It’s not uncommon in today’s struggling economy for an LLC member to find itself unable or unwilling to satisfy the LLC’s capital calls. Can the other members recover damages from the defaulting member if they make up its required capital contribution? The Kansas Court of Appeals was faced with this question in Canyon Creek Development, LLC v. Fox, No. 103,190, 2011 Kan. App. LEXIS 128 (Kan. Ct. App. Sept. 2, 2011).
Background. Mike Fox, Don and Linda Julian, and Jeff Horn formed two Kansas LLCs in 2004 to develop residential real estate. Fox owned 50% of each LLC, and the others owned the other 50%. The real estate business struggled, and in 2008 Don Julian demanded that Fox contribute capital to each LLC to pay outstanding project loans. Fox failed to meet the capital calls, and Julian and Horn contributed capital and made loans to the LLCs to cover the debt-service obligations.
The additional capital contributed by Julian and Horn gave them a majority interest in each LLC, which they used to remove Fox from management and to elect themselves in his place. The LLCs then sued Fox to recover the amounts of the capital he had failed to contribute to the LLCs. The trial court found for the LLCs on their breach of contract claims and Fox appealed.
The LLCs’ operating agreements provided that a majority in interest of the members could require that all members contribute additional capital. (The operating agreements for the LLCs were identical in all relevant respects.) Under the original 50-50 ownership split there was no majority, and Fox argued that Julian therefore had no authority to demand that the members contribute capital.
Court’s Analysis. The agreements went further, though, and also stated: “Notwithstanding the foregoing, each Member and Economic Interest Owner shall contribute such additional capital as may be required to pay debt service, insurance and real estate taxes owing by the Company.” Id. at *14. The court found that this requirement was not subject to a majority vote and that Julian, as one of the managers, was empowered by this clause to make the debt-service capital call on behalf of the LLCs. Id. at *19.
The court therefore found that Fox breached the operating agreements by failing to provide the capital contributions demanded by the LLCs. It then turned to what it called “the more vexing issue regarding the proper remedy for Fox’s breach.” Id. at *20.
The operating agreements provided that if a member failed to contribute capital that was required by the agreement, then the other members had the right, but not the obligation, to contribute pro rata any portion of the non-contributing member’s required capital contribution. The contributed capital would then be added to the capital accounts of the contributing members, and the percentage interests of the members would be adjusted accordingly. The percentage interests of the contributing members would therefore be increased and the percentage interests of any non-contributing members decreased. (The percentage interests control voting and the allocation of profits, losses, and distributions.)
Fox argued that he should not be personally liable for the capital contributions because under the operating agreements the exclusive remedy for failure to meet a capital call was a reduction of his ownership interest.
Section 17-7691(a) of the Kansas LLC Act states 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 specified consequences.” The court saw this as a suggestion that any remedy for damages should be specified in the operating agreements. The operating agreements did not specifically state that the LLC could recover damages from a member that failed to contribute capital when required to do so, and the court noted that the damages remedy was “conspicuously absent” from the operating agreements. Canyon Creek Dev., 2011 Kan. App. LEXIS 128, at *25.
The court concluded:
[I]n the absence of clear statutory authority for imposing personal liability on an LLC member who fails to meet a capital call for an ongoing venture, when the LLCs’ operating agreements specify a reduction in the defaulting member’s capital share as the sole consequence, the LLCs are not entitled to seek personal judgments for damages against the defaulting member.
Id. at *30-31.
Comments. It’s striking that the court relied on the lack of any statement in the operating agreements that a breaching member would be liable in damages, while at the same time ignoring the lack of any statement that limited the remedy to a reduction in the defaulting member’s capital share. One would generally expect damages to be available for a breach of contract absent clear language to the contrary.
The court quoted Section 17-7691(a) of the Kansas LLC Act, which authorizes “specified penalties or specified consequences,” and Section 17-76,100(c), which lists several penalties or consequences that an operating agreement may impose on members who fail to make required capital contributions. Those include reducing or subordinating the member’s interest, a forced sale, or even a forfeiture of the offending member’s interest.
The law of contract damages usually prevents the imposition of forfeitures or penalties for a breach of contract, so those statutory provisions are obviously intended to expand the ability of an operating agreement to penalize or impose forfeitures on members in breach for failing to contribute capital. For the court to interpret the statutory language on “penalties” and “consequences” to exclude a damages remedy unless explicitly referred to seems at variance with the remedy-expanding approach of the LLC Act.
The result in this case is probably not what most LLC organizers would have expected or intended. Lawyers representing an LLC and drafting the LLC agreement usually try to maximize the LLC’s flexibility in dealing with defaults, by providing alternative remedies. At least it’s not difficult to draft around this case – simply list the desired remedies and include something like “and any remedy at law or in equity against the Defaulting Member including specific performance and damages.”