Senior Housing Capital, LLC v. SHP Senior Housing Fund LLC, C.A. No. 4586-CS (Del. Ch. May 13, 2013)
Issue Addressed: Whether judicial review is permitted on an appraisal that followed a process required by an LLC agreement which contained no mechanism for substantive judicial review of the appraisal?
Short Answer: No, the Court of Chancery determined that there was no authority to review the appraisal process unless the dissatisfied parity could show bad faith or improper conduct by the other party.
Practice Tip: This opinion contains a relatively rare result given the number of times the allegation of a breach of the implied duty of good faith and fair dealing is made. In this case, the Court found that CalPERS improperly coerced Cushman & Wakefield into reducing the appraised value, and thus breached its contractual duty of good faith and fair dealing.
Background: This 108-page post-trial decision addresses a dispute between investors in SHP Senior Housing Fund (the “Fund”), which was formed to invest in retirement homes. Two of the plaintiffs, the former manager of the Fund, SHP Asset Management (“SHP”) and its affiliate, held a 5% stake in the Fund. California Public Employees’ Retirement System (“CalPERS”) held the remaining 95% stake in the Fund. SHP and CalPERS signed the LLC Agreement creating the Fund in 2001. The LLC Agreement provided that SHP would receive an “Incentive Distribution” at the end of 2007, and every seven years thereafter, based on how much the retirement homes that were purchased (the “Projects”) had appreciated in value, and how much cash SHP had distributed to CalPERS and itself over the relevant calculation period. In addition, SHP was entitled to receive a quarterly Asset Management Fee for managing the Projects, based on the fair market value of the Projects. The LLC Agreement also provided that if SHP withdrew as the Fund manager, it was entitled to have CalPERS buy out its Membership Interests in the Fund based on the fair market value of the Fund’s assets. The agreement also provided that CalPERS had the right to select the appraiser who would value the Projects but there was no provision for any judicial review of the appraisal that the appraiser produced.
In 2007, CalPERS had the Projects appraised for the purpose of determining the Incentive Distribution. Because of the significant increase in value of the Projects between 2003 and 2006, CalPERS was unhappy about the potential payout that would result from these appraisals, and while it objected to the appraisals , it never made any substantive comments on the appraisals. In June 2008, SHP gave CalPERS notice that it would be withdrawing from the Fund, effective December 2008. CalPERS then ordered Duff & Phelps to revise its 2007 appraised estimates of the market values downwards. CalPERS then sought to replace the original 2007 appraisals with the revised 2008 appraisals.
SHP‘s withdrawal from the Fund obliged CalPERS, in addition to paying the Incentive Distribution for the Calculation Period ending in 2007, to pay SHP for the value of its 5% Membership Interests, based on the fair market value of the Fund in October 2008. The process for determining the value of the Membership Interests at the end of CalPERS‘ relationship with SHP was different from that used to determine the value of the Projects for the Incentive Distribution.
If a party disagreed with the appraisals that were produced at the end of CalPERS‘ relationship with SHP, the Agreement permitted that party to request another set of appraisals from another appraiser that was pre-approved by CalPERS. However, the LLC Agreement provided no mechanism whereby CalPERS might replace the original 2007 appraisals with new ones that it liked better.
CalPERS obtained one set of appraisals of the Projects from Cushman & Wakefield. But, before it signed off on them, CalPERS pressured Cushman & Wakefield into adjusting the appraisals downwards. CalPERS then invoked the appraisal dispute process in the LLC Agreement and commissioned new appraisals. CalPERS pressured the new appraisal firm, CB Richard Ellis, to produce low values. SHP objected to CalPERS’ invocation of the appraisal dispute process, on the grounds that CalPERS had put improper pressure on Cushman & Wakefield in order to obtain a lower value for SHP’s Membership Interests. SHP withdrew from the Fund in December 2008, however, CalPERS did not pay it the Incentive Distribution, the Membership Interests or the Asset Management Fees that were due under the LLC Agreement.
In May 2009, SHP filed suit against CalPERS seeking to force it to pay: (i) an Incentive Distribution of approximately $52 million; (ii) a 5% Membership Interest of $2 million, based on the appraisals that Cushman & Wakefield produced; (iii) Asset Management Fees of $500,000; (iv) Severance Compensation of $1 million; and (v) attorneys’ fees, costs, and interest. In response, CalPERS counterclaimed, arguing that SHP demands were based on erroneous appraisals that valued the Projects too highly and that SHP had abused the cash management system and wrongly extracted nearly $34 million.
With respect to the primary issue of judicial review of the appraisal, CalPERS argued that the contractually determined appraisal value was entitled to almost no deference and that the court should do a de novo review. SHP argued that the court may not exercise any judicial review of the appraisals.
Summary of Court Decision
The Court, in agreeing with SHP, noted:
Where, as here, (i) a contract written by one party (ii) says that that party will make a payment based on a formula, (iii) the formula says that an input into the formula will be determined by an appraiser, and (iv) the party making the payment gets the contractual right to select the appraiser, the parties have clearly agreed to be bound by that appraiser’s professional judgment. Unless the party unhappy with the appraiser’s judgment can show that the appraised market value resulted from a concerted course of bad faith action between the appraiser and the other party-i.e., a breach of contract by a party–or that the appraiser’s result was otherwise tainted by the contractually improper conduct of the other party (such as intentionally providing the appraiser with false information to taint the valuation), the parties are stuck with what they bargained for. The lack of room for law-trained judicial second-guessing makes sense because such unschooled second-guessing undercuts the parties’ choice to have an expert on the relevant property type perform the task.
The Court made the following findings:
1.) Incentive Distribution — CalPERS is required to pay SHP an Incentive Distribution based on the leased fee value that was appraised by Duff & Phelps in 2007. As a separate issue that affects the value of the Incentive Distribution, the Court found that SHP has not abused the cash management system, therefore, CalPERS was required to pay the Incentive Distribution that SHP demands in full.
2.) Membership Interests — CalPERS is required to pay SHP for its 5% interest in the Fund based on the leased fee value that was appraised by Cushman & Wakefield.
3.) Asset Management Fee — CalPERS is required to pay SHP its unpaid Asset Management Fees, based on the fee simple value-not just the leased fee value-in the original Duff & Phelps appraisals.
4.) Severance Compensation — CalPERS is required to pay SHP Severance Compensation, as provided in the Management Agreements.
5.) Attorneys Fees — CalPERS must pay SHP its attorneys’ fees, because the LLC Agreement contains a fee-shifting provision.
6.) Breach of Good Faith and Fair Dealing–CalPERS improperly coerced Cushman & Wakefield into reducing the appraised value, and thus breached its contractual duty of good faith and fair dealing.