Kansas Court Broadens Charging Order Against Single-Member LLC
Judgment creditors of LLC members usually have the right under state law to obtain a charging order against a member’s LLC interest. A charging order mandates that any distributions by the LLC that would otherwise be made to the member be paid instead to the creditor. The charging order provides no benefit, though, if no distributions are made to the LLC’s members. And if the judgment debtor is the only member of the LLC, it’s unlikely that he or she will cause the LLC to make distributions, since those would have to go to the creditor.
The U.S. District Court in Kansas recently had to determine the scope of a charging order against a single-member LLC in Meyer v. Christie, No. 07-2230-CM, 2011 U.S. Dist. LEXIS 118590 (D. Kan. Oct. 13, 2011). Although the Kansas LLC Act says a charging order against an LLC member’s interest is the creditor’s exclusive remedy, the court surprisingly found that, in the case of a single-member LLC, the creditor could assert management rights and take control of the LLC.
The relevant facts are straightforward. The plaintiffs obtained a final judgment of about $7 million against the defendants, who had interests in several Kansas LLCs. The plaintiffs asked the judge to issue a charging order against the defendants’ interests in the LLCs, under the authority of Kansas’s LLC Act:
Rights of judgment creditor. On application to a court of competent jurisdiction by any judgment creditor of a member, the court may charge the limited liability company interest of the member with payment of the unsatisfied amount of the judgment with interest. To the extent so charged, the judgment creditor has only the rights of an assignee of the limited liability company interest. This act does not deprive any member of the benefit of any exemption laws applicable to the member’s limited liability company interest. The rights provided by this section to the judgment creditor shall be the sole and exclusive remedy of a judgment creditor with respect to the member’s limited liability company interest.
Kan. Stat. Ann. § 17-76,113 (emphasis added).
A charging order is a limited remedy – the creditor has only the rights of an assignee, i.e., the economic right to receive distributions, and no rights to participate in management. The Kansas statute also provides that the charging order is the exclusive remedy, so the creditor cannot attach or foreclose on the member’s interest and thereby take control. (The charging order provisions of some state LLC Acts are silent on whether the charging order is a creditor’s exclusive remedy. See my discussion of Florida’s Olmstead v. FTC case on charging orders, here.)
The court acknowledged the Kansas LLC Act’s clear statement that the charging order is the only remedy by which a member’s judgment creditor can reach the member’s LLC interest, and discussed the partnership law origins of the LLC charging order. In the case of partnerships, a creditor’s charging order against a partner will not entitle the creditor to participate in the management of the partnership. Meyer, 2011 U.S. Dist. LEXIS 118590, at *10.
But, said the court, the result is different in the case of an LLC with only one member. That’s because of a specific provision in the Kansas LLC Act:
If the assignor of a limited liability company interest is the only member of the limited liability company at the time of the assignment, the assignee shall have the right to participate in the management of the business and affairs of the limited liability company as a member.
Kan. Stat. Ann. § 17-76,112(f). That paragraph is not in the Act’s section on charging orders, but is part of a long section dealing with assignments of LLC interests.
Without discussion, the court simply assumed that the holder of a charging order not only has the rights of an assignee but actually is an assignee. The court then held that under Section § 17-76,112(f), “the assignee/creditor shall have the right to participate in the management of the business and affairs of the LLC as a member.” Meyer, 2011 U.S. Dist. LEXIS 118590, at *11. With those rights, the holder of a charging order against an LLC’s sole member can take over the LLC, make distributions to itself, and liquidate the LLC if it so chooses.
The problem with the court’s holding is that the creditor’s rights under a charging order are limited to satisfaction of the debt. Once the judgment debtor’s obligation is satisfied, the charging order is extinguished. An assignment, in contrast, is a permanent transfer of the property rights assigned. The charging order statute accordingly recognizes that the rights of the creditor are limited: “To the extent so charged, the judgment creditor has only the rights of an assignee of the limited liability company interest.” Kan. Stat. Ann. § 17-76,113 (emphasis added). The Meyer court ignored the inherent limitations of charging orders. Its confusion between the limited economic rights granted under a charging order and the full transfer of rights granted under a true assignment led it to the wrong result.
