Delaware Supreme Court Affirms Reformation of LLC Agreements But Reverses Award of Attorneys' Fees - Law Firm Was Working for Free
Last year the Delaware Court of Chancery reformed the cash distribution waterfall provisions of three real estate joint venture LLC agreements. Chancery also awarded attorneys’ fees to the successful plaintiff, even though the plaintiff’s law firm was not charging to represent it. The law firm was not charging because of its errors in drafting the three LLC agreements. ASB Allegiance Real Estate Fund v. Scion Breckenridge Managing Member, LLC, C.A. No. 5843-VCL, 2012 WL 1869416 (Del. Ch. May 16, 2012).
Last week the Delaware Supreme Court affirmed Chancery’s reformation decision but reversed the award of attorneys’ fees. Scion Breckenridge Managing Member, LLC v. ASB Allegiance Real Estate Fund, No. 437, 2012, 2013 WL 1914714 (Del. May 9, 2013).
Background. The case involved errors in three Delaware LLC agreements that were entered into in 2007 and 2008. Each agreement was for a real estate development project, each agreement contained a distribution waterfall that allocated cash distributions in a specified order to the members, and each agreement contained the same error in the scheme of distributions. The errors originated in draft agreements prepared by the investors’ law firm.
The errors would have benefited the real estate developer at the expense of the investors, if enforced. The developer knew of the mistake but kept silent, and the investors did not notice the errors and signed the agreements. Eventually the mistakes came to light, but the developer contended there was no mistake. The investors put their law firm on notice of a malpractice claim and sued the developer to reform the LLC agreements to correct the mistake. The investors’ law firm agreed not to charge for representing them in the lawsuit. Scion Breckenridge, 2013 WL 1914714 at *5.
For a more detailed summary of the facts and a review of the Court of Chancery’s analysis, see my 2012 post here and Francis Pileggi’s post on his Delaware Corporate & Commercial Litigation Blog here.
Reformation. In the course of affirming the Chancery Court’s grant of reformation, the Supreme Court clarified prior Delaware case law on two points.
Failure to Read the Contract. The developer argued that failure to read a contract bars a claim for reformation. ASB, the advisor to the investors, had approved the first of the three incorrect LLC agreements based on an internal review and memorandum which summarized the deal terms as agreed upon in the parties’ preliminary emails, not as they were memorialized in the detailed LLC agreement. ASB’s president had relied on the internal review and had reviewed parts but not all of the final agreement. He acknowledged in his testimony that the error was obvious once it was pointed out. The two subsequent agreements were based on the first incorrect agreement and contained the same mistake, which the investors failed to recognize.
The Supreme Court recognized that prior Delaware cases were unclear on whether a negligent mistake, such as failure to carefully read a contract, should bar reformation. To resolve the confusion, the court adopted the standard in the Restatement (Second) of Contracts: “[a] mistaken party’s fault in failing to know or discover the facts before making the contract” will not bar a reformation claim “unless his fault amounts to a failure to act in good faith and in accordance with reasonable standards of fair dealing.” Restatement (Second) of Contracts§ 157 (1981). The court expressly overruled prior Delaware cases to the extent inconsistent with this standard.
The court also noted that the rule is different when a party seeks to avoid or rescind a contract. A party cannot seek avoidance of a contract he or she had not read before signing.
Because ASB’s president had acted in good faith and in accordance with reasonable standards of fair dealing, the court held that his failure to read the contracts did not bar the company from seeking reformation of the agreements.
Unilateral Mistake. The developer argued that a unilateral mistake by one party, coupled with knowing silence by the other party, is not enough to support reformation. The Supreme Court recognized that prior Delaware case law was contradictory on whether reformation based on unilateral mistake requires something exceptional beyond the other party’s knowing silence, such as fraud or trickery. The court relied on Cerberus Int’l Ltd. v. Apollo Mgmt., L.P., 794 A.2d 1141 (Del. 2002) and held that unilateral mistake and knowing silence by the other party are sufficient to support a reformation claim. The court ruled that other cases are overruled to the extent they impose additional requirements such as exceptional circumstances.
