The link between capital contributions to an LLC and the LLC’s purpose is usually clear. The contributions from the members support the LLC’s purpose and are in proportion to the members’ interests in the LLC. Similarly, the increase in value of the LLC’s assets is shared among the members in proportion to their interests. But in a recent case before the Oregon Court of Appeals, one member objected when the required capital contributions were used to directly benefit individual members, as well as benefiting the LLC. Awbrey Towers, LLC v. Western Radio Servs., Inc.,278 P.3d 44 (Or. Ct. App. 2012).
Background. Awbrey Towers, LLC was formed in 2000 to purchase a 19-acre antenna site located on Awbrey Butte in Bend, Oregon. The LLC’s operating agreement stated that its purpose was to “[a]cquire, own and operate an antenna site on Awbrey Butte in Bend, Oregon” and to “[e]ngage in such other activities as are related or incidental to the foregoing purpose and such additional purposes as may be determined from time to time by the Members.” Id. at 46 (brackets in original). Each of the seven LLC members owned a communication tower on the site and leased the land for its tower from the LLC. Each apparently held a one-seventh interest in the LLC.
The LLC’s operating agreement allowed the LLC to require additional capital contributions from the members “as may be necessary to service any debt incurred in connection with the acquisition of the Tower Site and such additional capital needs of the Company as determined by a vote of the Members.” Id.
By late 2001 two members were preparing conditional use permit applications for the City of Bend in order to make changes to their towers, and another member, Western Radio Services, Inc., applied for a building permit from the City to build a new tower. It soon became clear to the members that all seven contemplated building new towers or expanding their towers at some point, so five of the members met with the City to discuss its permitting process. The City indicated that it did not want to deal with the conditional use permit applications separately. It informed the members that it would not accept permit applications from any member until a ten-year master plan for development of the entire site was submitted, and it denied Western Radio’s building permit application. Id.
The members concluded that the master plan required by the City would affect all the members’ interests and decided that the LLC should develop and submit the plan. Western Radio objected on the grounds that the master plan was necessary only for the conditional use permits required of the other six members, not for the type of tower that Western Radio desired to build. The other members nonetheless approved the LLC’s development of the master plan and its payment of the necessary legal and engineering expenses.
The LLC made a series of capital calls over the next several years, mainly in connection with the master plan. The members, other than Western Radio, voted in favor of resolutions approving the capital calls. Western Radio paid some of the requested amounts but withheld expenses for the master plan. Id. at 46-47.
Eventually the LLC sued Western Radio for its unpaid capital contributions. Western Radio argued at trial that the capital calls were invalid because they were intended to cover engineering and legal costs incurred by individual members for their own benefit, not for the benefit of the LLC, and therefore constituted illegal distributions in kind for the benefit of individual members.
The trial court found for the LLC and entered judgment in the amount of $51,310 against Western Radio, and also awarded the LLC its attorneys’ fees. Id. at 47.
Court’s Analysis. The heart of Western Radio’s argument was that the majority members improperly benefited themselves by making capital calls for expenditures that benefited those members but did not benefit the LLC or Western Radio. The Court of Appeals, however, pointed to trial testimony showing that expenditures supporting the master plan allowed the members to further develop the property, thereby increasing its value. Because the LLC owned the property, this testimony supported the trial court’s finding that the expenditures benefited the LLC. Id. at 48.
Western Radio argued that the LLC’s expenditures on the plan benefited the other members but not Western Radio and therefore were improper. The court rejected that argument because Western Radio’s President testified at trial that the City would not consider Western Radio’s building permit applications without a master plan for the site, which meant that the LLC’s expenditures on the master plan benefited Western Radio as well as the other members.
The Court of Appeals also affirmed the trial court’s other theory – “that defendant had ratified the expenditures in question by acquiescing in the informal procedures by which the members had reimbursed plaintiff for all sorts of expenses, including those that defendant acknowledged it should pay.” Id. The trial testimony showed that when the LLC’s income was inadequate to pay its bills, the LLC’s manager would often simply ask each member to deposit one-seventh of the amount of the bills into the LLC’s bank account, without a member authorization for a formal capital call.
