Court of Chancery Confirms Implied Covenant as Viable Basis for Relief in Alternative Entity Context
In this post-trial opinion, the Delaware Court of Chancery evaluated the enforceability of a “poison pill”—or shareholder rights plan—adopted to frustrate a redemption right in the alternative entity context. The Court ultimately concluded post-trial that the rights plan breached the implied covenant of good faith and fair dealing because it deprived the plaintiff of the fruits of its bargain.
Case Background
In December 2016, Whitestone REIT Operating Partnership, L.P. (Whitestone) and Pillarstone Capital REIT (Pillarstone) entered into a contribution agreement whereby Whitestone contributed 14 commercial properties to Pillarstone Capital REIT Operating Partnership L.P. (the Partnership). The transferred properties had a fair market value of $84 million. In connection with the transfer, the parties, along with the Partnership, entered into a limited partnership agreement (the LP Agreement) to govern their relationship. During the litigation, Whitestone owned 81.4% of the outstanding interest in the Partnership and Pillarstone held the remaining 18.6%. Pillarstone was the general partner of the Partnership and had exclusive control over the Partnership’s operations.
The LP Agreement gave Whitestone the right to unilaterally exit its investment by causing the Partnership to redeem its units. If Whitestone exercised its redemption right by providing a Notice of Redemption to the Partnership, Pillarstone was entitled to assume the redemption from the Partnership. If Pillarstone were to do so, it had the power, as general partner, to decide whether the redemption would be satisfied through cash or by issuing common shares to Whitestone.
At the end of 2020, Whitestone and Pillarstone considered a separation. Because the two entities shared the same CEO, they each created a special committee to negotiate potential separation terms. The discussions centered on the value of the Partnership’s real estate assets. A broker opinion valued the assets at more than $73 million. Pillarstone calculated the value of Whitestone’s Partnership units to be approximately $48 million.
The two special committees discussed ways to separate the two entities, including Whitestone exercising its redemption right. But Whitestone did not intend to exercise that right at that time. Instead, in June 2021, Whitestone signed a nonbinding letter of intent (the LOI) for the sale of its units to Pillarstone. Under the LOI, Whitestone would receive a $10 million, 10-year promissory note, plus a contingent payment in 10 years based on the net value of the Partnership’s properties, which could amount to a $49 million payout by 2031. However, Whitestone’s general counsel advised against the LOI transaction because exercising the redemption right was more favorable to Whitestone.
In late 2021, Pillarstone learned that Whitestone might redeem its Partnership units. After learning this, one of Pillarstone’s directors considered the possibility of adopting a shareholder rights plan to protect Pillarstone in the face of Whitestone’s contemplated redemption. In December 2021, Pillarstone’s board met to consider this option and ultimately formed a special committee to do so. The Pillarstone board met again later in the month to consider resolutions for adopting the proposed rights plan (the Rights Plan). The Pillarstone board ultimately voted in favor of the Rights Plan and Pillarstone executed a rights agreement (Rights Agreement) on December 27, 2021.
The Rights Agreement provided that dilution would follow a “Triggering Event,” including an “Acquiring Person” becoming the “Beneficial Owner of 5% or more of [Pillarstone’s] Common Shares then outstanding.” The potential dilution created an economic disincentive for Whitestone to redeem its Partnership units. By deterring Whitestone’s redemption, the Rights Agreement allowed Pillarstone to “buy time” and improve its leverage in separation negotiations.
Because Whitestone could not redeem its units without suffering dilution under the Rights Agreement, it sued Pillarstone in the Court of Chancery. Whitestone asserted three claims: (i) breach of the LP Agreement; (ii) breach of fiduciary duty; and (iii) breach of the implied covenant of good faith and fair dealing. Whitestone sought a declaration that the Rights Agreement was unenforceable and an award of damages.
Analysis
While the parties focused on the breach of contract claim, after trial, the Court viewed the implied covenant claim as more compelling. In the LP Agreement, the parties agreed that Whitestone would receive Partnership units in exchange for its property contribution, along with the right to unilaterally exit its investment in the Partnership by redeeming its units. The Court explained, “[T]hese express terms have the corresponding condition that Pillarstone would not engage in self-interested conduct to frustrate Whitestone’s redemption right.”
Because the Court determined that Whitestone proved at trial that Pillarstone breached the implied covenant, the Court did not need to analyze the remaining breach of contract and breach of fiduciary duty claims.
“The implied covenant [of good faith and fair dealing] is inherent in all contracts, including limited partnership agreements. At its core, the implied covenant ‘embodies the law’s expectation that each party to a contract will act with good faith toward the other with respect to the subject matter of the contract.’ It ‘ensures that parties do not ‘frustrat[e] the fruits of the bargain’ by acting ‘arbitrarily or unreasonably.’”
The Court analyzed the LP Agreement to determine the implied term inherent in that contract required to prove an implied covenant claim. The LP Agreement allowed Whitestone to redeem its units “at any time on or after six months of the issuance.” The Court concluded that the LP Agreement “places few limitations on the exercise of this redemption right.”
Thus, the Court further found that the LP Agreement implied a related condition: “[. . .] that Pillarstone will not frustrate Whitestone’s redemption right. Whitestone’s right to redeem is largely unrestricted.” Accordingly, “[a]n explicit term [in the LP Agreement] preventing Pillarstone from undertaking self-interested actions to impede Whitestone from redeeming was unnecessary.”
Pillarstone argued that Whitestone could have bargained for more protection in the LP Agreement because shareholder rights plans are common governance tools. While the Court acknowledged this, it described the Rights Agreement as “a different beast,” noting, “It is intended to mitigate a general partner’s financial fallout caused by a limited partner’s exercise of a contractual right to exit its investment in a limited partnership. There is no reason to suspect that Whitestone anticipated this unique turn of events.”
Accordingly, the Court found that Pillarstone had breached the implied term that barred it from impeding or frustrating Whitestone’s redemption right. The Court described Pillarstone’s conduct as “an effort to undermine Whitestone’s ability to invoke Section 8.6 of the LP Agreement. Pillarstone’s acts deprived Whitestone of the benefit of its bargain and are contrary ‘to the scope, purpose, and terms of the parties’ contract.’”
The Court did not find persuasive Pillarstone’s arguments that it was concerned about a fire sale of the Partnership (if Whitestone redeemed its units) or that the Rights Agreement was designed to protect against a purported takeover threat. The evidence confirmed that Pillarstone could raise the funds needed to fund a redemption in six to twelve months and, at the time the Rights Agreement was adopted, Pillarstone controlled more than 90% of its outstanding common and preferred votes. Thus, Pillarstone’s concerns were unfounded.
The Court also concluded that Pillarstone’s breach of the implied covenant caused Whitestone harm. While Whitestone requested a primary damages award of more than $51 million, (reflecting the possible value of the Partnership’s assets as of December 31, 2021), the Court viewed this as premature. Instead, the Court agreed with Whitestone’s alternative request that it (i) declare the Rights Agreement unenforceable, (ii) permit Whitestone to tender a Notice of Redemption, (iii) allow Pillarstone to determine the current value of the Partnership’s assets, and (iv) if needed, later enter a monetary judgment against Pillarstone for the difference between the amount Whitestone would have received in or around December 2021 and the current value.
Takeaway
This opinion reflects and confirms that the implied covenant remains a viable basis for recovery, including in the alternative entity context, despite the high bar for proving this type of claim. Parties should take note that even if they act in a way that does not violate the express terms of their agreement, their conduct can still run afoul of Delaware law if it has the effect of destroying the benefit other parties to the contract thought they had bargained for.