Ratification. The developer also argued that the investors had ratified the three mistaken agreements by various acts, including an amendment of one of the agreements. All of the alleged acts of ratification occurred before the investors learned of the error. The court affirmed the Chancery Court’s conclusion: “[R]atification does not preclude reformation unless the ratifying party actually knew of the error.” Scion Breckenridge, 2013 WL 1914714 at *9.
Attorneys’ Fees. The agreements contained an attorneys’ fee clause:
In the event that any of the parties to this Agreement undertakes any action to enforce the provisions of this Agreement against any other party, the non-prevailing party shall reimburse the prevailing party for all reasonable costs and expenses incurred in connection with such enforcement, including reasonable attorneys’ fees.
ASB Allegiance Real Estate Fund, 2012 WL 1869416 at *20.
The Court of Chancery had ruled that the investors were entitled to an award of their reasonable attorneys’ fees: “Here, the non-breaching side of the case caption litigated the dispute at significant cost, albeit a cost that DLA Piper and ASB have allocated between themselves. The contractual fee-shifting provision obligates the breaching side of the caption to bear that cost, regardless of the allocation between DLA Piper and ASB.” Id.
The Supreme Court disagreed, instead focusing on the language of the attorneys’ fee clause: “The plain meaning of ‘incurred,’ combined with ‘reimburse,’ does not extend to this situation where ASB did not incur any payment obligation because DLA Piper agreed to represent it without charge.” Scion Breckenridge, 2013 WL 1914714 at *10. Under its arrangement with the law firm, ASB was not liable for payment at any point. The court noted that an award of attorneys’ fees to ASB would either (a) result in a windfall to ASB (if ASB retained the award), or (b) if ASB passed on the fees to its law firm, “effectively reward DLA Piper for successfully litigating this reformation action to correct its own mistakes.” Id. at *11. The court therefore reversed Chancery’s award of attorneys’ fees to ASB.
ASB, however, had also sought attorneys’ fees under the trial court’s inherent equitable powers. Chancery had not ruled on that claim because it relied on the contractual fee-shifting provision.
The Supreme Court noted that trial courts have inherent equitable power to shift attorneys’ fees under recognized exceptions to the American rule that litigants generally bear their own legal fees, except under contractual or statutory rights to receive fees. The court therefore remanded the case to Chancery to consider whether ASB is entitled to attorneys’ fees under the trial court’s equitable powers.
Comment. The Supreme Court’s clarifications on reformation were useful. Its reversal of the award of attorneys’ fees, on the other hand, seems a hyper-technical and strict interpretation of the language of the attorneys’ fee clause in the parties’ agreements.
The denial of an award of attorneys’ fees seems somewhat unfair, given the gist of the parties’ fee-shifting agreement and the facts of the case – the developer’s in-house attorney knowingly let the mistake be written into the contracts and then tried to enforce the mistake. It will be interesting on the remand to see if Chancery sees fit to apply any of the equitable grounds for shifting the investors’ attorneys’ fees to the developer.
The Supreme Court’s analysis also suggests that the investors and their attorneys might have been able to structure a fee agreement that would have satisfied the investors and yet accommodated an award of attorneys’ fees. For example, they could have agreed that the law firm would be paid its customary fees, except that it would be obligated to write off its fees if the lawsuit was not successfully resolved and to the extent the award of attorneys’ fees did not cover its bill. This approach would yield the same result to the investors, who would not end up paying any net attorneys’ fees under any circumstances. And the law firm would not receive a windfall, since it would be owed fees to the extent the court made an award.
Sometimes pushing the envelope is not a good strategy, and that’s clearly the case when your litigation strategy ends you up in jail. In an Ohio case the judge found an after-the-fact excuse for disobedience of the court’s order to be insufficient, held the LLC’s owner and its controller in contempt of court, and sentenced them to seven days in the county jail. Spero v. Project Lighting, LLC, No. 2011-P-0002, 2011 WL 6371881 (Ohio Ct. App. Dec. 19, 2011).
