Wednesday, September 2, 2020

Delaware Chancery Court Applies Implied Covenant of Good Faith and Fair Dealing, Finds Plaintiff Failed To Prove What Would Have Been Agreed Upon

Delaware Chancery Court Applies Implied Covenant of Good Faith and Fair Dealing, Finds Plaintiff Failed To Prove What Would Have Been Agreed Upon

      The implied contractual covenant of good faith and fair dealing, as applied by the Delaware courts, will in one of its aspects look to and enforce what the parties would have agreed to had they thought to actually negotiate on the point. Resolution of that question will involve a factual analysis of matters including how the parties have otherwise allocated risk in the transaction. In a recent decision, the court found that the plaintiff failed to demonstrate that the defendant would have agreed to what it said it would have been the negotiated rule. RoundPoint Mortgage Servicing Corp. v. Freedom Mortgage Corp., C.A. No. 2020-0161-SG, 2020 WL 4199957 (Del. Ch. July 22, 2020).

      RoundPoint Mortgage Servicing acquired, by means of a merger, Freedom Mortgage. The merger agreement, in addition to the usual restrictions on transactions outside the ordinary course between signing and closing, specifically addressed that RoundPoint might, in that period of time, face margin calls on a credit facility that was secured by certain of its assets. In order to make funds available to satisfy those obligations, the merger agreement allowed RoundPoint to borrow money from its controlling shareholder (the “Shareholder Loan”). That same merger agreement required as a closing condition that Round Point “shall have repaid, all amounts outstanding under the [Shareholder Loan].” Pursuant to that authorization, between the signing of the merger agreement and its ultimate close, that controlling shareholder loaned to RoundPoint some $123 million. However, except with respect to $1 million thereof, prior to closing the controlling shareholder forgave the Shareholder Loan without requiring any repayment; this worked to the controlling shareholder’s interest because the purchase price was net asset value plus a 7.5% premium. Had the Shareholder Loan been repaid, the net asset value would have been reduced. But as characterized by the Chancery Court, the controlling shareholder appreciated that with this that each dollar of the loan forgiven “benefits (almost) 7.5 cents per dollar of debt it forgives.” and that “each such dollar [forgiven by the controlling shareholder] requires [Freedom Mortgage] to come up with an additional dollar (plus premium) in cash at closing.” 

      RoundPoint Mortgage sought to avoid its obligation to close on the transaction unless the seller actually repaid, rather than forgave, the Shareholder Loan.

      After first determining that the merger agreement did not expressly prohibit the controlling shareholder from forgiving the Shareholder Loans (and thereby effecting a net increase in the purchase price), it recognized that, in support of its claim under the implied covenant, the buyer would want to prohibit forgiveness of the loan that it first sanctioned. The court, however, was not willing to imply into the agreement a no forgiveness limitation because Freedom Mortgage, the buyer, failed in its burden of demonstrating that, had the parties negotiated the terms, they would have negotiated in a no forgiveness condition. Rather, while it is not conclusive that the parties would have negotiated a no forgiveness limitation, is entirely possible that they would have negotiated something else.  Failing to satisfy that burden, Freedom Mortgage's implied covenant claim failed.

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