Chancery Reforms Scrivener’s Error; Imposes Attorneys’ Fees on Attorney/Party Who Stayed Knowingly Silent about Mistake

ASB Allegiance Real Estate Fund v. Scion Breckenridge Managing Member LLC, C.A. No. 5843-VCL (Del. Ch. May 16, 2012).

Issue Addressed: Should a real estate joint venture agreement be reformed to correct a scrivener’s error in the provisions of an agreement that “departed from settled real estate practice and produced an economically irrational result.”

Short Answer: Yes.

Background Facts

Entities affiliated with ASB Capital Management LLC sued to reform the capital-event waterfall provisions in a series of agreements governing real estate joint ventures managed by the affiliates of the Scion Group LLC.  The mistakenly drafted provisions called for Scion to receive incentive compensation even if the joint ventures lost money.  Scion seeks to enforce the agreements as written, and its affiliates advanced counterclaims for breach of fiduciary duty and related claims.  This post-trial opinion found that the plaintiffs proved that their entitlement to reformation was established by clear and convincing evidence.  The Court found that the testimony of the Scion witnesses was “at best self-serving.”  On the other hand, he found that the testimony of each of the ASB witnesses was candid and credible.

The Court found that the expert witness of Scion could not offer any plausible justification for the mistakenly drafted terms of the agreement known as the waterfall provision. The joint ventures in this case involved student housing.  ASB relied on a large law firm to prepare the joint venture agreements and an experienced real estate partner initially began the drafting responsibility but later ceded much of the work to an associate.

The parties’ intent was for Scion to receive incentive compensation known as a “promote.”  It was intended to be a two-tier promote.  The correct language was in the wrong place.  One of the net results of this misplacement was that Scion would begin to earn its promote before ASB and Scion received back their capital–contrary to standard industry practice.  Therefore on a money-losing deal, Scion would still receive 20% of every dollar that ASB invested.

Despite the dramatic economic consequences of this mistake, apparently nobody reviewing the drafts commented on the change.  However, Scion did notice that the first-tier promote did appear in a draft in the wrong location and “he understood the favorable implications of the error for Scion” even though he admitted that Scion did not provide any consideration for the favorable treatment.

Moreover, the lead partner responsible for preparing the agreement did not recall whether she had read the two drafts involved before they were circulated, but then testified that she must not have done so, because she acknowledged that it was simply wrong.  Her associate conceded that as a young associate she lacked the experience necessary to understand the terms involved and she only learned of the mistake from the partner afterwards.  The critical (wrong) provision, known as the Sales Proceeds Waterfall, was signed off by the associate with the net result being that the first-tier promote came before the return of the invested capital of the members. In the fall of 2007, an amendment was made to other provisions that did not relate to the promote.

A subsequent joint venture was entered into, and while the partner was on vacation, the associate took the lead on drafting the agreement.  She copied the original agreement and then made deal specific changes on business terms which did not correct the mistake.  Everyone assumed that the original agreement reflected the deal terms that everyone had negotiated, and therefore, that provision was not reviewed carefully.  The partner did not review the agreement carefully before it was approved.

Subsequent agreements among the parties were entered into whereby the associate would electronically copy the original agreement and then only made deal-specific edits without fixing the substantive mistake.  All the lawyers and the parties finalized the subsequent agreements again while assuming that it was correct, and not reviewing the provisions with the mistake.

The Court found that the brothers who controlled Scion were aware of the mistake but because it was to their benefit did not notify anyone.  One of those brothers, who was a lawyer, stayed “knowingly silent” about the mistake.

Several years later, in June 2010, Scion exercised a put right in one of the agreements.  At that point the venture was underwater and was worth less than what ASB had contributed in capital.  Based on the mistake, Scion would receive a gain of 282% and ASB would have a loss of $14 million or roughly 30%.  Without the mistake, Scion would have suffered a proportionate loss comparable to ASB.  Scion exercised a similar put right in other joint venture agreements with the parties that resulted in a similar substantial gain that was approximately 328%.