Background. Spero involved a dispute over a joint venture made up of several limited liability companies. Two were owned 50-50 by defendant Sam Avny and plaintiff Mitchell Spero. One of the LLCs was owned by Avny and ownership of the fourth was disputed. Id. at *1.
In the course of the litigation a receiver was appointed to take possession of all the assets of the three LLCs other than the one owned by Avny, Project Light, LLC. Two months later the trial judge entered a detailed order calling for the funds in all bank accounts controlled by the three LLCs “to be transferred immediately to the exclusive control of the Receiver,” and directing that “[a]ll funds derived from the sale of any Prospetto inventory will be deposited with the Receiver and remain under his control pending further order of the Court.” Id. (Prospetto was one of the three LLCs.)
When the plaintiffs learned that the court’s order had not been complied with, they filed a motion requesting that the defendants be held in contempt of court. After an adversarial hearing, the trial court found beyond a reasonable doubt that Sam Avny and Anthony DeAngelis, the controller of the three LLCs, had disobeyed the court’s order by causing at least $89,000 of proceeds from the sale of Prospetto’s inventory to be deposited in Project Light’s bank account. Id. at *2.
The court found DeAngelis, Avny, and Project Light to be in contempt of court. They were each fined $250, and DeAngelis and Avny were sentenced to serve seven days in the county jail.
Analysis. DeAngelis and Avny argued unsuccessfully on appeal that the trial court lacked jurisdiction because (1) a notice of appeal was filed before the contempt hearing, and (2) a subsequent settlement agreement disposed of the contempt issue.
The Court of Appeals held that when a case goes up on appeal, the trial court retains jurisdiction over collateral matters such as contempt of court. In considering the effect of the settlement, the court distinguished civil contempt, which is remedial in nature, from criminal contempt, which is intended to punish the offender for acts in disregard of the court’s authority. The sanctions in Spero were for criminal contempt and could therefore be pursued even after the underlying action was no longer pending. Id. at *3.
DeAngelis and Avny’s central argument was that there was not a clear violation of the trial court’s order because of the way the funds were handled. DeAngelis testified that although the money in question was deposited into Project Light’s bank account, “it was clearly earmarked on the books as payable to Prospetto Light so that all of that money could be segregated and any time that it was called for, it could be turned over.” Id. at *5.
The court didn’t buy it. First, the trial court’s order was clear: “all funds derived from the sale of any Prospetto inventory will be deposited with the Receiver and remain under his control pending further order of the Court.” Id. at *6. Second, the earmarking procedure was inadequate and plainly contravened the court’s order. And third, DeAngelis testified that he believed Project Light had paid for the inventory sold by Prospetto and therefore was entitled to be paid for it, although he never informed the receiver of his belief and the receiver was not aware until later that the funds had been diverted. Without saying so, the court implied that DeAngelis’s motivation was for Project Light to retain the funds notwithstanding the court’s order.
DeAngelis and Avny also argued that the seven-day jail term was unreasonable and disproportionate to their acts. The Court of Appeals pointed out, however, that under the Ohio statute that authorizes criminal contempt sanctions, a first offense may be punished by a fine of up to $250, and up to 30 days in jail. Ohio Rev. Code § 2705.05(A)(1). In light of the statutory potential for a 30-day sentence and the discretion accorded the trial court, the Court of Appeals found seven days not to be disproportionate to the conduct. Spero, 2011 WL 6371881, at *6. The trial court’s ruling was affirmed. Id. at *7.
Comment. Although this case involved LLCs, the issues were not LLC-specific. But LLC dissolutions and court-ordered receivers are not uncommon, and the lessons of the case are worth considering.
