Let’s Talk (Again) About The Implied Covenant Of Good Faith And Fair Dealing In Owners Agreements

The implied covenant of good faith and fair dealing is a useful doctrine in business divorce litigation, particularly where more conventional fiduciary-duty theories are unavailable or economically unfeasible. In those circumstances, as we’ve opined before, the implied covenant’s ability to survive the direct-versus-derivative distinction and its unwaivable nature make it a potentially powerful tool. Litigants and courts reach for the doctrine when the need arises to right a wrong that doesn’t quite fit more traditional theories.

That is especially true in the LLC context, where the implied covenant is one of the few checks on the absolute power of LLC members to order their business as they see fit; “it is the unwaivable protection of the implied covenant that allows the vast majority of the remainder of the LLC Act to be so flexible” (R & R Capital, LLC v Buck & Doe Run Val. Farms, LLC, CA No. 3803-CC [Del. Ch. Aug. 19, 2008]).

But the doctrine has long faced a core limitation, especially in the First Department. Where a party to a contract bargains for discretion—that is, where the written contract expressly gives one party discretion—courts have been reluctant to use the implied covenant to limit that discretion (see Tr. Funding Assoc., LLC v Capital One Equip. Fin. Co., 149 AD3d 23, 29 [1st Dept 2017] [“Where a contract allows one party to terminate the contract in its sole discretion . . . the covenant . . . cannot serve to negate that provision”]; Cambridge Investments LLC v Prophecy Asset Mgt., LP, 188 AD3d 521, 522 [1st Dept 2020] [“Defendant cannot breach the covenant of good faith and fair dealing if the contract gives it sole and complete discretion”]).

In the closely held business context, that limitation introduces a difficult tension, especially because owners’ agreements almost always vest managers and controlling owners with broad discretion—the same discretion that sometimes negates the doctrine. When an agreement expressly authorizes the challenged conduct (or provides discretion to do so), how much room remains for an extra-contractual doctrine to police the manner in which that authority is exercised? (We recently explored a similar tension in the context of breach of fiduciary duty claims).

This week’s post covers two decisions—just over 10 weeks apart—that together offer useful guidance. In the first, the Court of Appeals definitively holds that a contractual grant of broad discretion does not automatically foreclose a claim for breach of the implied covenant when that discretion is alleged to have been exercised in bad faith. In the second, New York County Commercial Division Justice Masley applied that fresh guidance to the closely-held business context, finding that the Court of Appeals’ ruling does not provide a path to challenge harsh exercises of an expressly conferred contractual right.

The Court of Appeals: “Sole Discretion” Does Not Mean Immunity from an Implied Covenant Claim

The Equity Investment

111 W. 57th Inv. LLC v 111 W57 Mezz Inv. LLC, 2026 NY Slip Op 03376 (Ct App May 28, 2026), arises from the development of the luxury condominium tower at 111 West 57th Street, where plaintiff invested $65 million in equity alongside the project sponsor and another investor.

When the project ran into cost overruns, the project’s $325 million mezzanine loan—held in part by Apollo—fell out of balance and went into technical default. Apollo agreed to a forbearance agreement that split the debt into a $300 million senior mezzanine loan and a $25 million junior mezzanine loan, both secured by the plaintiff’s equity in the project. Those loan documents gave Apollo broad discretion to assign the junior mezzanine loan, subject to certain specifically negotiated restrictions on eligible assignees.

The Alleged Backroom Deal

At about the same time as the forbearance agreement, Apollo allegedly began negotiating to sell the $25 million junior loan to Spruce Capital Partners. According to the complaint, Apollo gave Spruce financial models showing that, if Spruce bought the junior loan, left it in default, and effected a UCC strict foreclosure (i.e., took the pledged equity interests in full satisfaction of the debt), Spruce could convert its $25 million debt into approximately $600 million in equity, wiping out the plaintiff’s interest.

Ultimately, Apollo assigned the loan to Spruce for $25 million. Soon afterward, Spruce issued a notice of default and pursued a strict foreclosure. The strict foreclosure wiped out the joint venture’s pre-foreclosure equity, including plaintiff’s $65 million investment.

Plaintiff claimed that the assignment of the loan from Apollo to Spruce, then Spruce’s strict foreclosure was all part of a backroom deal to wipe out plaintiff’s equity interest in the project. In plaintiff’s telling, Apollo used its broadly drafted assignment power not simply to sell a loan, but to assign a loan in furtherance of a transaction that converted $25 million of debt into enormously valuable project equity while eliminating plaintiff from the capital structure altogether, entirely destroying the purpose of the forbearance agreement in the first place.