Analysis

The Court explained the concept of equitable reformation which involves the Court’s power to “reform a contract in order to express the real agreement” of the parties involved.  The Court explained that there are two doctrines that allow a reformation:

“The first is the doctrine of mutual mistake.  In such a case, the plaintiff must show that both parties were mistaken as to a material portion of the written agreement.  The second is the doctrine of unilateral mistake.  The parties asserting this doctrine must show that it was mistaken and that the other party knew of the mistake but remained silent.”

Regardless of which doctrine is used, clear and convincing evidence must be presented by the plaintiff to demonstrate that the parties came to a specific prior understanding that differed materially from the written agreement.

Reformation requires that there be a “specific prior contractual understanding” that conflicts with the terms of the written agreement, and that prior understanding “provides a comparative standard that tells the Court of Chancery exactly what terms to insert in the contract rather than being put in the position of creating a contract for the parties.”  Moreover, the prior understanding “need not constitute a complete contract in and of itself.”  Handwritten notes can constitute a prior specific understanding.  See Restatement (Second) of Contracts, § 155 cmt. a (1981).

In this case, the Court found that an e-mail (prior to the agreement being signed) reciting the terms of the deal, and an e-mail agreeing to those terms, formed the necessary “specific prior contractual understanding.”

The Court also relied on a term of art in the industry known as a “promote” which contemplates the return of invested capital and refers to a share of the profits from a project.  The Court found that the parties operated based on an understanding to use the established industry meaning of the word “promote.”

The Court concluded that there was a mistaken belief that the relevant provision reflected the correct terms.

The Court discredited the testimony of Scion, and found credible the ASB witnesses.

Knowing Silence of Party/Lawyer

The evidence also established the “knowing silence” of a principal of Scion, who also happened to be a lawyer, and who was aware that the provisions were mistakenly scrivened but intentionally remained silent. The Court did not address the legal ethics issues raised by this finding nor were the professional responsibility issues referenced elsewhere in the opinion. It is worth underscoring that the court found that a principal of Scion was a sophisticated real estate attorney with significant real estate joint venture experience, and the court determined that he provided less than credible testimony and that “he intentionally remained silent in an effort to capture an undeserved benefit for Scion.”

In connection with the attempt by Scion to take advantage of the scrivener’s error, the Court explained that:

“Delaware law states that the knowledge of an agent acquired while acting within the scope of his or her authority is imputed to the principal . . . It is the general rule that the knowledge of an officer or director of a corporation will be imputed to the corporation . . . This basic principal of agency law applies with equal force to LLCs.”

Thus, the knowledge of the representatives of Scion was imputed to Scion.

Failure to Read

The Court rejected the affirmative defense of Scion that “failure to read an agreement is no defense.”  The Court explained that:  “Delaware law does not require that a senior decisionmaker . . . read every agreement in haec verba.”  See fn. 2.

The Court also explained that failure to read the agreements before approving them would not bar equitable reformation because:  “Reformation is not precluded by the mere fact that a party who seeks it failed to exercise reasonable care in reading the writing . . ..”  (citing Restatement (Second) of Contracts § 155 cmt. a. See fn. 3 (citing cases that support this as the majority rule.)

The Court explained the difference between “avoidance” and reformation.  Unlike avoidance, an agreement subject to reformation is not voidable.  Equitable reformation does not void an agreement but rather corrects an error by conforming the as-written document to the agreed upon understanding.  See Restatement (Second) of Contracts § 157 cmt. b.

The Court also explained why ratification was not appropriate as an affirmative defense.  Likewise, the Court rejected the defense of unclean hands.

The Court also awarded attorneys’ fees pursuant to the contractual provisions of the parties in favor of ASB as the prevailing party.

UPDATE: This Chancery decision was appealed and on May 9, 2013, the Delaware Supreme Court upheld the reformation holding but reversed and remanded on the issue of fees because, in part, Delaware’s high court reasoned that the fees were not “incurred” in this case, as that term is used on the fee shifting provision of the applicable agreement (in light of the firm handling the case for free to avoid a malpractice claim), therefore, the trial court should determine on remand if there is another basis to award fees.

Supplement: Doug Batey on his LLC Law Monitor provides helpful commentary about the case.