Capital contributions by business owners are the lifeblood of any newly formed business entity. Typically the lifeblood consists of cash, but not always. In many instances the contribution may consist of tangible (e.g., real property) or intangible (e.g., intellectual property rights) assets. In other instances it may consist of services provided by an equity owner.
As in most if not all states, New York’s statutes governing business entities sensibly permit various forms of capital contributions as consideration for equity interests. With minor variations each of Section 504 of the Business Corporation Law, Section 121-501 of the Revised Limited Partnership Act, and Sections 102(f) and 501 of the Limited Liability Company Law provide that capital contributions may take the form of cash, property, services rendered, or promises to provide any of the foregoing.
LLCs and Indeterminate Membership Interests
The default rules under New York’s LLC Law are modeled on what I call indeterminate or variable membership interests. The measure of a member’s voting power (LLCL 402[a]), profit and loss share (LLCL 503), share of distributions (LLCL 504), and share of net assets distributed upon dissolution (LLCL 704[c]) all are based on the proportionate “value” of each member’s “contributions” which in theory may vary over time.
Most of the LLCs I encounter in my practice have operating agreements that depart from the default rules by granting the members fixed voting and economic rights based on static membership percentages which may be based on actual contributions or an arbitrary incentive-based allocation such as equal shares for all members. To the extent such operating agreements leave room for post-formation adjustments to member percentages and allocations, it’s usually captured by a provision contemplating possible additional cash contributions down the road.
The risk of member disputes over contributions is greater for LLCs either with no written operating agreement, and therefore governed by the statutory default rules, or with operating agreements that replicate the default rules. The latter often appear when LLCs use off-the-shelf operating agreements offered by various vendors such as LegalZoom. For those LLCs, when member relations sour and a power struggle ensues, there’s a strong incentive to challenge the value of member contributions where the facts warrant it.
This can take the form of claims that a managing member falsified the LLC’s accounting records and tax filings to record values for cash contributions that were never made or for services that never were disclosed or the subject of an agreed valuation among the members. The accusation invariably is tied to a claim for a greater share of voting rights, profit and loss allocations, or distributions.
The Meregalli Case
Over four years ago I wrote about the Meregalli case as an example of the perils of LLCs with indeterminate membership interests. In that case the non-managing members of an LLC formed to operate a restaurant filed suit against the managing member. Upon joining the LLC the plaintiffs and another member held a combined 40% membership interest in consideration of $400,000 total cash contributions. The plaintiffs alleged their contributions were conditioned on the defendant’s promise to make a $600,000 cash contribution for his 60% interest. The operating agreement was one of those useless off-the-shelf, fill-in-the-blank types.
The suit, brought after plaintiffs allegedly discovered the defendant’s failure to make his $600,000 cash contribution, sought to enforce the plaintiffs’ vote to remove the defendant as manager based on what they alleged was their newfound majority status and voting power resulting from their proportionately greater capital accounts. The defendant claimed that some or all of his $600,000 capital contribution was not made in cash but in the form of “services, assets or payables” as allowed under the LLC Law’s default rules.
The case never went to trial. Not long after the court denied both sides’ summary judgment motions, the defendant filed for bankruptcy.
The Lazar Case
Lazar v Mor, decided last month by Manhattan Commercial Division Justice Andrea Masley, involved facts somewhat similar to those in Meregalli. The case involves a dispute among real estate investors over a pair of LLCs formed in 2011 and 2012 to acquire multifamily properties in Manhattan.
The LLCs’ operating agreements stated 21.5% membership interests in one of the LLCs based on equal capital contributions of $740,000 for the four members plus a 14% interest for a fifth non-party member. The second LLC had other percentages and contribution amounts.
Both operating agreements provided that any distributions “shall be allocated among the members on the basis of the ratio of the monetary value of the Member Capital Account of each member to the total value of all Member Capital Accounts in this Company.”
One LLC’s operating agreement provided that the members’ “sole Capital Contribution” “may be in cash, property, or services rendered” or an obligation to contribute any of those. The other LLC’s operating agreement had no provision addressing the form of capital contributions.
The LLCs sold the properties in 2015 at a substantial profit. In 2019, the two non-managing members of the LLCs filed suit against the two managing members after allegedly discovering that they had falsely recorded repayment of loans made to them by the LLCs as well as non-existent contributions by them for deposits when the properties were acquired.
After motion practice and an appeal that considerably narrowed the original and subsequently amended claims, and after discovery was substantially completed, the plaintiffs moved to amend their complaint a second time to add claims for breach of the LLCs’ operating agreements based on the defendants allegedly having taken a disproportionately large share of the net proceeds from the sale of the properties.
Specifically, the plaintiffs alleged that the each of the two defendants contributed only a fraction of their required capital contributions and, in one of the LLCs, they had negative capital accounts. The result, according to plaintiffs, was that the defendants were overpaid, and the plaintiffs were shorted, millions in distributions from the net proceeds from the sale of the properties.
The defendants opposed the plaintiffs’ motion to amend, arguing that the proposed claims were time-barred and that the proposed contract breach claims were “palpably insufficient” because the challenged distributions were not wrongful.
I won’t discuss Justice Masley’s rejection of defendants’ statute of limitations defense. Their chief argument in support of their merits defense was that their percentage membership allocations in the operating agreements reflected the agreed value of their cash contribution as well as the value of their “services rendered” including finding the investment properties, arranging financing for the properties, retaining attorneys and accountants, signing loan documents, and finding the management company for the properties. They bottomed their argument on the one LLC’s operating agreement that expressly included “services” as a form of capital contribution, and on the default rule in LLC Law 501 that was not “otherwise provided” in the other LLC’s operating agreement.
The plaintiffs countered that there was never any agreement among the members that plaintiffs’ alleged services would be deemed part of their capital contributions, much less was there any agreement as to the value of any such services.
Justice Masley granted plaintiffs’ motion to amend, finding that the operating agreements
unambiguously state that distributions are allocated based on Member Capital Accounts’ monetary values, and not on the basis of Membership Interests. Accordingly, the entities’ operating agreements do not demonstrate that the breach of contract claims are palpably insufficient.
In her ruling Justice Masley also found misplaced defendants’ reliance on a 2021 opinion by Commercial Division Justice Jennifer Schecter in Santelli v Spitzer, writing,
Santelli held that alleged distributions to an LLC member were not wrongful because the agreement in question “provided that ‘the parties will distribute income to each of the owners of the LLCs on a 50%/50% basis in accordance with their ownership interests in the LLC.”‘ (Id. *5 [citation omitted].) Here, however, there is no such language in the agreements.
Indeterminate Membership Interests Can Work, But Only With the Right Operating Agreement
I said it before, and I’ll say it again.
Indeterminate membership interests are not inherently bad. There may be perfectly good reasons for members of an LLC to agree in advance that the voting power, allocation of distributions, and other attributes of ownership of those whose “skin in the game” proportionately increases or decreases over the life of the LLC likewise should increase or decrease.
But if members wish to utilize such variable interests, it must be done carefully in the operating agreement. Among other things, the members need to agree upon the recognition (or not) and manner of valuing capital contributions in a form other than cash, be it property or services. The agreement may also need to provide for a non-conflicted approval process for approving and valuing property and services which may require resort to outside appraisers or other professionals.