The Implied Covenant of Good Faith and Fair Dealing: Delaware Rocks On

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Earlier this month, the Delaware Court of Chancery released its opinion in Winshall v. Viacom International, Inc. The Court dismissed a claim for breach of the implied covenant of good faith and fair dealing in a merger agreement. The sellers of Harmonix Music Systems, Inc., the creator of the music-oriented video games Rock Band and Guitar Hero, alleged that the buyer, Viacom, breached this implied covenant in connection with an earn-out provision contained in the merger agreement.

The earn-out provision provided the sellers of Harmonix with an opportunity to earn additional cash payments from Viacom in the two years following closing based on the extent to which gross profit from sales of the Rock Band video game exceeded certain targets. During the earn-out period, Viacom had an opportunity to renegotiate the distribution agreement with the video game’s distributor, Electronic Arts, to reduce distribution costs. A reduction in the distribution costs for the Rock Band game would have increased gross profits and thus generated higher earn-out payments for the sellers. Instead, Viacom and Electronic Arts agreed to amend the distribution agreement to confer other benefits on Viacom (including reduced distribution costs for another video game that had not yet been released) and not lower the distribution costs for the Rock Band game. The sellers alleged that Viacom purposefully renegotiated the distribution agreement with Electronic Arts so as to reduce the earn-out payments and thus breached the covenant of good faith and fair dealing implied in the merger agreement. 

The Court described the implied covenant of good faith and fair dealing as follows:

Under Delaware law, an implied covenant of good faith and fair dealing inheres in every contract. The implied covenant “requires a party in a contractual relationship to refrain from arbitrary or unreasonable conduct which has the effect of preventing the other party to the contract from receiving the fruits of the bargain.” A party is liable for breaching the covenant when its conduct “frustrates the overarching purpose of the contract by taking advantage of [its] position to control implementation of the agreement’s terms.”

The Court dismissed the sellers’ claim primarily on the basis that the sellers had no reasonable expectancy interest in the subject matter of the amendment. The amendments to the distribution agreement had no effect, positive or negative, on the amount of the earn-out payment over what would have been expected under the original distribution agreement with Electronic Arts. 

In clarifying the application of the implied covenant of good faith and fair dealing, the Court states:

The court must be mindful that the implied covenant of good faith and fair dealing should not be applied to give plaintiffs contractual protections that “they failed to secure for themselves at the bargaining table.” In other words, the implied covenant is not a license to rewrite contractual language just because the plaintiff failed to negotiate for protections that, in hindsight, would have made the contract a better deal. Rather, a party may only invoke the protections of the covenant when it is clear from the underlying contract that “the contracting parties would have agreed to proscribe the act later complained of . . . had they thought to negotiate with respect to that matter.”

So, you ask, does the implied covenant of good faith and fair dealing apply here in Canada? Not sure, actually… My partner, Geoff Hall, does an excellent job canvassing the divergent case law in this area in his book, Canadian Contractual Interpretation Law (LexisNexis Canada Inc., 2007) and ultimately concludes that there is no clear answer in Canada (except in Quebec, where a similar duty exists under civil law). Geoff says that such a thing would be good to have since contracts work better when there is a duty of good faith performance. In one of the closing paragraphs to his book, Geoff states, “Relationships can inherently require adjustment, and work best when problems, which inevitably arise, are smoothed out by parties working reasonably and cooperatively to fulfil the purpose of their agreement rather than clinging to the letter of their contract.”

contractual intent Delaware earn-out fair dealing good faith implied covenant merger agreement

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