Attorneys’ Fees. Western Radio objected to the trial court’s award of attorneys’ fees, which was based on the operating agreement and on the relevant Oregon statute. The operating agreement provided:
Attorneys’ Fees. In the event any Member brings an action to enforce any provisions of this Operating Agreement against the Company or any other Member, whether such action is at law, in equity or otherwise, the prevailing party shall be entitled, in addition to any other rights or remedies available to it, to collect from the non-prevailing party or parties the reasonable costs and expenses incurred in the investigation preceding such action and the prosecution of such action, including but not limited to reasonable attorney’s fees and court costs.
Id. at 49. The LLC acknowledged that this paragraph, by its terms, applies only if the lawsuit in question is initiated by a Member. The LLC based its claim, however, on Or. Rev. Stat. § 20.096(1) (2007), which at that time stated:
In any action or suit in which a claim is made based on a contract, where such contract specifically provides that attorney fees and costs incurred to enforce the provisions of the contract shall be awarded to one of the parties, the party that prevails on the claim, whether that party is the party specified in the contract or not, shall be entitled to reasonable attorney fees in addition to costs and disbursements.
Western Radio contended that the issue was not mutuality of remedy and that the statute was not relevant – the paragraph in the operating agreement was mutual and provided for the prevailing party to recover its attorneys’ fees. It argued, rather, that the language “[i]n the event any Member brings an action to enforce [the agreement]…” was a pre-condition to any party having a right to recover fees, and that because the LLC had brought the suit it could not recover attorneys’ fees. 278 P.3d at 49.
Relying on Jewell v. Triple B. Enterprises, Inc., 626 P.2d 1383 (Or. 1981), and subsequent cases, the court held that under the statute, whenever a party to a contract with an attorneys’ fees clause brings the kind of action contemplated by the clause, regardless of who brought the suit, the prevailing party can recover its attorneys’ fees. The court accordingly upheld the award of attorneys’ fees to the LLC. 278 P.3d at 51.
Comment. The court upheld the LLC’s expenditures on the master plan on the grounds that (a) the LLC itself benefited because the master plan made the LLC’s antenna site more valuable, and (b) each of the members enjoyed some benefit. This may be a sort of “rough justice,” but it ignores the potential disparity of benefit from one member to another. The City required the master plan as a precondition to accepting applications for the members’ conditional use permits and for Western Radio’s building permit. Presumably the permits would have different utility to the various members, but the opinion implicitly treats the benefit to each member as equal.
The drafting lesson from the dispute over the attorneys’ fee clause is straightforward. If the attorneys’ fee clause in an LLC agreement is intended to include any potential suit brought by the LLC, it could read, for example: “In the event that any dispute between the Company and any Member or between any Members should result in litigation or arbitration, the prevailing party in such dispute shall be entitled to recover its reasonable fees, costs and expenses, including without limitation its reasonable attorneys’ fees and expenses.”
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.”
LLC agreements sometimes require members to contribute additional capital upon demand of the LLC. This is risky business for the members. The LLC may unexpectedly ask for more capital when the members are not expecting it. And worse, sometimes creditors will attempt to force the LLC to call for capital from the members, in order to satisfy the creditor’s claim.
In just such a case, the Kentucky Supreme Court last month overruled the trial court and the Court of Appeals, holding that the creditor could not force the members to contribute capital to the LLC to cover the creditor’s claim. The members of the LLC had agreed in its operating agreement to contribute additional capital on the call of the LCC’s manager:
“The Investor Members . . . shall be obligated to contribute to the capital of the Company, on a prorata basis in accordance with their respective Percentage Interests, such amounts as may be reasonably deemed advisable by the Manager from time to time in order to pay operating, administrative, or other business expenses of the Company which have been incurred, or which the Manager reasonably anticipates will be incurred, by the Company.”
Racing Inv. Fund 2000, LLC v. Clay Ward Agency, Inc., No. 2009-SC-000007-DG, 2010 Ky. LEXIS 180, at *12 (Ky. Aug. 26, 2010).