Some states have added provisions to their LLC Acts to clarify this point and avoid a Meyer result. Thomas Rutledge recently blogged about the Meyer case, here, and pointed out that Kentucky has amended its LLC Act to provide that “[a] charging order does not of itself constitute an assignment of the [LLC] interest.” Ky. Rev. Stat. § 275.260(3).
Michigan similarly provides in its LLC Act that a charging order is not an assignment of the member’s interest, and that the holder of a charging order does not become a member of the LLC. Mich. Comp. Laws § 450.4507.
One recent publication that is a useful reference for investigating state LLC charging order laws is Carter G. Bishop, Fifty State Series: LLC Charging Order Statutes , Suffolk University Law School Research Paper No. 10-03 (Oct. 6, 2011) .
Absent a Written Operating Agreement, Withdrawing Member of Kentucky LLC Has No Claim for Value of His Interest
The lawyers’ maxim is, “get it in writing.” Oral agreements can be difficult to prove and often leave unanswered questions. In Chapman v. Regional Radiology Associates, PLLC, 2011 Ky. App. Unpub. LEXIS 251 (Ky. Ct. App. Mar. 25, 2011), the members had no written agreement and not much of an oral agreement. One of the two members withdrew and they couldn’t agree on what the withdrawing LLC member was entitled to.
Background. Dr. Shiben organized Regional Radiology Associates, PLLC in 2000 and was its sole manager and member. In 2001 Dr. Chapman became employed by the LLC, and in 2002 negotiated with Shiben to become a 40% member and tendered a $10,000 check for his initial capital contribution. The check was never cashed and the doctors never executed a written agreement. Nonetheless, on January 1, 2003 the LLC began treating Chapman as a member of the LLC, and did so through the end of 2005. Profits were allocated 40% to Chapman, distributions were made accordingly, and the LLC’s tax returns showed Chapman as a 40% member.
In January 2006 Chapman gave notice that he intended to terminate his employment, and on April 14, 2006 he ceased working for the LLC. Chapman received his salary through the end of his employment, but he also asked for additional cash for his member interest in the LLC.
Trial Court. The trial court awarded Chapman $20,709 for the LLC’s net income allocated to him through April 2006. Chapman didn’t dispute that amount, but he claimed he was also entitled to receive 40% of the value of the LLC as of April 14, 2006. Chapman, 2011 Ky. App. Unpub. LEXIS 251, at *8.
Neither party contested that Chapman was a member of the LLC from January 1, 2003 until April 14, 2006. The Court of Appeals therefore looked to Kentucky’s LLC Act: “Next, we will consider whether under KRS Chapter 275 Dr. Chapman was entitled to any additional payment upon his voluntary withdrawal from RRA.” Chapman, 2011 Ky. App. Unpub. LEXIS 251, at *11-12.
Termination of Employment vs. Member Withdrawal. The court never discussed the difference between termination of a member’s employment by the LLC and the member’s withdrawal as an LLC member. The court simply treated the termination of Chapman’s employment as being equivalent to his withdrawal as a member of the LLC.
Employment and LLC membership are two different statuses. In general one need not be employed by an LLC to be a member of the LLC. It may be that both members implicitly agreed that Chapman’s employment termination constituted a withdrawal as a member from the LLC, but it is puzzling that the court did not address the issue.
Dissociation. After reviewing Sections 275.210 (distributions) and 275.205 (allocations of profits and losses), the court found that Chapman was a member of the LLC from 2003 until April 2006. The court then found that Chapman withdrew from the LLC pursuant to Section 275.280 (Cessation of Membership), as it was then in effect:
(1) A person shall disassociate from the limited liability company and cease to be a member of a limited liability company upon the occurrence of one (1) or more of the following events;
(a) Subject to the provisions of subsection (3) of this section, the member withdraws by voluntary act from the limited liability company[.]
Ky. Rev. Stat. § 275.280.
