do they have to exercise good faith in declaring a default? Consider a condominium development in which the development has a value of $100 and the loan outstanding is $80 or less. The bank loan officials declared that as long as the loan to value ratio was maintained at 80% or less, no default would be declared. But when payments were missed, the loan was transferred to a workout group, which decided to declare a default and foreclose. They had discretion to declare a default, but was it exercised in good faith if the loan to value ratio were still 80% or less?

In Chemical Bank v. Paul, 244 Ill.App. 2d 772, 614 N.E.2d 436 (1st Dist. 1993), I helped prove that the bank violated its obligation of good faith when it failed to promptly approve legitimate commercial leases and condominium sales, and declared a default despite a favorable loan to value ratio, crippling the real estate developer’s ability to repay its loan. Since that time, courts have limited the obligation of good faith, reasoning that, if the contract allows the bank to declare a default under certain conditions, if those conditions occur, the bank should not be prevented from doing what the contract allows. This would not change the result in Chemical Bank because the bank was also guilty of bad faith in failing to approve leases and condominium sales: the loan documents gave it discretion to approve these transactions, but that discretion had to be exercised in good faith.

LLC Acts and other statutes.
As noted in my prior post, Delaware permits LLC agreements to eliminate fiduciary duties. Nevertheless, the parties cannot overrule the duty of good faith. The proponents of the Delaware approach like the idea of implementing only contract-based duties, leaving it to the parties to define them, and limiting the role of the courts. The model LLC Act forbids disclaimer of certain fiduciary duties. Proponents of this approach note the value of forbidding chicanery and the difficulty of differentiating between breach of a fiduciary duty and breach of the obligation of good faith.

Fiduciary duties and good faith duties overlap.
If an LLC manager has the discretion under an operating agreement to purchase goods for the LLC and if fiduciary duties have been disclaimed in the operating agreement, how does one examine a transaction in which the manager buys the goods from an affiliate? In my view, there should not be a presumption of fraud as there would be if fiduciary duties existed (that is, if they had not been disclaimed in the operating agreement), but if the price were too high or the goods were of the wrong type for the LLC, the manager should be guilty of bad faith. The question is whether the elimination of the presumption is a good idea.

A cynical real estate investor once told me that limited liability partnerships were simply vehicles for transferring wealth from the limited partners to the general partner. I wonder whether Delaware’s LLC Act that permits the complete disclaimer of fiduciary duties simply operates to facilitate the transfer of wealth from LLC non-managers to cynical LLC managers. In Delaware, I hope that the obligation of good faith will prevent this.