DealLawyers.com Blog

It isn’t often that you see a stockholders’ representative argue that funds held in escrow shouldn’t be released to the seller, but that’s the situation the Chancery Court recently confronted in American Healthcare Administrative Services v. Aizen, (Del. Ch.; 11/22). The case arose out of an asset purchase agreement providing for the sale of two lines of business to a third-party buyer.  The selling company’s stockholders were also parties to the agreement, and its CEO was appointed to serve as their representative. In that capacity, he had the authority to make certain decisions about the escrowed funds.

After the closing, the CEO’s employment was terminated, and he and the seller ended up enmeshed in a lawsuit. Meanwhile, the contractual escrow period ended without any claims from the buyer, and the seller’s stockholders sought to have the funds released from escrow and paid over to the seller.  Apparently concerned that if the selling company received the funds and distributed them to its stockholders it would become judgment-proof, the former CEO refused.  He pointed to the terms of the agreement providing him with sole discretionary authority in his capacity as the sellers’ rep to support this position.

Vice Chancellor Laster disagreed. He concluded that the plain meaning of the escrow provision required the funds to be disbursed because each of the requirements set forth in the agreement had been satisfied. As a result, the sellers’ rep was contractually obligated to join with the buyer in instructing the escrow agent to release the funds. While acknowledging that the sellers’ rep was granted broad discretionary authority, the Vice Chancellor said that authority couldn’t be used to override the plain language of the agreement:

Section 10.10 vests Aizen with the discretion to carry out his post-closing duties and obligations as Sellers’ Representative. That discretion extends to his duties and obligations under the Escrow Release Provisions, but it does not give Aizen the authority to ignore a mandatory provision of the Purchase Agreement governing the release of the escrowed funds. It would create an internal contradiction to read the Purchase Agreement as mandating that Aizen release the escrowed funds, while at the same time granting Aizen the authority to ignore that mandate. Aizen cannot cherry-pick the contractual provisions that he finds advantageous, while simultaneously ignoring the contractual obligations that he finds inconvenient.

In reaching this conclusion, VC Laster said that the defendant’s argument ignored the constraints imposed by the implied covenant of good faith. After reviewing Delaware precedent, the Vice Chancellor reached the following conclusion about the role of the implied covenant in the present action:

Applying these principles, the Delaware Supreme Court has made clear that the implied covenant of good faith and fair dealing restrains a party’s exercise of discretion under an agreement. The general rule is that 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. That rule operates with special force “when a contract confers discretion on a party.”

He concluded that the defendant was empowered under the agreement to use his “sole and absolute discretion” to act on behalf of the seller’s stockholders. The defendant could not use his discretion to act on behalf of himself as a contingent creditor or on behalf of creditors in general – and in doing so, he exceeded his authority.

– John Jenkins