According to the court, “[t]he statute, however, gives no instruction as to compensation for the withdrawing member.” Chapman, 2011 Ky. App. Unpub. LEXIS 251, at *17. After discussing the manager’s authority under Section 275.165(2), the court concluded that the LLC’s manager had the authority to decide how much the LLC should pay Chapman upon his withdrawal from the LLC. The court found the default rules for allocations of profit and loss under Section 275.205 to be inapplicable to a withdrawing member.
Holding. The court held that Chapman failed to demonstrate that the LLC had a legal obligation to pay him anything for his member interest upon his withdrawal from the LLC. No written agreement ever governed his membership, and no provision of the LLC Act required that he be paid anything for his member interest. Chapman, 2011 Ky. App. Unpub. LEXIS 251, at *20.
Mistaken Analysis. The court’s analysis reflects a fundamental misreading of the Kentucky LLC Act. The court without discussion treated Chapman’s withdrawal as equivalent to giving up his economic rights as a member. But the Act clearly recognizes that one may be a non-member while still holding the economic rights of a member. For example, when a member assigns its member interest, the assignee receives only the right to receive distributions and may not participate in management of the LLC unless a majority in interest of the members consent. Ky. Rev. Stat. §§ 275.255(1), 275.265(1). The assigning member remains a member unless removed by a vote of the other members, notwithstanding that the assignor has no remaining economic rights. Id. These sections of the Act imply that a withdrawing member still has the right to receive distributions.
This point is made even more clearly by Section 275.265(5): “Unless otherwise set forth in the operating agreement, a successor in interest to a member who is disassociated from the limited liability company shall have the rights and obligations of an assignee with respect to the member’s interest.” The court determined that Chapman’s withdrawal was a disassociation under Section 275.280(1)(a). But under Section 275.265(2), any successor in interest to a disassociated member is an assignee and retains the economic rights of the disassociated member. And if a successor in interest to a disassociated member has the former member’s economic rights, certainly the disassociated member retains those economic rights when there is no successor.
Because the statute provides for Chapman’s continued ownership of the economic rights, he would be entitled to ongoing distributions under Section 275.210. Since there was no written operating agreement, this Section requires the members to share in distributions on the basis of the agreed value of their contributions as shown in the records of the LLC. The tax returns and the records of the LLC for 2003 through 2005 showed that the agreed value of the members’ contributions were in the ratio of 40% for Chapman to 60% for Shiben.
There was apparently no agreement between the parties that entitled Chapman to payment for his economic interest in the LLC upon his withdrawal as a member, but the court’s analysis failed to recognize that Chapman had an ongoing right to receive distributions of $40 for every $60 of distributions made to Shiben.
More States Are Considering Low-Profit LLCs
At least 10 state legislatures are considering bills to authorize low-profit limited liability companies (L3Cs) – all introduced in the last two and a half months:
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Arizona; Senate Bill No. 1503 |
Arkansas; Senate Bill No. 5 |
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Hawaii; Senate Bill No. 674 |
Indiana; Senate Bill No. 501 |
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Kentucky; House Bill No. 110 |
Maryland; House Bill No. 552 |
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Montana; House Bill No. 415 |
New York; Senate Bill No. 3011 |
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Oregon; House Bill No. 2745 |
Rhode Island; Senate Bill No. 353 |
These have the potential to more than double the number of states that authorize L3Cs. Currently eight states have authorized L3Cs: Illinois, Louisiana, Maine (effective July 1, 2011), Michigan, North Carolina, Utah, Vermont, and Wyoming.
The L3C is a relatively new type of limited liability company, a hybrid which attempts to combine a charitable purpose with a profit-making motive. An L3C is not a nonprofit and is taxed on its profits like any other LLC. I have previously written about L3Cs, here.
Advocates of L3Cs suggest they will encourage investment by private foundations in L3C enterprises. Typical program-related investments (PRIs) made by private foundations in either for-profit or tax-exempt enterprises include equity investments and loans, on terms more favorable to the recipient than a market rate investment. The purpose of the investment must be to support the foundation’s charitable purpose. L3Cs are promoted as facilitating increased investment by private foundations, because the state statutes apply to L3Cs the Internal Revenue Code requirements for the recipient of a PRI made by a private foundation. IRC § 4944(c). The idea is that because L3Cs automatically apply those standards to L3Cs, private foundations will be more willing to invest in L3Cs.
