Interest Dilution and Damages as Contribution-Default Remedies in Failing LLCs and Partnerships

19 Min Read By: Bradley T. Borden, Thomas E. Rutledge

IN BRIEF

  • Contribution-default remedies appear in most operating agreements and partnership agreements.
  • Recent cases illustrate the legal repercussions of drafting contribution-default remedies for LLC or limited partnership ventures that fail.
  • Such repercussions may differ from those in ventures that have positive, increasing value, and exploration of the nuances of interest-dilution provisions is necessary.

Failure is not an option—at least not until it happens. Starting a venture with the attitude that failure is not an option may reflect the American spirit, but the reality is that attitude alone does not control the fate of the venture—even if it did, events can change attitude, precipitating the decline of a once-promising idea. Market or other forces often affect whether a venture fails or succeeds, and failure is a definite possibility for most ventures. Advisors working with venturers in their euphoric, optimistic days of formation must maintain a realistic perspective and help them draft provisions of their entity documents that effectively address the possibility of failure. For instance, the preference for particular contribution-default remedies can change as a venture’s promise and condition change. Consider how the members’ preference for interest dilution and damages can change as the fortunes of a venture change. Recognizing such preferences should affect the venturers’ decisions as their advisors help them draft the entity documents. A recent case from the Delaware Superior Court and earlier cases from the Kansas Court of Appeals help illustrate the legal repercussions of drafting contribution-default remedies for LLC or limited partnership ventures that fail. The cases all considered contribution-default remedies in LLC operating agreements, but the principles should apply to limited partnership agreements as well.

The operating agreement in Canyon Creek Development, LLC v. Fox, 46 Kan. App. 2d 370, 263 P.3d 799 (2011), allowed a majority in interest of the members (i.e., those holding more than 50 percent of the ownership interests (percentage interests) in the LLC) to issue a capital call. The majority in interest (following a contribution to service the LLC’s debt, which was excepted from the Majority-in-Interest capital call rule) did issue such a call, and Fox, one of the members, defaulted on his obligation to contribute additional capital. The LLC’s operating agreement provided that if a member defaulted on a contribution obligation, the other members had the right, but not the obligation, to cover the defaulted amount. The agreement further provided that in the event that a member covered a defaulting member’s default amount, the percentage interests of the members would be adjusted to reflect each member’s contribution as a percentage of total contributions.

The contributing members, having obtained a majority interest in the LLC through additional contributions, appointed themselves managers and caused the LLC to sue Fox for, among other things, breach of the operating agreement, claiming that the LLC was entitled to damages for his failure to satisfy his additional contribution obligation. Fox argued that the dilution in his interest in the LLC that he suffered consequent to his default was the contractually agreed-upon remedy. He further claimed there could not be in substitution or addition a suit for damages (in effect specific performance). The court recognized that Kansas state law provides:

  • an operating agreement may specify the penalties or consequences to members who fail to comply with the terms and conditions of the operating agreement (KSA § 17-7691);
  • that a member who fails to make a required contribution is obligated, at the option of the LLC, to contribute cash equal to the value of the agreed obligation (KSA § 17-76-100(a));
  • that reduction in membership interest was an acceptable penalty for defaulting on a contribution obligation (KSA § 17-76-100(c)); and
  • a catch-all providing that the rules of law and equity apply, if not otherwise provided in the act (KSA § 17-76-135).

The court was satisfied that the interest-dilution provision was clearly stated and that the operating agreement did not provide for any additional remedies. It noted that a remedy such as damages is so fundamental that failure to mention it in an operating agreement is an expression of clear intent that damages cannot be assessed against a member who defaults on a contribution obligation absent such a stated remedy.

By contrast, although the operating agreement under consideration in Skyscapes of Castle Pines, LLC v. Fischer, 337 P.3d 72 (Kan. App. 2014) (slip opinion), provided an interest-dilution remedy for contribution-defaults, the court found that was not the exclusive contribution-default remedy in the agreement. This case involved a real estate venture that collapsed along with the real estate market generally in the late 2000s. When one member refused to make contributions required by a managers-initiated capital call, see Brief of Appellee, 2014 WL 2113037 (Kan. App. Apr. 7, 2014), the LLC sued the defaulting member. The court found that the Skyscapes operating agreement did not make interest-dilution the sole remedy for contribution-defaults. In fact, the court stated that interest dilution does not extinguish the defaulting member’s personal liability. This operating agreement specifically provided that the rights and remedies of the parties under the agreement are not mutually exclusive and preserved equitable remedies. The court noted that money damages (a remedy at law) might be inadequate in some instances and that nothing in the operating agreement was intended to limit any rights at law or by statute or otherwise for breach of a provision.

