“Sidney Turner, my good friend, and an excellent transaction attorney, wrote this insightful blog about operating agreements for LLC, and I wanted to share it with my readers.” Chris Curtin
The Story of Mr Duff and Mr Curto
Mr. Duff and Mr. Curto were friends, neighbors, or business associates when they decided to start their relatively modest venture. The two went into business together to develop real estate and formed a limited liability company for that purpose. Their relationship provided confidence and enthusiasm. Along with that was a casual attitude toward documenting the economic and management rights and obligations owed to one another. In not an unusual situation, they used a boilerplate form of an LLC operating agreement without consulting an attorney.
The Business Failure
Mr. Duff sued Mr. Curto after the business venture failed. He alleged that Mr. Curto did not put in his pro-rata share of capital contributions. Mr. Duff lost his suit because he and Mr. Curto left blank the space in the operating agreement. This is where they were supposed to fill in their required capital contributions. And because the agreement did not otherwise address member financing.
I do know that this kind of oversight happens all too frequently. This is especially true with new business partners who fail to appreciate the insurance value of seeking out competent legal advice to assist them in crafting a partnership agreement that adequately addresses the partners’ financial responsibilities, among other issues.
In his lawsuit, Duff contended that he made a $300,000 capital contribution during the LLC’s formation. Another $173,000 during the project. And another $50,000 to cover the shortfall upon the property’s sale. Duff claimed that the LLC’s operating agreement required each member to provide 50% of the capital contributions. This was to fund the land acquisition and construction. Duff alleged that Curto made no capital contributions. Curto, therefore, was liable for breach of contract, unjust enrichment, and other claims.
Section 3.1 of the operating agreement, captioned “Initial Contributions. This is ”provided that “[u]pon the execution of this Agreement, each Member shall contribute cash or property to the Company as set forth opposite their names in Exhibit A.”
Notwithstanding that the columns for cash and property contributions were left blank, Duff argued Section 3.1 required matching capital contributions by Curto. Duff asserted that he had no obligation to make any capital contribution. This is because Exhibit A did not list any capital either member must contibute.
Curto alleged that the funding provided by Duff was in the form of loans. And not capital contributions, as demonstrated by the LLC’s 2007 and 2008 tax returns listing a loan payable to Duff of approximately $309,000.
The New York court agreed with Duff that the operating agreement is ambiguous. This is as to whether both Duff and Curto required initial capital contributions. “The first sentence of section 3.1 of the Operating Agreement, the court stated, “appears, on its face, to mandate initial capital contributions by each Member.” But “Exhibit A does not set forth the amount of any such initial contribution.” The court, therefore, “may consider extrinsic evidence of the parties’ intent.” The tax returns showing loans and Duff’s deposition testimony. In which he admitted that he reported a recourse loan to the LLC on its tax return, “demonstrate as a matter of law that Duff loaned the funds to [the LLC].”
Business partners forming an LLC must carefully consider the immediate and future capital needs of the venture. They must include in the operating agreement a provision that meets those needs. The provision also should spell out the consequences when a member fails to contribute his or her shares. This includes such as dilution or even forfeiture of membership interest. The provision also can be made for member loans to the LLC in place of capital contributions.
Under no circumstances should the parties sign an operating agreement. Such as the one in Duff with missing entries for the capital contributions.
Author Sidney Turner is a highly experienced business attorney with extensive knowledge and experience in Commercial Transactions, Buying, Selling Businesses, Corporate Governance, and agreements. For more information visit www.sidneyturnerllc.com