One of the hallmarks of contract law is that it is not fault-based. A court, and especially a ‘contractarian’ Delaware court, only looks at whether a party performed the duties the contract imposes, not why. If parties want to be able to excuse performance for the ‘right’ reasons, or to trigger extra protections against breach for the ‘wrong’ reasons – that is, if they want to depart from the default no-fault analysis – then they need to write those reasons into the contract language itself. In the recent XRI Investment Holdings, LLC v. Holifield decision, the Court of Chancery examined a contract that did just that, containing provisions triggered by a finding of “willful breach,” but left that term undefined. Thus, the Court had to answer the question: what is a “willful breach” of contract?
In XRI, an LLC’s operating agreement required the LLC to advance legal fees to its members for LLC-related litigation, but allowed the LLC to recoup those fees if the litigation found the member had acted with “gross negligence or willful breach” of the LLC operating agreement. In the litigation, the LLC sued a member to challenge the putative transfer of the member’s membership interest in the LLC to an entity he controlled. In accordance with the agreement, the LLC advanced the member’s legal fees to defend against the LLC’s suit against him. The LLC prevailed in a 2022 decision that found the transfer breached the LLC’s operating agreement and was void, a finding the Delaware Supreme Court affirmed in an opinion last year. In these post-remand proceedings, the LLC sought to recoup those previously-advanced legal fees under the argument that the member’s attempt to transfer his membership interest had “willfully breached” the LLC operating agreement.
As the Court explained, clauses specifying remedies for “willful” breach are common in commercial contracts, especially in merger agreements, but more often than not, the commercial contracts themselves do not supply a definition of “willful breach.” In addition, despite the frequency of undefined “willful breach” clauses, no prior Delaware decision provided a default definition. Scholarly sources the Court examined suggest three different possible measures of when a breach of contract becomes ‘willful.’
Under the most expansive standard, a breach is ‘willful’ if the breaching party simply did the breaching act on purpose. A middle definition further requires the breaching party to subjectively understand at the time that the act violated the contract. A narrow definition requires a further showing that the breaching party acted with malice.
The XRI decision does not identify a one-size-fits-all definition of willful breach. But in evaluating the facts of this case, since “willful breach” followed “gross negligence” in the same sentence of the operating agreement, the Court construed such placement as embodying a meaning that goes beyond mere voluntary action, in line with the middle definition. At least in the context of “gross negligence and willful breach,” conduct must be undertaken in subjective cognizance that it is a breach in order to be “willful.” Since the Court also found that the member had known the LLC operating agreement prohibited the transfer and did it anyway, the court held that the breach was willful under that standard and ordered the member to repay the LLC for his litigation costs, which were in the millions.
The Court’s decision has consequences well beyond the relatively niche world of advancement-recoupment actions. Because protections against “willful breach” occur so frequently in merger agreements without a contractual definition of the term (in the decision, the Court noted that in a study of over 1,000 merger and acquisition agreements while “a majority tie damages to a concept of willful breach, less than one third of public deals, and under one tenth of private deals, define the term”), the default rules supplied by Delaware case law may prove significant in cases involving mergers and acquisitions, which are among the marquee subject areas of Delaware litigation.
Moreover, recent amendments to the Delaware General Corporate Law (“DGCL”), which we have previously discussed outside this blog, have added an additional dimension of importance. As previously discussed, the amendments authorize the inclusion of corporate governance provisions in stockholder agreements, but the outer bounds of inclusion of such provisions remains unknown. The DGCL amendments have already set off a flurry of discussion among practitioners and scholars over what happens when such a stockholder agreement requires a corporate fiduciary to act one way while their fiduciary duties command the opposite. If a fiduciary, in the face of such contradictory duties, prioritizes the fiduciary duty over the contractual one, is that breach “willful”? With the court’s answer to that question unknown, parties may want to consider addressing it themselves through an express provision in the contract for added clarity.
Finally, with “willful breach” terms so common in the context of mergers & acquisitions agreements, XRI v. Holifield demonstrates the prudence of parties setting out an express definition within the body of their agreements to ensure the parties have clarity on its meaning.