In Nemec v. Shrader, Nos. 305, 2009 & 309, 2009 (Del. Apr. 6, 2010), the Delaware Supreme Court, in a 3-2 split decision, affirmed the dismissal of a complaint by former officers against Booz, Allen & Hamilton Inc. and its board of directors for failure to state a claim, holding that the directors did not breach either express or implied contractual obligations or fiduciary duties when they redeemed the plaintiffs’ stock at a price substantially lower than would have been applicable as the result of a not-yet consummated transaction, because the relevant Officers Stock Rights Plan expressly authorized the timing and price of the redemption and because the contractual obligations established in the Stock Plan superseded the fiduciary duties that might otherwise have applied to the redemption.
Plaintiffs Joseph Nemec and Gerd Wittkemper retired from Booz Allen after collectively spending over 50 years with the company. During their tenure, the plaintiffs were partially compensated with annual grants of stock rights, convertible into common stock of the company, under the Stock Plan. Under the Stock Plan, the plaintiffs had a put right, exercisable for a period of two years from the date of their retirement, to sell their shares back to the company at book value. After the expiration of two years, the company had the right to redeem, at any time, all or part of the plaintiffs’ stock at book value. The plaintiffs’ put rights expired in March 2008.
In November 2007, The Carlyle Group offered to purchase Booz Allen’s government unit for $2.54 billion. The Carlyle transaction, as ultimately agreed upon, generated over $700 per share for the company’s stockholders. During this time period, the book value of the plaintiffs’ shares was significantly lower than the transaction value. One month after the plaintiffs’ put right expired (and four months before the Carlyle transaction closed), the company redeemed the plaintiffs’ shares at book value for $162.46 per share. As a result of the redemption, the plaintiffs received nearly $60 million less than they would have under the Carlyle transaction.
The Court of Chancery dismissed the action for failure to state a claim upon which relief can be granted, reasoning that the Stock Plan specifically authorized the company to redeem the plaintiffs’ shares at the end of two years following the plaintiffs’ retirement. Accordingly, the plaintiffs could not maintain a claim for breach of the implied covenant of good faith and fair dealing because of conduct authorized by the express terms of the contract. The Court also dismissed the plaintiffs’ breach of fiduciary duty and unjust enrichment claims.
On appeal, the company argued that the Court of Chancery correctly ruled that the dispute was governed by an express contractual provision which authorized the board to redeem the shares at any time after the two-year period expired. The plaintiffs, on the other hand, asserted that the board exercised its right to redeem the plaintiffs’ shares in breach of the implied covenant of good faith and fair dealing. The Supreme Court held that a party asserting a claim for breach of the implied covenant of good faith and fair dealing must establish that the other party acted in an arbitrary or unreasonable manner which frustrated the fruits of the bargain that the asserting party reasonably expected. Absent such a showing, a court will not imply contract terms. A party’s reasonable expectations under a contract are measured at the time of contracting, and cannot be changed by developments that occur after the contract is executed.
The majority concluded that the plaintiffs did not have a reasonable expectation of participating in the Carlyle transaction at the time they executed the Stock Plan. The implied covenant only applies to later developments that the parties did not anticipate at the time of contracting and not to developments that the parties failed to consider. Here, the Stock Plan expressly authorized the company to redeem the plaintiffs’ shares at book value after the expiration of the two-year period. The majority noted that “contractually negotiated put and call rights are intended by both parties to be exercised at the time that is most advantageous to the party invoking the option.” The company exercised an express, bargained-for contractual right under the Stock Plan at a time that was most advantageous to the company’s existing stockholders. Accordingly, the majority held that the implied covenant of good faith and fair dealing will not imply language that contradicts a party’s clear exercise of an express contractual right.
Further, the Court warned that the crafting of a post-contracting equitable amendment that shifts the economic benefits under a contract would vitiate the limited reach of the implied covenant. “Delaware’s implied duty of good faith and fair dealing is not an equitable remedy for rebalancing economic interests after events that could have been anticipated, but were not, that later adversely affected one party to a contract. Rather the covenant is a limited and extraordinary remedy.”
The Court also affirmed the Court of Chancery’s dismissal of the plaintiffs’ claims that the company’s board of directors breached its duty of loyalty and unjustly enriched itself. The plaintiffs asserted that the board acted to further its own economic interest to the detriment of the plaintiffs, thereby breaching the duty of loyalty. The Court affirmed the dismissal on the ground that the plaintiffs sought to enforce contract rights and therefore the dispute must be adjudicated within the analytical framework of a breach of contract claim. The Court held that a dispute arising out of obligations expressly addressed by contract will be treated as a breach of contract claim, which effectively precludes the assertion of any fiduciary claims arising out of the same facts that underlie the contract claim. Turning to the plaintiffs’ unjust enrichment claim, the Court noted that Delaware courts “have consistently refused to permit a claim for unjust enrichment when the alleged wrong arises from a relationship governed by contract.” Accordingly, the Court affirmed the Court of Chancery’s dismissal of the plaintiffs’ final claim for unjust enrichment because the alleged wrong stemmed from a contractual relationship.
Justice Jacobs, joined by Justice Berger, wrote a rare dissent in this case, explaining their belief that “under Delaware case law, a contracting party, even where expressly empowered to act, can breach the implied covenant if it exercises that contractual power arbitrarily or unreasonably.” According to the dissent, the company’s redemption of the plaintiffs’ shares was arbitrary and unreasonable because it prejudiced the plaintiffs while serving no legitimate interests of the company. The dissent concluded that the complaint pled facts from which one can infer that if the parties had specifically addressed the issue at the time of contracting, the parties negotiating the Stock Plan would have agreed that the company could not exercise its right to redeem the plaintiffs’ shares immediately before the transaction closed. Relying on the conclusion that the pre-transaction redemption did not serve any legitimate business interest of the company, the dissenting Justices would have reversed the Chancellor’s decision to dismiss the complaint with respect to the implied covenant of good faith and fair dealing claim.