Reformation is an equitable remedy that courts use to “reform” or correct a mistake in a written agreement, to conform it to what the parties actually intended their agreement to say. The Delaware Court of Chancery recently reformed the cash distribution waterfall provisions of the limited liability company agreements for three real estate joint ventures in ASB Allegiance Real Estate Fund v. Scion Breckenridge Managing Member, LLC, No. C.A. No. 5843-VCL, 2012 WL 1869416 (Del. Ch. May 16, 2012).
Background. Investors and Developer entered into five real estate deals in 2007 and 2008, each structured as an LLC. In each deal the Investors put up 99% of the cash and Developer put up 1%. Each agreement provided that when the LLC’s property was sold, the sale proceeds would be distributed to the members according to a hierarchy that established the order in which funds would be distributed, often called a “waterfall.” The waterfall from the first two deals, using simplified language, was:
(a) First, 99% to Investors and 1% to Developer until each has received an 8% preferred return (similar to an annual interest rate) on its invested capital;
(b) Then 99% to Investors and 1% to Developer until each has received the return of its invested capital; and
(c) Then 20% to Developer, and 80% to be divided 1% to Developer and 99% to Investors.
In other words, both parties receive interest on their investment, then they get their investment back, and then they share, not based on the 99%-1% ratio of invested capital, but based on a ratio that gives the Developer a higher percentage return. The higher level of return to the Developer, after the threshold amounts are paid out, is intended as an incentive for the Developer. It is often referred to as a “promote” by real estate professionals. The above waterfall has a 20% promote.
When the parties negotiated the third of the five deals, they agreed on a two-tiered promote. This was similar to the waterfall above, except that the final level, which defines the promote, shifts to a higher promote percentage for the Developer after a specified amount has been distributed. In the example above, the third level would have a limiting cap added, and a fourth level would be added with the higher promote.
The Mistake. Unfortunately, in the process of preparing the written LLC agreement for the third deal, the return of capital paragraph was mistakenly placed after the first promote paragraph. That’s a much better deal for the Developer, which would receive the first portion of its promote before the parties get their capital returned. Thus the Developer could get its promote even if the overall deal were a loss and did not return any of the parties’ invested capital. This written agreement was approved and signed by the parties, even though it was not what they had negotiated.
This mistake happened because the responsible partner at the Investors’ law firm, who was heavily involved in the first transaction, turned the second deal over to an inexperienced associate lawyer. The terms of the second transaction mirrored the terms of the first, but when the terms of the waterfall changed in the third transaction the associate accidentally placed the key paragraph in the wrong position. The partner either did not read the final agreement or did not notice the mistake, and the error remained in the final agreement.
The court found that the in-house lawyer at the Developer knew of the mistake and knew that it was favorable to Developer, but said nothing about it to the Investors’ counsel. The executive in charge of the deal for the Investors reviewed the agreement, but did not notice the mistake and signed the agreement.
To compound the error, in short order the parties entered into two more real estate ventures, using the same structure and copying the same erroneous waterfall language. In both cases the waterfall as written by the Investors’ lawyer was not what the parties negotiated, the Developer knew of the mistake and knew that it was favorable to Developer, the Developer said nothing, and the Investors did not catch the mistake.
This situation inevitably led to conflict, which was precipitated by the Developer’s exercise of a put right in one of the three LLC agreements with the mistaken waterfall. The Developer’s buyout price under its put right was based on the agreement’s distribution provisions and the venture’s fair value.
The venture was underwater, since it had a fair market value of $35.5 million and the Investors had invested $47.3 million. As written, the waterfall entitled the Developer to $1.83 million, but as negotiated, the waterfall would have entitled the Developer to only $348,000. The result would be that instead of the Investors and the Developer sharing the loss 99%-1%, the Developer would make a 282% profit and the Investors would lose roughly 30% of their investment. Id. at *10.
The Developer demanded the higher amount based on the language of the waterfall. The Investors examined the agreement and determined that it was in error and was not in accordance with what they had negotiated. The Investors had what their executive called “a very, very tough conversation” with their law firm, and put the law firm on notice of a malpractice claim. Id. The executive said at trial that he was “incredibly upset that this had happened because it was clear what the document said, and that it was just wrong.” Id.