L3Cs have generated a lot of interest in the non-profit and social enterprise community, and a fair amount of commentary is becoming available. The Vermont Law Review sponsored a symposium on L3Cs and other developments in social entrepreneurship in February 2010. (Vermont was the first state to authorize L3Cs.) Articles related to the Symposium were published in a symposium edition of the Vermont Law Review, Symposium, Corporate Creativity: The Vermont L3C and Other Developments in Social Entrepreneurship, 35 Vt. L. Rev. 1 (2010).
Two articles in the symposium edition caught my eye. The first was Program-Related Investments in Practice, 35 Vt. L. Rev. 53 (2010), by Luther M. Ragin, Jr., Chief Investment officer of the F. B. Heron Foundation. Heron has been an active PRI maker since 1997, and at the end of 2009 had $21 million in outstanding PRIs, in 38 separate transactions. Heron’s PRIs were made to a variety of organizations. Most were to non-profits, but 10 were equity or subordinated debt investments in limited partnerships, LLCs, and corporations.
The critical driver for Heron is not the legal form of the organization seeking capital. Heron has found that it can apply the PRI rules and reach positive decisions on PRIs to various types of for-profit entities as well as non-profits, provided the PRI serves a charitable purpose. (The two other PRI tests – no lobbying, and income from the PRI not being a significant purpose of the foundation’s decision to make the investment – must also be satisfied.)
The other article in the Symposium edition that jumped out was The L3C Illusion: Why Low-Profit Limited Liability Companies Will Not Stimulate Socially Optimal Private Foundation Investment in Entrepreneurial Ventures, 35 Vt. L. Rev. 275 (2010), by J. William Callison and Allan W. Vestal. The article nicely reviews the law of private foundations and PRIs. It then examines the L3C requirements of the state LLC laws and how they attempt to match the PRI requirements. The article concludes that the statutory form does not match well with the PRI requirements and that private foundations will still need to conduct the same due diligence they would conduct before making a PRI to a non-L3C entity.
The experience of the F. B. Heron Foundation buttresses Callison and Vestal’s analysis. The type of entity, and whether it is a for-profit or a non-profit, play little part in Heron’s decisions about making PRIs.
The article concludes with a discussion of why L3Cs are considered harmful. First, smaller, less well-advised foundations may unduly rely on the L3C status of the recipient when making a PRI rather than on their usual due diligence, resulting in non-compliance with tax requirements and possibly endangering the foundation’s charitable status. Second, in an L3C with profit-seeking participants, where the foundation makes a high-risk, low-return investment vis-à-vis the other investors, there is risk that the foundation may run afoul of the “private benefit” doctrine, which is intended to prevent tax-exempt organizations from conferring private benefit on private participants.
Callison and Vestal’s conclusion is succinct: without changes to federal PRI rules there is little or no value to the L3C structure, the existence of the L3C form is a dangerous trap for the unwary, and the form should be shelved.
The article makes a strong case for the states to stop adopting the L3C form, and for the states that currently authorize the L3C form to revise their LLC laws to delete the L3C authorizations.
Will careful legal analysis and commentary take the wind out of the sails of the L3C movement? It’s hard to say. Popular enthusiasms and fads take on a life of their own. And one of the drivers of the L3C movement is the laudable goal of increasing the flow of private foundation money to ventures with charitable purposes. But that goal appears to be blinding the L3C promoters and some state legislators to the legal realities – L3Cs don’t and won’t accomplish that goal unless and until the federal tax rules are changed, which appears unlikely.
Capital Calls and Personal Liability in Kentucky
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.
Who Are the Owners of an LLC?
A lender took an assignment of a 25% interest in an LLC in exchange for the lender’s cancellation of the LLC’s debt, but the lender was never admitted as a member. Later the lender agreed to sell his “25 percent ownership interest,” but his buyer defaulted and claimed that the lender did not have an ownership interest in the LLC.
