Policemen’s Annuity and Benefit Fund of Chi., Ill. v. DV Realty Advisors LLC, C.A. No. 7204-VCN (Del. Ch. Aug. 16, 2012) (Noble, V.C.)
In this memorandum opinion, the Court of Chancery held that where a limited partnership’s partnership agreement provides discretion to one party and the scope of that discretion is not specified, the implied covenant of good faith and fair dealing requires that the discretion be used reasonably and in good faith. If, however, the scope of discretion is provided for in the partnership agreement, the Court will not look to the implied covenant to see how discretion should be exercised.
The limited partners (the “Limited Partners”) of DV Urban Realty Partners I L.P., a Delaware limited partnership (the “Partnership”), brought an action seeking a declaration that their removal of the Partnership’s last remaining general partner, DV Realty Advisors LLC (the “General Partner”), was valid. The General Partner, however, argued that its removal failed to meet the express and implied requirements of the relevant provision (the “Removal Provision”) of the Partnership’s partnership agreement (the “Partnership Agreement”). The Removal Provision provided that the Limited Partners could remove the General Partner “without Cause by an affirmative vote or consent of the Limited Partners holding in excess of 75% 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.”
As an initial matter, the Court discussed which party had the burden of proving whether the removal of the General Partner was valid. In declaratory judgment actions, the general rule is that the plaintiffs (i.e., the Limited Partners) have the burden of proof. The Court noted, however, that this rule could be overcome if the Partnership Agreement expressly provided otherwise. The Partnership Agreement, however, had no such provision. This, combined with the facts that the Limited Partners, and not the General Partner, were trying to change the status quo and that the Limited Partners could more readily access relevant evidence, led the Court to hold that the Limited Partners had the burden of proof.
The Court then addressed the General Partner’s argument that the Court should imply in the Removal Provision a requirement that the Limited Partners must act reasonably if they exercise their discretion to remove the General Partner. The Court disagreed and held that such an implication is only necessary where a contract fails to provide the scope for a party’s discretion. According to the Court, the good faith requirement in the Removal Provision provided the scope for the Limited Partners discretion in removing the General Partner. There was, therefore, no need to imply a reasonableness requirement into the provision.
Next, the Court analyzed the meaning of “good faith,” as such term was undefined in the Partnership Agreement. Because the Partnership Agreement was “made pursuant to and [was to] be governed by the laws of the State of Delaware,” the Court presumed that the parties intended to adopt Delaware’s common law definition of good faith as applied to contracts. Although the Court stated that this definition is primarily subjective, it noted that there is likely some conduct which is so unreasonable that the Court would necessarily determine that it could not have been undertaken in good faith. Whether the conduct is so unreasonable depends on the situation – what is unreasonable in one setting could be perfectly acceptable in another. The Court found that the Limited Partners’ conduct did not approach the sort of unreasonable conduct that is necessarily taken in bad faith.
To analyze further the Limited Partners’ conduct, the Court stated that it needed some rubric. As such, the Court looked to the definition of “good faith” as defined under Section 1-201(20) of the Uniform Commercial Code, as in effect in Delaware, which defines good faith as “honesty in fact and the observance of reasonable commercial standards of fair dealing.” This definition, according to the Court, is at least as broad as the common law definition of good faith as applied to contracts. Thus, the Court reasoned, if the Limited Partners could satisfy this definition, they would necessarily satisfy the common law definition.
Under this standard, the Court found that the Limited Partners’ removal of the General Partner was in good faith and in accordance with the Partnership Agreement. Among other things, the General Partner failed on numerous occasions to prepare timely audited financial statements for the Partnership. The Court found that this provided the Limited Partners with a good faith belief that removal of the General Partner was in the best interest of the Partnership.
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