Failure to Read Documents Incorporated by Reference Leads to Dilution of 50% Stake in Company to a Minority Interest The obligation of a contracting
Failure to Read Documents Incorporated by Reference Leads to Dilution of 50% Stake in Company to a Minority Interest The obligation of a contracting
party to read a contract extends to documents incorporated by reference. These documents can become part of the terms of the parties’ agreement just as much as the contract
itself. A sophisticated investor recently learned this lesson the hard way after the Delaware Court of Chancery determined that the investor’s stake in an LLC decreased from 50% to 48.5% as a result of loan and warrant agreements which granted a lender the right to purchase a 2.5% stake in the company.
In simple terms, this change meant that the other two members of the LLC (after the lender exercised its warrant rights) could now approve decisions without the consent of the investor, which was not the case before the transaction.
Although results may (and probably will) vary by jurisdiction, this case provides a good overview of the perils of signing documents without carefully reviewing and understanding them, including any documents referenced therein, copies of which sometimes are not provided to all parties before execution.
In this case, the investor argued that it should not be bound by the agreement for numerous reasons, including that it never received a copy of the warrant agreement.
The court disagreed. It noted that the LLC (of which the investor was a member) duly authorized a written consent which provided that “any Member or Officer” was “fully authorized to execute and deliver” and to cause the Company “to perform its obligations under . . . all documents relating [to] or contemplated [by]” a commitment letter.
Since the loan and warrant agreements related to and were contemplated in the commitment letter, the court concluded that they were properly authorized.
The fact that the warrant agreement was not mentioned in the written consent was of no consequence, since the written consent did reference the commitment letter that, in turn, addressed the warrant agreement.
The investor also argued that it was mistaken or misled about the terms of the transaction. This argument also missed the mark because, under Delaware law, rescission of a contract due to unilateral mistake is only available when a party can demonstrate that “the mistake occurred regardless of the exercise of ordinary care.” In this case, the court found that the investor could have discovered the warrant agreement by exercising ordinary care; namely requesting and reviewing the commitment letter referenced in the written consent.