McReynolds v. Trilantic Capital Partners IV, L.P., C.A. No. 5025-VCL (Del. Ch. Sept. 23, 2010), read opinion here.

Short Overview

The Delaware Court of Chancery rejected the argument of certain limited partners of an investment fund who filed suit to assert that they should be entitled to "back out" of the investment fund they joined, which was formed as a limited partnership, and avoid a capital call, based on their unsuccessful allegations that they were misled into believing that the fund would always be supported by Lehman Brothers, the major investment banking firm that famously failed after the L.P. was started, and after which the capital call was triggered. This is one of many recent Chancery cases that deal with hedge funds or other investment entities in which one or more of the investors try to avoid their obligations to contribute, or who otherwise attempt to extract themselves from the investment partnership.

Issues Addressed

The three arguments on which the limited partners based their efforts to extricate themselves from the partnership, each of which the Court rejected, involved the following issues:

1) Was there a "supervening frustration" that relieved them of their contractual obligation?

2) Was there a "mutual mistake" that allowed them to avoid their contractual duty to make payments?

3) Did the Texas Securities Act give them the ability to "back out" of the deal?

Highlights of Court’s Legal Reasoning   

The doctrine of supervening frustration can be invoked:

“[w]here, after a contract is made, a party’s principal purpose is substantially frustrated without his fault by the occurrence of an event the non-occurrence of which was a basic assumption on which the contract was made.”  Restatement (Second) of Contracts § 265 (1981).  The doctrine is generally limited to cases where “a virtually cataclysmic, wholly unforeseeable event renders the contract valueless to one party.” 
Wal-Mart Stores, Inc. v. AIG Life Ins. Co., 872 A.2d 611, 620 n.35 (Del. Ch. 2005) (quoting Sage Realty Corp. v. Jugobanka, D.D., 1997 WL 370786, at *2 (S.D.N.Y. July 2, 1997)), aff’d in part, rev’d in part on other grounds, 901 A.2d 106 (Del. 2006); cf. Restatement (Second) of Contracts § 265 cmt. a, illus. 1-4 (1981).

The Court added that “the doctrine does not apply if the supervening events were reasonably foreseeable, and could (and should) have been anticipated by the parties at the time of contract.” The Court explained that “by parity of reasoning, the doctrine cannot apply if the events in question were actually foreseen, anticipated by the parties, and explicitly provided for at the time of contracting.”

The Court reasoned that in this case the claim of supervening frustration was based on an event that the parties foresaw and specifically provided for in the LP Agreement–that is, Lehman’s disassociation from the fund. Moreover, the agreements specifically contemplated a successive general partner in the event of Lehman’s exit. Thus, because the LP Agreement contemplated and addressed the possibility that Lehman would disassociate from the fund, the event was a known or foreseeable risk to which the doctrine of supervening frustration could not apply.

Mutual Mistake

The Court explained that under the doctrine of mutual mistake, a party can rescind an agreement if: (1) Both parties were mistaken as to a basic assumption underlying the agreement; (2) The mistake materially affects the agreed-upon exchange of performances; and (3) The party adversely affected did not assume the risk of mistake.

The Court explained that a claim for mutual mistake must rest on the basic assumption about the contract. The analysis is comparable to claims for supervening frustration. Thus, based on the prior reasoning, it was not plausible that the continuing involvement of Lehman was a basic assumption underlying the agreement.

Assumption of Risk

Moreover, mutual mistake was not available because the plaintiffs assumed the risk of Lehman having financial trouble. Under Delaware law, a party assumes the risk of mistake where: (1) “The risk is allocated to that party by contract; (2) The party enters the contract knowing that he has limited knowledge about the relevant facts or treats that knowledge as sufficient; or (3) The Court assigns the risk to the party because it is reasonable to do so.” As applied to this case, the plaintiffs had limited knowledge but regarded that knowledge as sufficient and still decided to invest. Therefore, mutual mistake is not available.

Due to its limited applicability to readers of this blog, we will not include a discussion of the Court’s analysis of the Texas Securities Act. Regardless, that discussion did not change the conclusion of the opinion, in which all the arguments of the plaintiff were rejected.