September 3, 2020

Implied Covenant: Buyer’s “Hail Mary” Falls Incomplete

A claim based on the implied covenant of good faith and fair dealing has always reminded me of the “Hail Mary” play in football – it’s usually a desperate last gasp, but every now and again, it works.  However, that didn’t happen in Roundpoint Mortgage Servicing Corp. v. Freedom Mortgage Corp.(Del. Ch.; 7/20, a recent Delaware Chancery Court Case in which a buyer’s implied covenant Hail Mary fell incomplete.

This case arose out of a merger agreement that called for the buyer to pay consideration equal to the seller’s book value plus a premium (minus a fixed amount). The merger agreement permitted the seller’s controlling stockholder to extend credit to the seller between signing and closing. However, the merger agreement also made it a condition to the buyer’s obligation to close that the seller “shall have repaid” any such credit “outstanding” to its controlling stockholder.

What actually happened was that the controlling stockholder & the seller engaged in some strategic behavior.  The controller lent the seller $150 million, but the seller didn’t repay the vast majority of it – instead, the controller forgave all but $1 million of the loans. The seller paid off that little slice, but the controller’s forgiveness of the rest of the loan had the effect of juicing the seller’s book value and significantly increasing the purchase price that the buyer had to pay.

The buyer balked, and the seller sued for a declaratory judgment & specific performance.  The buyer argued that the closing condition in the merger agreement excluded retiring debt by forgiveness. What’s more, the buyer argued that even if the language of the closing condition doesn’t exclude it, the implied covenant serves to provide that term.  Vice Chancellor Glasscock rejected both of those arguments. This Morris James blog summarizes his reasoning on the inapplicability of the implied covenant:

The Court reached the Buyer’s implied covenant issue after first agreeing with Seller that the Merger Agreement did not expressly prohibit the controlling stockholder from forgiving the indebtedness. In addressing the implied covenant claim, the Court recognized that it was in the Buyer’s financial interest to prohibit forgiveness.

The Court declined to imply a “no forgiveness” term, however, because Buyer had failed to meet its burden to prove that the parties would have agreed to prohibit forgiveness had they thought to negotiate about it. Considering the parties’ circumstances, the structure of the agreement and the negotiating history, the Court found that the Seller for non-bad-faith reasons may have preferred flexibility in repaying the credit facility.

The Court concluded that, had the issue been discussed, the parties may have reached a compromise on something other than a “no forgiveness” provision. While the Court had no doubt that Buyer would have agreed to the no forgiveness term, the Buyer failed to carry its burden to prove that Seller also would have agreed to that term.

The good news for the buyer is that its implied covenant Hail Mary throw came at the end of the first half, not at the end of the game.  The Vice Chancellor granted the seller’s declaratory judgment motion on the limited issues before the Court, but ordered the case to proceed to trial.  In that regard, while VC Glasscock ruled that the closing condition at issue in the declaratory judgment action does not prohibit forgiveness of loan, he specifically noted that his ruling didn’t mean that such a restriction could not be found elsewhere in the merger agreement.

John Jenkins