Subsequent litigation resulted in a judgment against Racing Investment Fund 2000, LLC (Racing Fund) for unpaid insurance premiums. The LLC partly paid the judgment by tendering its remaining assets to Clay Ward, the judgment creditor. Not satisfied with part payment, Clay Ward contended that the operating agreement’s provision for additional capital calls provided a way for Racing Fund to obtain funds to satisfy the judgment, and that the court should order the LLC to make the call. The trial court agreed and ordered Racing Fund to call for additional capital from the members to satisfy the judgment. The LLC was held in contempt of court when it failed to comply with the court’s order. Id. at *4.
The Kentucky Supreme Court viewed the unpaid insurance premiums, which were the basis of the judgment against the LLC, as a legitimate business expense. The court also recognized that under the operating agreement the manager could have made a capital call against the members to fund payment of the judgment. But the court declined to order the LLC to make the capital call, saying that the capital call provision in Racing Fund’s operating agreement “is not a post-judgment collection device by which any legitimate business debt of the LLC can be transferred to individual members by a court-ordered capital call.” Id. at *17.
The court’s refusal to order a capital call turned on the limited liability provision of Kentucky’s LLC Act, which is emphatic: “no member, manager, employee, or agent of a limited liability company … shall be personally liable by reason of being a member [or] manager … under a judgment, decree, or order of a court, agency, or tribunal of any type, or in any other manner … for a debt, obligation, or liability of the [LLC], whether arising in contract, tort, or otherwise.” Ky. Rev. Stat. § 275.150(1). The court described the limited liability of LLC members and managers as the “centerpiece” of an LLC. Racing Inv. Fund, 2010 Ky. LEXIS 180 at *5.
Clay Ward contended that the operating agreement’s capital call provision should be applied to Racing Fund’s debt on the judgment, and that the court should order the capital call to satisfy the judgment. But because of the centrality of limited liability in LLCs, the court required that to be enforceable, any assumption by members of personal liability must be stated in unequivocal terms, leaving no room for doubt about the parties’ intent. Id. at *16. The Racing Fund agreement did not meet this standard, said the court. Id.
It is unclear where the court was drawing the line. Was the LLC’s capital call provision inapposite because the manager elected not to make the capital call, because the LLC was defunct and the judgment was therefore not an ongoing expense of the business, or because the court did not interpret “operating, administrative, or other business expenses of the company” to include a judgment against the company (even though the court recognized that the judgment was for an unpaid business expense)? If the LLC’s members had included language covering judgments, even judgments at a time when the LLC was insolvent and defunct, would Clay Ward’s claim still have failed if the manager declined to call for additional capital?
What is clear is that the drafting lessons from this case are legion. Members who agree in advance to subsequent capital calls usually have some expectations about those capital calls. The drafter should reflect those expectations in the agreement.
First, don’t create unlimited member liability for additional capital calls. Use a cap of some sort.
Second, don’t rely on the manager’s judgment. Things change over the life of an LLC; a new manager may come in with a different view of how much additional capital the company requires from its members.
Third, carefully define terms such as “operating, administrative or other business expenses.” For example, say the LLC is hit with a large, uninsured tort claim that resulted from its business operations. Is that an operating or business expense? The agreement should have definitions that would answer such questions.
Fourth, if capital calls are authorized, consider providing that if a member does not satisfy the capital call, the exclusive remedy is some form of economic adjustment to the defaulting member’s LLC interest. Adjustments such as dilution, subordination, or partial forfeiture of a non-contributing member’s interest are expressly validated by some state LLC Acts. E.g., Wash. Rev. Code § 25.15.195(3); Del. Code tit. 6, § 18-502(c).
Fifth, consider adding a “no third-party beneficiary” clause, to make clear that no creditor or other third party has any right to rely on or to enforce any of the provisions of the operating agreement, including any obligation of members to contribute capital. Such a clause could also be considered for the LLC’s certificate of formation, which unlike most LLC agreements is a public document.