Scion Breckenridge Managing Member, LLC v. ASB Allegiance Real Estate Fund

• Decision Date: 09 May 2013
• Docket Number: No. 437, 2012,437, 2012
• Parties: SCION BRECKENRIDGE MANAGING MEMBER, LLC, SCION 2040 MANAGING MEMBER, LLC and SCION DWIGHT MANAGING MEMBER, LLC, Defendant Below Appellants, v. ASB ALLEGIANCE REAL ESTATE FUND, EBREF HOLDING COMPANY, LLC and DWIGHT LOFTS HOLDINGS, LLC, Plaintiffs Below Appellees.
• Court: Supreme Court of Delaware

SCION BRECKENRIDGE MANAGING MEMBER, LLC,SCION 2040 MANAGING MEMBER, LLCand SCION DWIGHT MANAGING MEMBER, LLC, Defendant Below Appellants,

v. ASB ALLEGIANCE REAL ESTATE FUND, EBREF HOLDING COMPANY, LLCand DWIGHT LOFTS HOLDINGS, LLC, Plaintiffs Below Appellees.

No. 437, 2012

SUPREME COURT OF THE STATE OF DELAWARE

Submitted: March 27, 2013

Decided: May 9, 2013

Court Below: Court of Chancery

of the State of Delaware

C.A. No. 5843

Before STEELE, Chief Justice, HOLLAND, BERGER, JACOBS and

RIDGELY, Justices constituting the Court en Banc.

Upon appeal from the Court of Chancery. AFFIRMED in part, REVERSED in part and REMANDED.

Gregory P. Williams (argued) and Kelly E. Farnan, Richards, Layton & Finger, P.A., Wilmington, Delaware. Of Counsel: Kenneth T. Brooks and Richard J. Zecchino, Honigman Miller Schwartz and Cohn LLP, Lansing, Michigan for appellants.

John L. Reed and Scott Czerwonka, DLA Piper LLP, Wilmington, Delaware. Of Counsel: Bruce E. Falby (argued), Bruce S. Barnett and Justin Brown, DLA Piper LLP, Boston, Massachusetts for appellees.

STEELE, Chief Justice:

In this reformation action concerning cash flow distributions in three real estate joint venture agreements, we hold that the Vice Chancellor properly reformed the agreements on the basis of unilateral mistake and knowing silence by the other party. Negligence in discovering an alleged mistake does not bar a reformation claim unless the negligence is so significant that it amounts to a failure to act in good faith and in accordance with reasonable standards of fair dealing. Ratifying a contract does not create an equitable bar to reformation unless the ratifying party had actual knowledge of the mistake giving rise to the reformation claim. We reverse the Vice Chancellor's fee award because a contractual fee-shifting provision incorporating the words "incurred" and "reimburse" does not apply where counsel for the party seeking fees represented the party free of charge to avoid a malpractice claim. We also clarify that 10 Del. C. § 5106's reference to "costs" does not include attorneys' fees.

I. FACTUAL AND PROCEDURAL HISTORY¹

Rob and Eric Bronstein² cofounded (and remain principals of) The Scion Group, LLC.³ ASB Capital Management, LLC, is the registered investmentadviser for approximately 150 pension funds (ASB or the Funds). Between January 2007 and January 2008, ASB-advised pension funds⁴ entered into five joint ventures for the ownership, operation, and development of student housing projects through special purpose entities.⁵ Keyvan Arjomand, Scion's primary contact at ASB, negotiated the agreements with Rob. ASB's president, Robert Bellinger, actively oversaw the negotiations and personally approved each venture. ASB's Real Estate Investment Advisory Committee also approved the investments based on internal memorandums.

Rob testified that he left the "wordsmithing" of the agreements to Eric. ASB relied on DLA Piper LLP as outside counsel. DLA Piper partner Barbara Trachtenberg drafted and negotiated the first joint venture agreement, the University Crossing project. After that, she ceded most of the drafting responsibility to Cara Nelson, a junior associate who only had been working on real estate joint venture deals for a few months.

Real estate joint venture projects generally follow a basic framework: a promoter provides the bulk of the capital and a sponsor arranges the deal andmanages the property.⁶ ASB served as the promoter in each of the five ASB-Scion joint ventures, providing at least 99% of the capital and retaining at least 99% of the equity. Scion served as the sponsor and invested no more than 1% of the capital. Scion earned a management fee for overseeing the project's day-to-day operations, as well as a leasing fee and an acquisition fee. Scion primarily earned its compensation, however, through an incentive payment known as a "promote."⁷

Generally, a promote is triggered once the project generates a specified preferred return on the invested capital. Once the project achieves the specified preferred return, the promote rewards the sponsor with a greater proportion of the project's profits.⁸ Real estate professionals commonly discuss promotes using industry shorthand, in which they describe the economics as "an X over a Y."⁹ Forexample, the phrase "20% over an 8%" means the sponsor would receive 20% of incremental profits after the project generated an 8% preferred return.