The result here underscores the importance of paying attention to the wording of a court order. Unilaterally implementing a non-compliant procedure (here, depositing the funds to the wrong company’s account but earmarking the source of the funds), which might have been allowed by the court if properly requested, is simply asking for trouble. Failing to disclose the process to the court-appointed receiver compounded the difficulty. Placing the funds in the wrong account and not disclosing the situation to the receiver could have led to the receiver’s filing of inaccurate reports to the court, and conceivably could have led to the receiver’s having inadequate funds to carry on the operations of the three jointly owned LLCs.
The maxim “It’s easier to ask forgiveness than it is to get permission” (generally attributed to U.S. Navy Rear Admiral Grace Hopper) is bad advice when it comes to a court order.
It’s not uncommon in today’s struggling economy for an LLC member to find itself unable or unwilling to satisfy the LLC’s capital calls. Can the other members recover damages from the defaulting member if they make up its required capital contribution? The Kansas Court of Appeals was faced with this question in Canyon Creek Development, LLC v. Fox, No. 103,190, 2011 Kan. App. LEXIS 128 (Kan. Ct. App. Sept. 2, 2011).
Background. Mike Fox, Don and Linda Julian, and Jeff Horn formed two Kansas LLCs in 2004 to develop residential real estate. Fox owned 50% of each LLC, and the others owned the other 50%. The real estate business struggled, and in 2008 Don Julian demanded that Fox contribute capital to each LLC to pay outstanding project loans. Fox failed to meet the capital calls, and Julian and Horn contributed capital and made loans to the LLCs to cover the debt-service obligations.
The additional capital contributed by Julian and Horn gave them a majority interest in each LLC, which they used to remove Fox from management and to elect themselves in his place. The LLCs then sued Fox to recover the amounts of the capital he had failed to contribute to the LLCs. The trial court found for the LLCs on their breach of contract claims and Fox appealed.
The LLCs’ operating agreements provided that a majority in interest of the members could require that all members contribute additional capital. (The operating agreements for the LLCs were identical in all relevant respects.) Under the original 50-50 ownership split there was no majority, and Fox argued that Julian therefore had no authority to demand that the members contribute capital.
Court’s Analysis. The agreements went further, though, and also stated: “Notwithstanding the foregoing, each Member and Economic Interest Owner shall contribute such additional capital as may be required to pay debt service, insurance and real estate taxes owing by the Company.” Id. at *14. The court found that this requirement was not subject to a majority vote and that Julian, as one of the managers, was empowered by this clause to make the debt-service capital call on behalf of the LLCs. Id. at *19.
The court therefore found that Fox breached the operating agreements by failing to provide the capital contributions demanded by the LLCs. It then turned to what it called “the more vexing issue regarding the proper remedy for Fox’s breach.” Id. at *20.
The operating agreements provided that if a member failed to contribute capital that was required by the agreement, then the other members had the right, but not the obligation, to contribute pro rata any portion of the non-contributing member’s required capital contribution. The contributed capital would then be added to the capital accounts of the contributing members, and the percentage interests of the members would be adjusted accordingly. The percentage interests of the contributing members would therefore be increased and the percentage interests of any non-contributing members decreased. (The percentage interests control voting and the allocation of profits, losses, and distributions.)
Fox argued that he should not be personally liable for the capital contributions because under the operating agreements the exclusive remedy for failure to meet a capital call was a reduction of his ownership interest.
Section 17-7691(a) of the Kansas LLC Act states that “[a] member who fails to perform in accordance with, or to comply with the terms and conditions of, the operating agreement shall be subject to specified penalties or specified consequences.” The court saw this as a suggestion that any remedy for damages should be specified in the operating agreements. The operating agreements did not specifically state that the LLC could recover damages from a member that failed to contribute capital when required to do so, and the court noted that the damages remedy was “conspicuously absent” from the operating agreements. Canyon Creek Dev., 2011 Kan. App. LEXIS 128, at *25.
The court concluded:
[I]n the absence of clear statutory authority for imposing personal liability on an LLC member who fails to meet a capital call for an ongoing venture, when the LLCs’ operating agreements specify a reduction in the defaulting member’s capital share as the sole consequence, the LLCs are not entitled to seek personal judgments for damages against the defaulting member.
