Small business owners sometimes run into difficulties with their business partners after much time has passed since they first set up the business. They come to discover that the operating agreement either does not address their problem or the result is not what they intended. Small business owners should take care to draft their controlling documents by considering as many scenarios as possible.
Members of limited liability companies are given considerable leeway to craft a management and business structure as they see fit. This control is one of the reasons why the LLC form is attractive to those engaged in new business ventures. The LLC’s operating agreement is the contractual means by which the members will determine the business structure – and courts continuously warn parties that failure to craft the operating agreement carefully will sometimes force unintended results.
We are reminded of this situation by a recent case from the Kansas Court of Appeals in Canyon Creek Development, LLC v. Fox. (available here). Mike Fox and three other members formed two LLCs for the purpose of developing residential real estate. Fox owned 50% of each LLC and the other members owned the other 50% interest.
When the LLCs struggled to meet costs due to economic downturn in 2008, a member demanded that Fox contribute capital to each LLC. When Fox failed to do so, two of the members contributed additional capital, which gave them a majority interest in each LLC and removed Fox from management. They then brought suit against Fox to recover the amount of capital that he failed to contribute. The trial court found for Canyon Creek’s breach of contract claim, but Fox appealed the decision.
After determining that Fox had breached the operating agreement by failing to meet the capital call, the Court had to turn to the more problematic issue of the proper remedy for this breach. To make this determination, the Court depended on the terms of the LLC’s operating agreement.
The operating agreement held that the other members could adjust the relative interest ownership of a member that failed to meet a capital call by adding the additional sum to their own capital accounts. While this was allowed, but not required, by the operating agreement, this was the course taken by the other members against Fox. The Court ultimately found that a lack of clear statutory language and lack of additional remedies beyond those already used in the operating agreement prevented the imposition of personal liability against Fox.
NJ LLC Act
Under normal contract rules, breaching parties are typically not subject to additional penalties or forfeitures. This is why, at first glance, the Court seems correct in preventing personal liability on Fox for breach of contract when the members already used the remedy of reducing his membership interest and removing him from management. While New Jersey courts appear not to have dealt with this issue directly, both the Kansas and New Jersey statutes governing LLCs allow for broad penalties and consequences for a member’s failure to make a required contribution.
The New Jersey Limited Liability Company Act states:
An operating agreement may provide that the limited liability company interest of any member who fails to make any contribution that he is obligated to make shall be subject to specified penalties for, or specified consequences of, such failure. Such penalty or consequence may take the form of reducing or eliminating the defaulting member’s proportionate interest in a limited liability company, subordinating his limited liability company interest to that of non-defaulting members, a forced sale of his limited liability company interest, forfeiture of his limited liability company interest, the lending by other members of the amount necessary to meet his commitment, a fixing of the value of his limited liability company interest by appraisal or by formula and redemption or sale of his limited liability company interest at such value, or other penalty or consequence.
N.J.S.A. § 42:2B-33(c)
While this statute grants the ability of an LLC to impose penalties outside of those normally allowed in contracts, one thing is clear – such penalties must be provided for in the operating agreement. Courts can only enforce contracts as written and operating agreements are no exception. While N.J.S.A. § 42:2B-33(c) grants broader remedies, the statute specifically states that these must be contained in the operating agreement itself and the statute declines to grant these penalties independently. LLC members should take care to craft their operating agreements in a manner that provides as many remedies as possible in the event of such a breach.
We welcome questions and comments about operating agreements, LLC member expulsion, and any other business dispute you may need assistance with.