The Vice Chancellor found that Arjomand and Rob negotiated Scion's compensation using industry shorthand. In an October 2, 2006 email, Arjomand proposed a "20% above an 8% preferred return;" Rob replied the next day that he was "probably okay with the promote structure." Neither side questioned the shorthand's meaning or sought to clarify whether Scion would get its promote before ASB recovered its initial capital investment.

The parties' first joint venture, the University Crossing LLC Agreement, incorporated the promote and preferred return terms Rob and Arjomand discussed into the Sales Proceeds Waterfall, which provided, in relevant part:

(ii) Second, among the Members in proportion to the Unrecovered 8% Preferred Return Amounts of the Members at such time, until such time as each Member's Unrecovered 8% Preferred Return Amount has been reduced to zero;

(iii) Third, among the Members in proportion to the Invested Capital of the Members at such time, until such time as each Member's Invested Capital has been reduced to zero;

(iv) Fourth, (x) the Remaining Percentage to the Members in proportion to each Member's respective Percentage Interests at such time, and (y) the Promote Percentage to Venture Partner.

The LLC Agreement defined the Promote Percentage and the Remaining Percentage as 20% and 80%, respectively. In effect, the Waterfall provided that the parties would receive distributions in proportion to their respective percentageequity investments, approximately 99% for ASB and 1% for Scion, until each member received an amount equal to an 8% preferred return on that investment. Therefore, distributions would continue at a 99:1 ratio until each member recovered its initial capital investment. Only after ASB recovered its investment would Scion receive a promote payment equal to 20% of the excess profits, with ASB and Scion splitting the remaining 80% according to their 99:1 equity ratio.

The parties' second joint venture, Millennium Bloomington Apartments, LLC, mirrored the University Crossing terms. Scion had asked for higher acquisition and management fees on the Millennium deal, but ASB had refused. Rob continued to seek greater compensation for Scion, discussing a two-tier promote structure in the context of a proposed project that the parties ultimately abandoned.¹⁰ Discussions continued, however, and in a March 20, 2007 email, Arjomand told Rob that Bellinger wished to structure deals with lower fees but a higher promote that would incentivize the sponsor to earn greater compensation through successful property management. Rob responded that he understood and was open to reducing his fees in exchange for greater promote compensation.

The parties continued to negotiate a trade-off between fees and promote consideration. In May 2007, Arjomand sent an email titled "ASB/Scion General Deal Parameters Going Forward," which summarized the deal structure that he believed both sides had finally negotiated: "Promote—On an unlevered deal, 20% over an 8%, and 35% over a 12%. On a levered deal, 20% over a 9%, and 35% over a 15%" (the May 2007 Terms). Rob replied the next day stating that he "agree[d] with all this." Arjomand forwarded these terms to the entire deal team on May 22, describing them as "the basic economics of our deal format with Scion on a go forward basis."

The parties entered into their third joint venture, Breckenridge, LLC, in June 2007. DLA Piper used the Millennium LLC Agreement as a template and made deal-specific adjustments to prepare the initial draft of the Breckenridge LLC Agreement. Nelson circulated the first draft on June 14, 2007. Although DLA Piper revised both the operational cash flow waterfall and the Sale Proceeds Waterfall to add the second tier of preferred return, the waterfalls only included one level of promote. Eric replied the same day and identified the problem. The Vice Chancellor found that Eric did not intend in his email to alter the economic terms for the Sale Proceeds Waterfall but rather to memorialize accurately the two-tier promote structure to which Rob and Arjomand had agreed.

Nelson revised the Waterfall provisions, but her June 15, 2007 draft of the LLC Agreement placed the missing first-tier promote after the first preferred return provision, but before the return of capital provision in the Waterfall.¹¹ This placement meant that Scion would begin to earn its promote immediately after the project satisfied its first preferred return amount but before the parties recovered their initial capital investment. Despite these significant consequences, no one commented on the change.

Eric testified that he reviewed the Waterfall in detail. The Vice Chancellor found that Eric realized that the first-tier promote appeared before the return of capital and understood that Scion would benefit from this error.¹² Trachtenberg could not recall whether she read the drafts before Nelson circulated them, but if she did, she must not have focused on the Waterfall because "it's just wrong. It's a terrible translation of the [May 2007 Terms]."¹³ Nelson conceded that she did not have the experience to understand the Waterfall provisions at the time and only learned of the mistake when Trachtenberg explained it to her in the fall of 2010.

After one minor change,¹⁴ the parties executed the Breckenridge deal agreement with the following relevant parts of the Sale Proceeds Waterfall:

(ii) Second, among the Members in proportion to the Unrecovered First Preferred Return Amounts of the Members at such time, until such time as

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