Id. at *30-31.
Comments. It’s striking that the court relied on the lack of any statement in the operating agreements that a breaching member would be liable in damages, while at the same time ignoring the lack of any statement that limited the remedy to a reduction in the defaulting member’s capital share. One would generally expect damages to be available for a breach of contract absent clear language to the contrary.
The court quoted Section 17-7691(a) of the Kansas LLC Act, which authorizes “specified penalties or specified consequences,” and Section 17-76,100(c), which lists several penalties or consequences that an operating agreement may impose on members who fail to make required capital contributions. Those include reducing or subordinating the member’s interest, a forced sale, or even a forfeiture of the offending member’s interest.
The law of contract damages usually prevents the imposition of forfeitures or penalties for a breach of contract, so those statutory provisions are obviously intended to expand the ability of an operating agreement to penalize or impose forfeitures on members in breach for failing to contribute capital. For the court to interpret the statutory language on “penalties” and “consequences” to exclude a damages remedy unless explicitly referred to seems at variance with the remedy-expanding approach of the LLC Act.
The result in this case is probably not what most LLC organizers would have expected or intended. Lawyers representing an LLC and drafting the LLC agreement usually try to maximize the LLC’s flexibility in dealing with defaults, by providing alternative remedies. At least it’s not difficult to draft around this case – simply list the desired remedies and include something like “and any remedy at law or in equity against the Defaulting Member including specific performance and damages.”
Arbitration of contract disputes is not generally required unless the parties agree to arbitration in their contract. LLC founders will therefore often include mandatory arbitration clauses in their LLC agreement. These are intended to require all disputes about the LLC to be arbitrated instead of being tried in court.
Montana Arbitration Clause. Arbitration clauses are usually enforceable. The Montana Supreme Court, however, recently refused in a case of first impression in Montana to enforce an LLC agreement’s arbitration clause. Gordon v. Kuzara, 2010 MT 275, 358 Mont. 432 (December 21, 2010). The plaintiff in Gordon sought judicial dissolution of the LLC, and the defendant filed a motion to compel arbitration based on the arbitration clause in the parties’ LLC agreement. Peter Mahler has nicely described the case and the court’s reasoning in his New York Business Divorce blog.
The gist of the court’s holding was that arbitration was not mandatory because the arbitration language in the LLC agreement did not cover a request for judicial dissolution. The contract said that arbitration was mandatory if any member was “challenging this agreement, any activity conducted pursuant to this agreement, or any interpretation of the terms of this agreement.” Gordon, 358 Mont. at 432.
That language is broad, but the dissolution petition was not based on a right granted by the LLC agreement. The LLC agreement had no provision requiring judicial dissolution, and the request for a dissolution order was instead based on the statutory remedy under the Montana LLC Act. Mont. Code Ann. § 35-8-902. Although the petitioner cited examples of conduct by the other member to show that the LLC was no longer economically feasible, the court concluded that the request for dissolution was based on the statutory remedy, not the LLC agreement. Gordon, 358 Mont. at 437.
Idaho Attorneys’ Fees. Arbitration is not the only contractual dispute resolution procedure that can turn out to be unavailable when dissolution is sought. Last year I posted about a case in Idaho, Henderson v. Henderson Investment Properties, LLC, where an attorneys’ fees clause in an LLC agreement was not enforced.
The trial court awarded attorneys’ fees in Henderson based on the LLC agreement’s attorneys’ fees clause, which covered actions brought to enforce any provision of the LLC agreement. The Idaho Supreme Court reversed the trial court’s award because the plaintiff did not seek to enforce the LLC agreement, but instead sought judicial dissolution, a statutory remedy.
Drafting Lessons. Both the Montana case and the Idaho case involved contractual clauses that were not enforced because they were not written broadly enough to encompass a petition for the LLC’s dissolution. One case involved a clause requiring arbitration, the other involved a clause requiring the loser to pay the winner’s attorneys’ fees.