The First Department: Grant of “Sole Discretion” Defeats Implied Covenant Claim

The New York County Supreme Court allowed the implied covenant claim against Apollo to proceed, holding at the pleading stage that plaintiff stated a viable claim.

On appeal, the First Department directed dismissal of the implied covenant claim. Because the forbearance agreement gave Apollo sole and absolute discretion to assign the loan,the implied covenant could not be used to negate that bargained-for discretion. After all, reasoned the First Department, plaintiff is a sophisticated party that bargained for an agreement giving Apollo sole discretion. Why should it be heard to complain when Apollo exercised that discretion in a manner that plaintiff didn’t like?

The Court of Appeals: A Restriction on “Who” Is Not a Restriction on “How”

The Court of Appeals rejected that categorical approach, holding that a grant of sole contractual discretion does not, by itself, exculpate a party from the implied covenant when it exercises that discretion.

In so doing, the Court of Appeals treated us to a thoughtful analysis of the tension between freedom of contract and the implied covenant. Says the State’s highest court:

Although “parties to a contract are basically free to make whatever agreement they wish, no matter how unwise it might appear to a third party … [t]here exists an unavoidable tension between the concept of freedom to contract … and the equally fundamental belief that an enlightened society must to some extent protect its members from the potentially harsh effects of an unchecked free market system.”

In this case, the Court distinguished between what the contract permits a party to do and how the party uses that contractual power. Apollo had broad discretion to assign the loan, and in the agreement the parties carefully negotiated to whom the loan could be assigned. That did not mean, the Court held, that Apollo had completely unchecked discretion to undertake an assignment as part of an alleged scheme to destroy the plaintiff’s benefit of the bargain.

So 111 West 57th stands as a new high-water mark for the reach of the implied covenant, especially useful for business divorce litigants: even where an owners’ agreement expressly vests one owner with broad discretion to take some action, the implied covenant may police that action if taken in bad faith.

Finally—although too much of a tangent for this blog—Judge Garcia’s dissent (joined by Judges Singas and Cannataro) is worth a read.

NY County Commercial Division: Member’s Discretionary Choice to Exercise Express Contractual Rights Unlikely to Breach an “Implied Covenant”

HM RX 2024 LLC v MCCP Inv. Partners LP (Sup Ct, NY County Aug. 10, 2026), arose from a post-bankruptcy investment in Optio Rx, LLC, where HM RX held equity, governance, and information rights under a series of LLC and financing agreements.

Those agreements gave the defendant MCCP several remedies in the event of default. When Optio allegedly committed what plaintiff characterized as a minor, technical projection-covenant default, MCCP declared a default and selected a particularly aggressive remedy—one allowing it to vote the pledged equity as though it were the owner, replace Optio’s manager, and strip HM RX of its governance rights.

HM RX alleged that MCCP seized upon the technical default as a pretext, rejected HM RX’s allegedly superior and more commercially reasonable financing proposal, declined less drastic remedies available under the agreements, and instead selected the remedy best suited to squeeze HM RX out of governance and capture the value of its equity.

Those facts arguably seem a lot like 111 West 57th: a party armed with a contractual choice allegedly making that choice to accomplish an unfair result far beyond the commercial problem supposedly being addressed.

Justice Masley nevertheless found at the preliminary injunction stage that this was “the opposite” of 111 West 57th. MCCP’s chosen remedy was not some unanticipated maneuver lurking outside the parties’ contractual framework; it was one of the remedies expressly laid out in the transaction documents.

The Court was unwilling to decide that MCCP should have chosen a more proportional remedy or accepted HM RX’s allegedly superior financing proposal. Those, Justice Masley reasoned, were business judgments—not a basis for using the implied covenant to rewrite the remedial choices the parties had expressly negotiated.

Conclusion

Read together, 111 West 57th and HM RX give business divorce litigants some useful guideposts.

A contractual grant of “sole discretion” is no longer enough, standing alone, to defeat an implied covenant claim. But the covenant remains a gap-filler, not a bargain-rewriter: it may police an unforeseen, bad-faith use of contractual discretion that is inconsistent with the agreement’s overall purpose, but it generally will not rescue a sophisticated party from the consequences of a contractual right it expressly agreed its counterparty could exercise.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.