The implied covenant of good faith and fair dealing is inherent to every contract. It “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.” Dunlap v. State Farm Fire & Cas. Co., 878 A.2d 434, 442 (Del. 2005). 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.” Id. While it may be unclear as to when courts should implement implied covenant analysis, a recent Delaware decision, Winshall v. Viacom Int’l Inc., No. 6074-CS (November 10, 2011), sheds some light on the issue.
In Winshall, defendant Viacom had acquired defendant Harmonix Music Systems, Inc., creator of the music-oriented video games Rock Band and Guitar Hero, in a 2006 merger. Under the merger agreement, Viacom promised the Selling Stockholders an up-front payment of $175 million for their shares, as well as the contingent right to receive uncapped earn-out payments based on Harmonix’s financial performance in the two years following the Merger, 2007 and 2008.
About one year after the Merger closed, Harmonix released a new video game, Rock Band and had already entered into an agreement with Electronic Arts, Inc. (“EA”) for the distribution of Rock Band through March 2010. However, due to the game’s popularity, EA wanted to renegotiate the contract in 2008 to gain a broader scope of rights to Rock Band and its sequels. Because of EA’s interest in amending the distribution agreement, Harmonix and Viacom allegedly had an opportunity to negotiate for an immediate reduction in distribution fees that would have potentially increased the Selling Stockholders’ earn-out payments for 2008. But, at the direction of Viacom, Harmonix did not amend its contract with EA so as to immediately reduce its distribution fees. Rather, Harmonix and EA’s amended agreement involved a reduction in distribution fees in upcoming years, after the expiration of the earn-out period. The revised contract also granted EA a number of important new rights having nothing to do with EA’s already firm right to distribute Rock Band during 2008. On behalf of the Selling Stockholders, Winshall sued Viacom and Harmonix, alleging that Viacom and Harmonix purposefully renegotiated the distribution contract with EA so as to reduce the earn-out payments payable to the Harmonix stockholders, and thus breached the covenant of good faith and fair dealing implied in the merger agreement.
Winshall’s view of the implied covenant would require that a party to an agreement not simply refrain from upsetting the fundamental expectations of the other party, as implied by the explicit terms of the deal, but actually improve that deal by expanding its contractual counterparty’s expectancy. The Court rejected this view and determined that while Viacom and Harmonix were under an implied duty not to reduce any reasonable contractual expectation of the Selling Stockholders, they were not obligated to take any and all opportunities during the earn-out period to increase the earn-out payment for 2008, regardless of whether that opportunity was offered to Viacom and Harmonix in exchange for granting the counterparty rights to future assets in which the recipients of the earn-outs had no reasonable expectancy interest. In dismissing Winshall’s claim, the Court concluded that the facts do not support an inference that Viacom and Harmonix acted to deprive the Selling Stockholders of their reasonably expected benefits under the Merger Agreement and that the Selling Stockholders had no legitimate expectation that, if Harmonix was offered a chance to renegotiate the amount of distribution fees payable under a distribution agreement that was entered into after the Merger, it would choose a structure that benefited the Selling Stockholders and increased the amount of already unlimited earn-out payments that it was obligated to make under the Merger Agreement.
In the Winshall decision, the Court also clarified the application of the covenant. “[I]mplied covenant analysis will only be applied when the contract is truly silent with respect to the matter at hand, and only when the court finds that the expectations of the parties were so fundamental that it is clear that they did not feel a need to negotiate about them.” Allied Capital Corp. v. GC-Sun Holdings, L.P., 910 A.2d 1020, 1032-33 (Del. Ch. 2006). Further, 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. When conducting an analysis of whether a party breached the implied covenant of good faith and fair dealing, the court “must assess the parties’ reasonable expectations at the time of contracting and not rewrite the contract to appease a party who later wishes to rewrite a contract he now believes to have been a bad deal.” Nemec v. Shrader, 991 A.2d 1120, 1126 (Del. 2010).