Baseball has the squeeze play. Majority owners of closely held companies have the squeeze out. It’s only fitting, then, that I refer to what happened in the recently decided case, Cooperstown Capital, LLC v. Patton, 60 AD3d 1251 (3d Dept 2009), involving a dispute between majority and minority owners of a baseball camp, as the “squeeze-out play.”
Martin and Brenda Patton owned land in upstate New York about 20 miles from the Baseball Hall of Fame in Cooperstown. In 2004, they entered into agreements with Cooperstown Capital, LLC to build and operate a baseball camp and hotel on the Patton land. The Pattons contributed the land to Abner Doubleday, LLC (“Abner”) in exchange for 35% membership interests in Abner and a second company formed to operate the baseball camp, called Cooperstown All Star Village, LLC (“CASV”). Cooperstown Capital paid $400,000 and gave a $1 million promissory note for 35% interests in the two companies. A third investor, Marco Lionetti, acquired the remaining 30% interests.
The $1 million promissory note was made payable to the Pattons, but the operating agreements designated the payments as operating expenses of the companies and treated Cooperstown Capital’s additional capital contributions as credits against the Patton note.
The baseball camp opened under the name Cooperstown All Star Village, but relations among the owners soon deteriorated over various financial disputes which erupted in a pair of lawsuits centering on Cooperstown Capital’s obligations for capital contributions and payments on the Patton note. In December 2007, in a suit commenced by the Pattons against Cooperstown Capital demanding payment of the note, the Appellate Division, Third Department, upheld the denial of the Pattons’ summary judgment motion, stating that “[b]ecause the note requires defendants to pay, but the operating agreements include payments under the note as operating expenses of Abner and CASV, questions of fact exist concerning the breach of the agreements and the amount, if any, due under the note.” (Read decision here.)
Now comes the “squeeze-out play.” Apparently not content to await trial, in February 2008, the Pattons with the support of the other 30% member, Lionetti, called a meeting of Abner’s members to vote upon and approve a capital call upon Cooperstown Capital alone, demanding that it contribute over $450,000 for operating expenses consisting of amounts allegedly due under the Patton note. Under Abner’s operating agreement, the other members may make a capital contribution if a requested party fails to do so, and such action is treated as a loan for a period of 90 days. Thereafter, if the loan is not repaid, the defaulting member’s interest may be decreased and the contributing member’s interest increased accordingly.
Cooperstown Capital quickly sought to enjoin implementation of the February 2008 capital call, contending that when it refused to make the demanded contribution, the Pattons purported to loan Abner the funds (to pay themselves) and were threatening to dilute Cooperstown Capital’s membership interest so as to give the Pattons absolute control of the business.
LLC member disputes usually turn on the express provisions of the operating agreement, and Cooperstown is no exception. Section 5.2 of Abner’s operating agreement governing additional capital contributions provides:
The Members shall contribute such additional capital on a pro rata basis in proportion to their respective “Membership Interests”, as hereinafter set forth in Section 6 hereof, as such amount is determined in good faith by the consent of Members holding a majority in interest.
In support of its injunction application, Cooperstown Capital argued that Section 5.2 does not authorize a selective capital call upon one member, and that by diluting its membership interest the Pattons effectively would wrest over two-thirds control of the LLC giving them the unchecked power to sell major LLC assets and dissolve the LLC. In a Memorandum Decision and Order dated April 21, 2008, Oneonta County Supreme Court Justice Kevin M. Dowd agreed with Cooperstown Capital and granted the injunction, stating:
Plaintiff has shown a probability of success on the merits. The operating agreement for Abner states in Section 5.2, “The Members shall contribute such additional capital on a pro rata basis in proportion to their respective ‘Membership Interest,’…” Section 5.8 further states that in determining the amount of any additional capital contribution the members shall consider all the operating expenses. Operating expenses are defined by Section 13.13 of the Operating Agreement to include payments of principal and interest due under the Patton notes. Based upon these sections, there appears to be no basis to make a capital call on Plaintiff alone.