The Lawsuit. The Investors filed suit and sought an order reforming the waterfall provisions in the three disputed LLC agreements to match what had been negotiated. The Developer counterclaimed, seeking to enforce the agreements as written. The trial lasted four days and included nine fact witnesses, two expert witnesses, 300 documentary exhibits, and 25 deposition transcripts.
The court applied the doctrine of unilateral mistake, which allows reformation of a contract if the party seeking reformation can show by clear and convincing evidence that it was mistaken and that the other party knew of the mistake but remained silent. The plaintiff must show that there was a specific prior contractual understanding that conflicts with the terms of the written agreement. Id. at *13.
After a detailed review of the evidence, the court found that the Investors had demonstrated by clear and convincing evidence that they were entitled to reformation of the three LLC agreements. The court also dismissed the Developer’s defenses that (a) the Investors’ representative had not read the agreements, (b) the Investors had ratified the agreements, and (c) the Investors had unclean hands. The court accordingly rewrote the waterfall provision, placed the corrected language in its opinion, and ordered the two other disputed LLC agreements to be corrected in the same way. Id. at *21.
The court also awarded the Investors their attorneys’ fees, under the contractual fee-shifting provisions of the disputed agreements. The Developer argued that the Investors had not incurred any attorneys’ fees because the Investors’ law firm was not billing for its fees. (The same law firm that had made the mistakes in the three agreements represented the Investors in the lawsuit. Presumably it was not charging for the litigation because without its mistakes on the three agreements there would have been no litigation.) The court found that the arrangements between the Investors and their law firm to allocate the litigation costs did not affect the Developer’s obligations under the fee-shifting provision in the agreements. Id. at *20.
For a more detailed review of the court’s analysis, see Francis Pileggi’s post on his Delaware Corporate & Commercial Litigation Blog, here.
Comment. This strikes me as a surprising case. Not because of the legal doctrine of reformation or the court’s legal analysis, but because of how the business transactions played out and the roles of the lawyers involved.
For one thing, lawyers and business people who work on large real estate ventures such as these know that the waterfall provisions are not boilerplate – they are at the heart of the deal. Who puts how much money into the deal and who gets how much out are major components of what real estate partnerships and LLCs are all about.
For another thing, waterfall provisions, and especially the ones in this case, are not all that hard to read. They are a series of fairly short clauses in reasonably simple language that specify an algorithm to pay out the cash from the venture to the members. The sequential order of those clauses is key to how the waterfall works. Getting the paragraphs out of order is roughly comparable to getting a divide and an addition out of order in an algebraic expression. The result will usually be wrong.
These truisms make the mistakes that took place here, on both sides, rather startling. I say on both sides because the Investors’ law firm made the drafting mistakes, but the Developer’s lawyer made a mistake in judgment by not revealing the drafting mistake.
The drafting mistakes appear to reflect a classic organizational blunder by the Investors’ law firm. A senior partner turns over responsibility for a series of transactions to an associate lawyer who lacks the experience to understand the terms of the waterfall. The associate makes the mistake, and then the partner either doesn’t read the agreement or if she did, doesn’t focus on the key terms of the waterfall. The Investors’ representative relies on the partner at the law firm, and the partner relies overmuch on the inexperienced associate.
The Developer’s attorney, on the other hand, showed bad judgment in not revealing the error. The court found that he was a sophisticated and experienced real estate venture attorney who recognized the error but intentionally remained silent in order to capture an undeserved benefit for the Developer. Id. at *15.
As Francis Pileggi pointed out in his blog post, here, the court did not address the legal ethics issues in its opinion. But even setting that aside, in deals of this magnitude it’s foolish to think that a fundamental drafting error, inconsistent with what the parties clearly had agreed on, will not be discovered when it comes to light and would cost the other party a lot of money unless corrected. And as the court’s opinion shows, basic contract law can provide relief in this type of situation.
This is not a case where the lawyers appear at their best.