On August 16, the Delaware Court of Chancery in Policemen’s Annuity and Benefit Fund of Chicago v. DV Realty Advisors LLC, C.A. No. 7204-VCN (Del. Ch. Aug. 16, 2012), addressed the question of whether limited partners of a limited partnership permissibly exercised their discretion in removing a general partner pursuant to the terms of a limited partnership agreement. In particular, the court analyzed the meaning of a provision in the partnership agreement that allowed the limited partners to remove the general partner without cause if they “in good faith determine that such removal is necessary for the best interest of the partnership.”

BACKGROUND

DV Urban Realty Partners I LP (the partnership), a Delaware limited partnership, was owned 4.9 percent by its former general partner, DV Realty Advisors LLC (the GP), and 95.1 percent by its limited partners (the LPs). Section 3.10(a)(ii) of the partnership’s limited partnership agreement (the LPA) provides a mechanism for the LPs to remove the GP without cause:

"Both general partners (and only both, not either general partner individually) may be removed without cause by an affirmative vote or consent of the limited partners holding in excess of 75 percent of the partnership interests then held by all limited partners; provided that consenting limited partners in good faith determine that such removal is necessary for the best interest of the partnership."

Occam-DV LLC had served as the other general partner of the partnership, but had resigned. The LPs elected to remove the GP as the remaining general partner without “cause” under Section 3.10(a)(ii) of the LPA.

The GP argued that, in order to do so, the LPs were required (and failed) to demonstrate not only that they acted in “good faith,” but also that, because of the implied covenant of good faith and fair dealing, they exercised their discretion to remove the GP in an “objectively reasonable” manner.

The LPs argued that the implied covenant of good faith and fair dealing does not apply to a contractual provision that does not have any contractual “gaps” and that Section 3.10(a)(ii) of the LPA does not have any such gaps. The LPs also argued that they had demonstrated that they had acted in “good faith” in determining to remove the GP without cause under Section 3.10(a)(ii).

NO IMPLIED COVENANT TO ACT REASONABLY

The court rejected the GP’s contention that the LPs were required to act “reasonably” in exercising their discretion under Section 3.10(a)(ii) of the LPA. Although the implied covenant of good faith will operate in contracts generally to require that a party exercise its discretion under a contract reasonably, the implied covenant is not applicable to a provision for which the scope of discretion is specified.

To describe a standard of discretion, a contract “‘may identify factors that the decision-maker can consider, and it may provide a contractual standard for evaluating that decision,’” the court said in the opinion, quoting ASB Allegiance Real Estate Fund v. Scion Breckenridge, 2012 WL 3027351, at *4 (Del. Ch. July 9, 2012). In dicta, the court went as far as to suggest that the use of the phrase “sole discretion” would be effective to convey unfettered discretion, citing Wilmington Leasing v. Parrish Leasing, L.P., WL 560190 (Del. Ch. Sept. 25, 1996), at *2.

Since Section 3.10(a)(ii) of the LPA specifically stated a standard (albeit an ambiguous one) with which the LPs could exercise their discretion — “good faith” — the implied covenant that the LPs exercise discretion reasonably did not apply.

WHAT IS MEANT BY “GOOD FAITH”?

The court then turned to the issue of whether the LPs had met the good-faith standard set forth in Section 3.10(a)(ii) of the LPA. To make this determination, the court first addressed what “good faith” means in the context of the LPA, noting that the term could encompass both subjective and objective elements, depending upon the circumstance. Since the LPA did not define the term or specify whether subjective or objective factors should be considered in determining whether the standard had been met, the court stated that the term was ambiguous. To help resolve the ambiguity, the court presumed (without referring, somewhat curiously, to other potential parol evidence) that, since the LPA was governed by Delaware law, the parties had intended the standard of good faith under Delaware common law to apply. Under Delaware common law, a party exercising discretion is permitted to consider subjective factors, which affords the decision-maker broad discretion. But, as the court described it, there is a certain “outer bounds” of unreasonable actions, even for instances in which subjective factors are to be considered. And what constitutes “unreasonable” is context-specific.

DETERMINING WHETHER A PARTY EXERCISED DISCRETION

Finally, the court considered whether the LPs had met the standard of good faith, as defined under Delaware common law, in exercising their discretion to remove the GP. In concluding that the LPs had met the standard, the court considered helpful to the cause of the LPs, among other things, the minutes of the boards of certain of the LPs explaining their determinations, their reliance upon the counseling of third-party testimony, and the observance of commercially reasonable standards in connection with their decisions.

PRACTICE POINTS

Policeman’s Annuity provides practitioners with some important takeaways.

First, when providing for discretion under a contract, parties should specifically state the standard of discretion that is to apply, including whether the decision-maker can act “in its sole discretion.” If the standard for discretion is less than an unfettered one, then the parties should consider expressly stating the factors that the party exercising discretion is permitted to consider, including whether the decision-maker is permitted to take into account subjective considerations. In the context of larger contracts, the parties might find it beneficial to include a general provision setting forth a blanket set of standards and factors that are applicable, at least as a default rule, to all provisions in which discretion can be exercised.

Second, a party electing to exercise contractual discretion should build a solid record that bolsters its bases for that exercise of discretion. This record might include, among other things, detailed board minutes (including all materials submitted to the board), a brief analysis of the extent to which the exercise of discretion is in line with industry norms, and, for more complicated decisions, reports and other evidence regarding advice from third parties with respect to such decisions.

Vincent R. Martorana is counsel in the corporate and securities group with Reed Smith’s New York office. His practice includes the representation of clients in domestic and cross-border mergers, stock and asset acquisitions and divestitures, joint ventures, strategic alliances, licensing arrangements, corporate restructurings, private equity investments and securities offerings. He can be reached at vmartorana@reedsmith.com

Reprinted with permission from the September 19 issue of Delaware Law Weekly © 2012 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited. For information, contact 877-257-3382, reprints@alm.com or visit www.almreprints.com