The Pattons appealed, arguing that the injunction was inconsistent with the Third Department’s December 2007 decision in which it found questions of fact concerning whether Abner and CASV or Cooperstown Capital was obligated to pay the Patton note. In its March 26, 2009 opinion, the appellate court rejected this argument and upheld the injunction, writing:
While both Supreme Court and this Court previously determined that questions of fact preclude summary judgment in the parties’ related case (Patton v Ferrara, 46 AD3d at 1205), plaintiff has still established a likelihood of success here. Abner’s operating agreement permits capital calls, but specifies that the “[m]embers shall contribute such additional capital on a pro rata basis in proportion to their respective ‘[m]embership [i]nterests.'” Under the operating agreement and the promissory notes, the Patton notes are payable as operating expenses of Abner and CASV rather than the individual members, and capital calls “shall” be shared pro rata by the “members” plural. Hence, despite questions of fact, it is at least likely that plaintiff will succeed in proving the impropriety of Abner’s notice requiring a capital contribution only from plaintiff to pay the Patton note.
An opportunity for defendants to shift the balance of power and wrest complete control over the company can constitute irreparable injury (see Vanderminden v Vanderminden, 226 AD2d 1037, 1041 ; Casita, LP v Maplewood Equity Partners [Offshore] Ltd., 17 Misc 3d 1137A, *8 ; see also Matter of Brenner v Hart Sys., 114 AD2d 363, 366 ). If plaintiff does not pay the capital contribution, the operating agreement permits the remaining members to meet the capital contribution on plaintiff’s behalf as a loan, then repay the loan with plaintiff’s equity interests in Abner. In that scenario, plaintiff would lose not only its shares of Abner, but also its ability to block certain actions which require a two-thirds vote. Those actions include selling major LLC assets and dissolving the LLC. The possibility of plaintiff losing any real say in Abner, as opposed to maintaining the status quo where defendants suffer no actual harm, suggests that the equities balance in plaintiff’s favor. Thus, Supreme Court did not abuse its discretion in granting the preliminary injunction (see Matter of Kalichman, 31 AD3d 1066, 1067 ).
The occasional need for additional capital contributions is a fact of life for many closely held businesses. A business organized as a New York limited liability company must pay attention to Section 502 of the LLC Law which sets forth certain default rules surrounding member liability for contributions. Section 502 does not, however, mandate any consequences to the membership interest of the defaulting member, leaving this entirely to the operating agreement. Here’s what it says in Section 502(c):
The operating agreement may provide that the membership interest of any member who fails to make any required contribution shall be subject to specified consequences of such failure. Such consequences may include, but are not limited to, reduction or elimination of the defaulting member’s interest, subordination of the defaulting member’s interest to that of nondefaulting members, a forced sale of the defaulting member’s interest, forfeiture of the defaulting member’s interest, the lending by the other members of the amount necessary to meet the defaulting member’s commitment, a fixing of the value of the defaulting member’s interest by appraisal or by formula and redemption or sale of such member’s interest at such value, or other consequences
In other words, if the operating agreement does not expressly authorize dilution, forfeiture, or other adverse consequences to the non-contributing member’s interest, the LLC has no immediate recourse beyond seeking to enforce the payment obligation. This was not the problem for the Pattons in Cooperstown. Rather, their problem was adopting a selective capital call designed to bring down the operating agreement’s “hammer” provisions upon only one member, contrary to the operating agreement’s pro rata formula for additional member contributions.
Update October 25, 2010: Read here my post on Georgi v. Polanski, where the Kings County Commercial Division held invalid a capital call in contravention of the operating agreement.
Update May 21, 2012: Read here my post on the April 6, 2012, decision by Justice Dowd granting a petition by Cooperstown Capital to dissolve the LLC based on the Pattons’ promotion and operation of competing hotel and restaurant facilities in violation of the operating agreement. In the same decision, the court denied a request to dissolve Abner.