LLC agreements sometimes require members to contribute additional capital upon demand of the LLC. This is risky business for the members. The LLC may unexpectedly ask for more capital when the members are not expecting it. And worse, sometimes creditors will attempt to force the LLC to call for capital from the members, in order to satisfy the creditor’s claim.
In just such a case, the Kentucky Supreme Court last month overruled the trial court and the Court of Appeals, holding that the creditor could not force the members to contribute capital to the LLC to cover the creditor’s claim. The members of the LLC had agreed in its operating agreement to contribute additional capital on the call of the LCC’s manager:
“The Investor Members . . . shall be obligated to contribute to the capital of the Company, on a prorata basis in accordance with their respective Percentage Interests, such amounts as may be reasonably deemed advisable by the Manager from time to time in order to pay operating, administrative, or other business expenses of the Company which have been incurred, or which the Manager reasonably anticipates will be incurred, by the Company.”
Racing Inv. Fund 2000, LLC v. Clay Ward Agency, Inc., No. 2009-SC-000007-DG, 2010 Ky. LEXIS 180, at *12 (Ky. Aug. 26, 2010).
Subsequent litigation resulted in a judgment against Racing Investment Fund 2000, LLC (Racing Fund) for unpaid insurance premiums. The LLC partly paid the judgment by tendering its remaining assets to Clay Ward, the judgment creditor. Not satisfied with part payment, Clay Ward contended that the operating agreement’s provision for additional capital calls provided a way for Racing Fund to obtain funds to satisfy the judgment, and that the court should order the LLC to make the call. The trial court agreed and ordered Racing Fund to call for additional capital from the members to satisfy the judgment. The LLC was held in contempt of court when it failed to comply with the court’s order. Id. at *4.
The Kentucky Supreme Court viewed the unpaid insurance premiums, which were the basis of the judgment against the LLC, as a legitimate business expense. The court also recognized that under the operating agreement the manager could have made a capital call against the members to fund payment of the judgment. But the court declined to order the LLC to make the capital call, saying that the capital call provision in Racing Fund’s operating agreement “is not a post-judgment collection device by which any legitimate business debt of the LLC can be transferred to individual members by a court-ordered capital call.” Id. at *17.
The court’s refusal to order a capital call turned on the limited liability provision of Kentucky’s LLC Act, which is emphatic: “no member, manager, employee, or agent of a limited liability company … shall be personally liable by reason of being a member [or] manager … under a judgment, decree, or order of a court, agency, or tribunal of any type, or in any other manner … for a debt, obligation, or liability of the [LLC], whether arising in contract, tort, or otherwise.” Ky. Rev. Stat. § 275.150(1). The court described the limited liability of LLC members and managers as the “centerpiece” of an LLC. Racing Inv. Fund, 2010 Ky. LEXIS 180 at *5.
Clay Ward contended that the operating agreement’s capital call provision should be applied to Racing Fund’s debt on the judgment, and that the court should order the capital call to satisfy the judgment. But because of the centrality of limited liability in LLCs, the court required that to be enforceable, any assumption by members of personal liability must be stated in unequivocal terms, leaving no room for doubt about the parties’ intent. Id. at *16. The Racing Fund agreement did not meet this standard, said the court. Id.
It is unclear where the court was drawing the line. Was the LLC’s capital call provision inapposite because the manager elected not to make the capital call, because the LLC was defunct and the judgment was therefore not an ongoing expense of the business, or because the court did not interpret “operating, administrative, or other business expenses of the company” to include a judgment against the company (even though the court recognized that the judgment was for an unpaid business expense)? If the LLC’s members had included language covering judgments, even judgments at a time when the LLC was insolvent and defunct, would Clay Ward’s claim still have failed if the manager declined to call for additional capital?
What is clear is that the drafting lessons from this case are legion. Members who agree in advance to subsequent capital calls usually have some expectations about those capital calls. The drafter should reflect those expectations in the agreement.
First, don’t create unlimited member liability for additional capital calls. Use a cap of some sort.
Second, don’t rely on the manager’s judgment. Things change over the life of an LLC; a new manager may come in with a different view of how much additional capital the company requires from its members.
Third, carefully define terms such as “operating, administrative or other business expenses.” For example, say the LLC is hit with a large, uninsured tort claim that resulted from its business operations. Is that an operating or business expense? The agreement should have definitions that would answer such questions.
Fourth, if capital calls are authorized, consider providing that if a member does not satisfy the capital call, the exclusive remedy is some form of economic adjustment to the defaulting member’s LLC interest. Adjustments such as dilution, subordination, or partial forfeiture of a non-contributing member’s interest are expressly validated by some state LLC Acts. E.g., Wash. Rev. Code§ 25.15.195(3); Del. Code tit. 6, § 18-502(c).
Fifth, consider adding a “no third-party beneficiary” clause, to make clear that no creditor or other third party has any right to rely on or to enforce any of the provisions of the operating agreement, including any obligation of members to contribute capital. Such a clause could also be considered for the LLC’s certificate of formation, which unlike most LLC agreements is a public document.