Two guys are sitting at a bar discussing how they are going to quit their current jobs and start their own business. A lawyer sits next to them, overhears their happy ramblings and pipes in, as lawyers always do, that their mutual promise to devote 100% of their working energy to the new biz has to be reduced to writing. You know this joke, right?
Well, maybe not, and maybe it’s not such a knee slapper anyway. Under Delaware’s Limited Liability Company Act (the “Act”), a person may be admitted to a LLC as a member and may receive a LLC interest without making a contribution or being obligated to make a contribution to the LLC. If an interest in a LLC is to be issued in exchange for cash, tangible or intangible property, services rendered or a promissory note or obligation to contribute one or more of these items, however, the LLC’s operating agreement can and should, identify that obligation. The Act goes further and makes it clear that the operating agreement may provide 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 consequences, When a member fails to make any contribution that the member is obligated to make, the operating agreement can provide that such penalty or consequence take the form of reducing or eliminating the defaulting member’s proportionate interest in a LLC, subordinating the member’s interest to that of nondefaulting members, a forfeiture of that interest, or a fixing of the value of his or her interest by appraisal or by formula with a forced redemption or sale of the LLC interest at such value.
If only our clients made it easy on us by letting us write agreements with such detail! A more common scenario is the member who wants us to get rid of the 50% member, formerly a dear buddy, who walked out the door for whatever reason after a few months (or, even worse, walks in and plays on the computer all day doing nothing that needs to be done). Unfortunately, without an operating agreement that clearly identifies expectations with respect to contributions of services and remedies for breach, it is a challenge to argue the defaulting member forfeits his or her interest for failure of consideration as s/he might for failure to “pay” for the interest with cash or property.
While I continue to look out for case law in support of the idea of forfeiture in the context of LLCs, a recent Kansas case did address alternative remedies for breach of obligations with respect to contributions of cash. In Canyon Creek Development, LLC v Fox, the court struggled with the appropriate remedy available to a LLC when a member failed to satisfy a required capital call. The defaulting member, Fox, argued that he should not be held personally liable for the nonpayment of a post-formation capital contribution where the only remedy set forth in the operating agreement was a reduction of his ownership interest. Interpreting a statute that appears to be similar to the Act, the court ultimately agreed with Fox, making a distinction between the initial contributions (which could be in the form of cash or services, measured by their “net fair market value”) and later capital infusions which had to be in cash (unless the manager otherwise consented). The court concluded that the statutory default rule that a member is obligated to perform any promise to contribute cash or property or perform services, even if a member is unable to perform, supports the proposition that a member may be required, at the option of the LLC, to contribute an amount of cash equal to the agreed value of any initial, unmade, contribution. The court stated this was the law even where the LLC may have other rights against the noncontributing member under the operating agreement or other law. Turning to subsequent capital calls, however, the court found it significant that the remedy of cash damages, the most fundamental remedy for breach of contract, was conspicuously absent from the provisions of the operating agreement. Thus, the court concluded that the failure to include such a fundamental remedy as damages when a member fails to contribute additional capital after the LLC’s initial capitalization was not an oversight, but rather expressed a clear intent that damages are not recoverable from a member who failed to contribute additional capital after the venture was up and running. In the Fox case, the right to reduce the breaching member’s LLC interest was all that the LLC could do to punish the breaching member. No divorce, but better than a non-collectable judgment for a sum certain from my perspective.