Is There Any Limit to Ostensibly Unfettered Discretion in a Contract?

In this article, litigation partner Matthew Solum explores a recent decision that found that even unfettered contractual discretion might be trumped by an allegation that the fiduciary is self-dealing or has otherwise acted in bad faith.

Contracts governing businesses or invest management often grant a fiduciary broad powers to manage the affairs of the business or the investment. A grant of such powers inherently calls for the fiduciary to be afforded some amount of discretion. In the context of managing a business or an investment undertaken by multiple stakeholders with sometimes competing views, the fiduciary needs to be able to make decisions, insulated from armchair quarterbacks. In an effort to maximally insulate fiduciaries from litigation exposure, some contracts grant fiduciaries “sole discretion” or something similar. While this broad language may mitigate the risk of a lawsuit from a business partner second-guessing a routine transaction, a recent decision has found that even unfettered contractual discretion might be trumped by an allegation that the fiduciary is self-dealing or has otherwise acted in bad faith.

The ‘Shatz’ Case

In Shatz v. Chertok, 180 A.D.3d 609 (1st Dept. Feb. 27, 2020), Daniel Shatz was an investor in a fund called Vast VI. The fund was structured as a limited liability company and subject to an operating agreement governed by New York law. The operating agreement gave the fund manager, Vast Ventures, “sole and absolute discretion” over the fund’s investment decisions.
One such investment decision concerned a startup called Ripple, which was raising capital in 2013. Around that time, Vast Ventures informed Shatz of the opportunity for the fund to invest in Ripple and made a capital call for that purpose, which Shatz paid. The opportunity fizzled, however, when Ripple announced that it was no longer raising cash, and Shatz’s capital call was refunded. But later that year, and allegedly unbeknownst to Shatz or the other investors in Vast VI, a different fund also controlled by Vast Ventures did make a subsequent investment in Ripple. After Shatz found out that Vast Ventures’ other fund invested in Ripple and made a profit, he brought a direct and derivative lawsuit against Vast Ventures and its principal, claiming breach of fiduciary duty by theft of corporate opportunity, breach of the implied covenant of good faith and fair dealing, and other claims.

Vast Ventures moved to dismiss, relying in part on the breadth of its contractual discretion to make decisions surrounding Vast VI’s investments. While the trial court dismissed almost all of Shatz’s claims, it found that Shatz’s derivative claim for breach of fiduciary duty could proceed: “[P]laintiff’s well-pleaded, plausible allegations of bad faith and express misrepresentations—made for the purpose of diverting the investment opportunity in a company in which defendants had an undisclosed interest to another fund managed by them-states a claim for breach notwithstanding the absolute discretion clause.” Shatz v. Chertok, 2019 N.Y. Slip Op. 32343[U] (N.Y. Sup. Ct., New York County 2019).

The First Department affirmed the trial court’s findings with respect to the fiduciary duty claim, citing a general principle that an explicitly discretionary contract right cannot be exercised in bad faith “so as to deprive the other party of the benefit of the bargain.” The appellate court also reinstated two claims that had been dismissed: a claim for breach of the implied covenant of good faith and fair dealing as well as an aiding and abetting claim against some other defendants.

The First Department case of Richbell Information Services v. Jupiter Partners, 309 A.D.2d 288 (1st Dept. 2003), was relied on by both the trial and appellate court in Shatz. There, two parties formed a joint venture for the purpose of acquiring a company. One of the two parties was contractually granted “apparently unfettered” discretion to veto certain transactions related to the deal. When that party exercised its veto rights, the counterparty brought suit for breach of fiduciary duty and other claims, alleging that the defendant was using its rights as part of a secret scheme to deprive the plaintiff, the contractual counterparty, of its benefits under the contract. Notwithstanding the defendant’s ostensibly unfettered discretion, the court held that the plaintiff could state a viable claim for breach of fiduciary duty. The court “recognize[d] that there is clearly some tension between, on the one hand, the imposition of a good faith limitation on the exercise of a contract right and, on the other, the avoidance of using the implied covenant of good faith to create new duties that negate explicit rights under a contract” but ultimately concluded that the plaintiff’s “allegations do not create new duties that negate [the defendant’s] explicit rights under a contract, but rather, seek imposition of an entirely proper duty to eschew this type of bad-faith targeted malevolence in the guise of business dealings.”

There are also cases holding that a party may exercise “sole” discretion in a way that enriches itself at the other party’s expense, including cases that dismiss claims at the motion to dismiss stage. A case decided by the First Department shortly after Shatz provides an example. In Seeking Valhalla Trust v. Deane, family members were in a legal battle surrounding an LLC that had an interest in a large property development in Brooklyn. There, Carol Deane was managing member of the LLC and the mother of adult children Anne Deane and Carl Deane. Carol indirectly owned approximately 52% of the LLC and the children 45%. However, following a refinancing transaction, Carol revised her own sharing ratio to 75% and the children’s to 22.5%—about half what it had been. When the LLC received nearly $86 million in proceeds from the property development, the children (through their trust) sued their mother to get what they claimed was the missing half of their proceeds. Carol moved to dismiss, citing the LLC agreement’s language vesting her with “sole discretion” to determine sharing ratios. The trial court granted dismissal of the children’s fiduciary duty claim, holding that there was no fiduciary duty separate and apart from what was contained in the contract. Seeking Valhalla Tr. v Deane, 2019 N.Y. Slip Op. 30877[U] (N.Y. Sup Ct., New York County 2019) (“Here, the [LLC] Agreement requires dismissal of the second cause of action because it confers on Carol complete discretion to act as she did … Plaintiffs cannot point to any basis in either the Preservation Agreement or in case law to support their argument for fiduciary breach.”). On April 9, 2020, the First Department affirmed, concluding that Carol “merely exercised the very power given to her by the operating agreement.” Seeking Valhalla Tr. formerly known as Carl Deane 2013 Revocable Tr. v. Carol Deane, 2020 NY Slip Op 02247 (1st Dept. April 9, 2020).

‘Shatz’ and a Path Forward

When complex transactions are perceived to enrich decision-makers at the expense of investors, litigation might ensue. Though the decision-makers appear to be insulated from such litigation by contractual clauses affording them discretion, the Schatz court appeared to limit the efficacy of such a clause. Seeking Valhalla and subsequent cases may clarify that such clauses are, in fact, enforceable per their terms.

Matthew Solum is a senior litigation partner of Kirkland & Ellis in New York. His practice focuses on high‑stakes disputes, including M&A, securities and complex commercial litigation.