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.