In my post on the Henderson case I discussed how the attorneys’ fees clause could have been written to cover a dispute over dissolution, by adding language along the lines of “or to interpret or enforce any rights under the [State] Limited Liability Company Act.” The attorneys’ fees clause would then apply to either a dispute over the terms of the LLC agreement or to a dissolution petition. The broader language I suggest should have changed the result in Gordon, as well.
Another approach would be to add an express reference to dissolution in the attorneys’ fees clause or arbitration clause, as suggested by Peter Mahler in his post. That would remove all doubts about whether dissolution is covered, but would not extend to disputes over other statutorily granted rights that often are not referred to in the LLC agreement. For example, LLC statutes usually require that certain documents and records be provided to members on request.
Members of an LLC are at loggerheads and one sues the other. The plaintiff decides that the remedies in the state LLC Act are inadequate. The plaintiff instead asks the court for damages under the common law, for repudiation of the LLC’s operating agreement and for breach of contract rather than for dissolution and an accounting under the LLC Act. That was the situation in OLP, L.L.C. v. Burningham, 2009 UT 75, 2009 WL 4406148 (Utah Dec. 4, 2009). The defendant in turn claimed that the plaintiff’s claims for repudiation and breach of contract were not allowable because the remedies under Utah’s LLC Act are exclusive. The court found otherwise and allowed the plaintiff’s contract claims.
Richard Wilson and Wayne Burningham formed OLP, L.L.C. as a Utah limited liability company, to purchase and operate an anti-reflective optical lens coating machine. They agreed to share equal control and ownership of OLP, and initially contributed equal amounts of capital. They agreed that Intermountain Coatings, a company owned by Burningham, would use the lens coating machine.
Acrimony between Wilson and Burningham soon reared its ugly head. They disagreed over how profits should be divided between OLP and Intermountain Coatings, and over whether the funds provided by Intermountain Coatings to OLP should be classified as a loan or as a capital contribution from Burningham.
Wilson eventually filed suit against Burningham and Intermountain Coatings for breach of fiduciary duty, repudiation of the contract, and breach of contract, and for an accounting of OLP’s expenses, revenues, profits, and losses. Burningham counterclaimed for dissolution of OLP. Burningham argued that in winding up OLP’s business, the members’ ownership interests should be determined and distributed according to each member’s capital account as provided in the LLC Act. Burningham’s theory was that Wilson’s claims should be resolved under the LLC Act’s dissolution procedures because those procedures are the exclusive remedy for claims between members.
The court pointed out that the LLC Act does not contain any explicit authorization or denial of common law claims, and examined a number of provisions in the LLC Act which imply that common law claims between members continue to apply. The court found that analogous partnership law allows common law claims between partners, without limiting remedies to equitable remedies. The court held that Utah’s LLC Act does not preclude common law claims between LLC members, such as claims for breach of contract, and that the remedies for such claims include equitable relief such as an accounting as well as damages.
The court rejected Burningham’s argument that dissolution is the sole remedy for wrongdoing between the members as being inconsistent with the jury’s finding that he had repudiated and abandoned the operating agreement. As the court said: “When one party effectively extinguishes a business agreement, whether it be a partnership agreement or a limited liability agreement, that party cannot rely on the agreement (or the default provisions of the LLC Act that supplement the agreement) to protect itself from the harm its actions have occasioned.” OLP, 2009 UT 75, ¶ 21.
The OLP decision is consistent with the approach of many courts to the rights and remedies of LLC members. For example, earlier this year I blogged on a New York decision which found that LLC members have a common law right to an equitable accounting, even though not explicitly authorized in the statute, here. I also described Idaho’s first case on fiduciary duties of LLC members, which found that fiduciary duties existed between managing members even though no such right was described in Idaho’s LLC Act, here. Courts generally seem to be reluctant to rule out common law rights of recovery or to exclude equitable remedies, in the absence of an explicit bar in their state’s LLC Act.