Delaware Court of Chancery Holds Discretionary Contract Rights Subject to Implied Covenant Constraints

In a decision involving commercial and financial transactions, the Delaware Court of Chancery denied defendants' motion to dismiss an implied covenant claim, holding that a party cannot exercise a discretionary contract right—even one exercisable in the party's "sole discretion"—for the sole purpose of harming its counterparty without any legitimate contractual justification. The decision reaffirms that the implied covenant of good faith and fair dealing constrains opportunistic use of contractual discretion, regardless of how broadly the contract purports to grant that discretion.

Key Highlights

• "Sole discretion" language does not eliminate implied covenant constraints. The mere grant of discretion does not authorize arbitrary or malicious use of that discretion.

• Bad intent matters again. The Court applied the Delaware Supreme Court's Baldwin decision, holding that exercising discretion with subjective bad faith—i.e., for the sole purpose of harming the counterparty—can constitute a breach of the implied covenant.

• Evidence of ulterior motives is crucial. The allegation that the Investor Funds secretly funded a loan they had rejected was described as "crucial" because it supported an inference that the discretion was wielded as a weapon, not for any legitimate purpose.

• Broad drafting cannot immunize opportunism. Parties should not expect that expansive discretion clauses will shield conduct designed solely to destroy the counterparty's benefit of the bargain.

Background

The case involves Calumet, a litigation finance company that agreed to source and service loans for Victory Park Capital (the "Investor") in exchange for servicing fees and a promote upon loan repayment. The Investment Agreement gave the Investor Funds a "right of first offer" on loans Calumet identified, exercisable in the Investor Funds' "sole discretion."

Calumet alleged the Investor exploited this right as part of a "systematic campaign" to weaken Calumet and replicate its business internally — demanding extensive diligence, stringing out negotiations, then declining to fund at the last minute, wasting Calumet's time and resources. Calumet further alleged the Investor Funds on at least one occasion rejected a loan proposal, then secretly funded the same loan themselves on similar terms.

The Court's Holding

The Delaware Supreme Court recently held, in Johnson & Johnson et al. v. Fortis Advisors, LLC, that the implied covenant applies in two circumstances: (1) as a gap-filling mechanism to address unforeseen developments; and (2) when a contract allocates discretionary authority to ensure that discretionary authority is applied consistent with the agreed bargain. This case dealt with the second circumstance. Specifically, the Court held that the implied covenant of good faith and fair dealing applies to discretionary contract rights, even those granted with "sole discretion" language. The Court emphasized that:

• The term "sole discretion" does not displace the implied covenant—rather, "[t]hat setting provides more reason for the implied covenant to apply, not less."

• The implied covenant prohibits wielding a discretionary right for the sole purpose of inflicting harm on the counterparty without any justification rationally related to the contractual relationship.

• While a party may use discretion to protect its own interests or advance the contract's purpose, it cannot wield discretion as a weapon to harm the counterparty or to coerce capitulation to unrelated demands.

The Court found it reasonably conceivable that the Investor Funds exercised their right of first offer maliciously and without a legitimate contractual justification, allowing the implied covenant claim to proceed.