Ownership of property is covered in a first-year law school class because it is a fundamental legal concept, but sometimes the application of even fundamental concepts can be troublesome. In this case the Kentucky Supreme Court overruled the Court of Appeals and held that in the context of an LLC, “ownership” and membership in the LLC are synonymous – that the owner of an economic interest in the LLC does not have an “ownership interest” if he is not admitted as a member. Spurlock v. Begley, No. 2009-SC-000050-DG, 2010 Ky. LEXIS 80 (Ky. Apr. 22, 2010).
Tate Begley loaned $75,000 to Caribou Coal Mining Processing, LLC (Caribou), in exchange for Caribou’s promissory note. The note was unpaid and went into default. Robert Griffin, the founder of Caribou, orally promised to give Begley a 25% interest in Caribou in exchange for the $75,000 debt. Begley and Ben Spurlock then entered into a one-paragraph written agreement (Sale Agreement) in which Spurlock agreed to pay Begley $70,000 in exchange for Begley’s “25 percent ownership of Caribou Coal Processing LLC.” Spurlock, 2010 Ky. LEXIS 80, at *8.
A year later Caribou was insolvent and had ceased operations, and Begley sued Spurlock for non-payment on the Sale Agreement. Spurlock defended on the grounds of failure of consideration, contending that Begley did not hold an ownership interest in Caribou. At trial the jury found that Griffin had indeed transferred a 25% ownership interest to Begley and ruled for Begley on his Sale Agreement with Spurlock. The Court of Appeals affirmed.
The Kentucky LLC Act uses the term “members” rather than “owners,” as do most other state statutes. Ky. Rev. Stat. § 275.015(16). If there is no written operating agreement, a person acquiring an interest directly from the LLC becomes a member only if all members consent in writing, and a person acquiring an interest by assignment from a member becomes a member only if a majority in interest of the members consent in writing. Ky. Rev. Stat. §§ 275.275(1), 275.265(1).
If the assignee is not admitted as a member, the membership interest becomes divided. The economic rights are held by the assignee and the governance rights are retained by the assignor, who continues to be a member. Ky. Rev. Stat. § 275.255(1)(d). If the members consent and the assignee is admitted, the transfer of the membership interest conveys both the economic and the governance rights. Spurlock, 2010 Ky. LEXIS 80, at *7.
After reviewing the Act’s provisions, the court concluded:
This, then, leads to the conclusion that simply acquiring economic rights does not, in and of itself, equate to “ownership” or “membership” in the limited liability company.
. . .
… In the context of limited liability companies, “ownership” and “membership” are synonymous.
Id. At *7-8. The court then reasoned that because Begley acquired only an economic interest and was not admitted as a member, he did not acquire an ownership interest in the LLC. Spurlock therefore had a valid defense of failure of consideration under the Sale Agreement.
The court’s analysis makes sense if one understands “ownership” in the sense of “[t]he complete dominion, title, or proprietary right in a thing or claim.” Black’s Law Dictionary 1260 (4th ed. 1968). After all, Begley did not have all of the rights of a member – he had the economic rights but not the governance rights. And if the word “membership” is used only for a person who is both admitted as an LLC member and who holds all of the associated economic rights, then the court’s conflating of ownership and membership is correct.
But as the Spurlock court itself pointed out, a member who transfers its economic interest to a non-admitted assignee continues to be a member even though it has no remaining economic rights. Presumably the court would not have found Begley to have “ownership” if he had been admitted as a member but had assigned his interest to a non-admitted assignee, leaving Begley a member holding governance rights and no economic interest. In that scenario, LLC membership would not equate to ownership.
More careful drafting of the Sale Agreement could have changed the result in this case. If the Sale Agreement had referred to an “economic interest” or simply an “interest,” rather than an “ownership interest,” or if it had included language otherwise clarifying that Begley had not been admitted as a member, then Spurlock would have had no defense. The court did not examine the intent of the parties; it simply construed any ambiguity in the phrase “ownership interest” against Begley because he drafted and prepared the Sale Agreement. Spurlock, 2010 Ky. LEXIS 80, at *8-9..
The court also could have been more careful with its language. Its generalized equating of “ownership” and “membership” reaches too far by ignoring the fact that an LLC can have a member with no economic interest. Words are slippery and should be used carefully. The question, as Humpty Dumpty said to Alice, is which is to be master, the words or their speaker.