The Skyscapes court recognized that the situation under which default occurs could affect parties’ preferences for different remedies. In the situation Skyscape faced, the court observed that in the circumstance of a failing venture, the participants would have strong economic incentive to avoid complying with a capital call, and interest-dilution as a remedy would be singularly ineffective. The contributing members would not “be too happy about making up the delinquency and, thereby, garnering a greater interest in what had turned into a losing proposition.” The preferable remedy for the other members and the entity would be suing to collect from the defaulting member the assessed but delinquent contribution. Based upon that reasoning, the court concluded that it “seems unlikely the operating agreement would have been written to limit the participants’ remedies that way.”

The Skyscapes court distinguished the Skyscapes operating agreement from the Canyon Creek operating agreement in holding that the defaulting member was personally liable to make the additional capital contribution. Although both agreements included interest-dilution remedies, the Skyscapes agreement did not make that the exclusive remedy. The Skyscapes preservation of remedies and other provisions provided other remedies that the entity could seek against a member who failed to satisfy contribution obligations.

The operating agreement in Vinton v. Grayson, 189 A.3d 695, 2018 WL 2993550 (Super. Ct. Del. June 13, 2018), granted Vinton, the manager, sole authority to make capital calls in good faith. Any member who failed to make an additional contribution within 45 days after the notice of the capital call automatically transferred 50 percent of the member’s units to the contributing members. A noncontributing member forfeited the remaining 50 percent of the member’s units by failing to make the contribution within 180 days after the first notice of the capital call. The operating agreement also provided: “The rights and remedies provided by this Agreement are given in addition to any other rights and remedies a Member may have by law, statute, ordinance or otherwise.” Given that the Kansas and Delaware statutes were similar, the Delaware court considered both the Canyon Creek and the Skyscapes rulings in its decision. It found that the preservation-of-remedies clause in the instant agreement approximated the provision in the Skyscapes agreement. Furthermore, the court noted that for the mandatory interest-transfer (and dilution) provision to be the exclusive remedy, the court would expect to see an explicit statement to that effect.

The lesson to be drawn from these three cases is that an LLC operating agreement or limited partnership agreement (entity agreement) may provide that interest-dilution (or readjustment-of-interests including forfeiture) is the exclusive remedy if a member defaults on a contribution obligation. What is less clear is whether an entity agreement must expressly provide that interest-dilution is the exclusive remedy, or whether failure to provide for any other remedy is sufficient to create exclusivity. The court in Canyon Creek found that the absence of a provision for other remedies made interest-dilution the sole remedy. The court in Vinton suggested that the absence of a statement that interest-dilution is the exclusive remedy, combined with other language preserving other options, indicated that the LLC could pursue a damages remedy. The court in Vinton also relied upon a preservation-of-remedies clause in the operating agreement to hold that the LLC had a cause of action for damages against the defaulting member. Absent such a preservation-of-remedies provision, perhaps the Vinton court, like the Canyon Creek court, would have found that interest-dilution was the exclusive remedy.

The combination of these cases provides a road map for either making interest-dilution the exclusive contribution-default remedy, or preserving damages as a remedy. To make interest-dilution the exclusive remedy, the entity agreement should provide for that remedy, should state that it is the exclusive remedy for failure to meet a contribution obligation, and either not include a preservation-of-remedies clause or, if one is included for other purposes, exclude from its scope contribution default. To provide for interest-dilution or damages as a remedy, an entity agreement should state that interest-dilution is not the exclusive remedy. The entity agreement may accomplish that with a preservation-of-remedies provision, but an express statement avoids ambiguity.

Drafting an entity agreement to establish interest-dilution as the exclusive contribution-default remedy or as one of multiple contribution-default remedies is only part of the challenge attorneys face in advising clients with respect to this issue. Clients may also seek advice about whether interest-dilution should be the exclusive remedy. The court in Skyscapes recognized that nondefaulting members will be disappointed if the LLC is unable to recover damages from a defaulting member of a failing LLC, and that interest-dilution would be singularly ineffective in such circumstances. The defaulting member would, of course, be relieved to know that the agreement did not require throwing good money after bad. If every member defaults, all might avoid the good-money-after-bad situation. Parties have the freedom to contract and determine which contribution-default remedies to include in their entity agreements. The difficulty they face is making that choice upon formation of the entity or as part of an amendment to an existing entity agreement.

At the time of formation, parties should be optimistic about a venture’s prospects. In that state of mind, the members may think about how they will deal with a weak member—one who is unable to meet a capital-call obligation. The optimism bias that infects all the members will blind them from seeing the possibility that one of them might be the member facing financial hardship and the inability to meet a capital-call obligation in the future. Thus, the members will be open to a contribution-default remedy that will be painful to the defaulting member. Under the influence of their optimism bias, they may believe that at the time of the future capital call, the entity will be increasing in value, and interest-dilution will be a painful and suitable remedy against the defaulting member. Thus, they will prefer interest-dilution with an eye toward upside potential.

Attorneys should remind the venturers that it is possible for the entity to lose money. If the venture is in a loss situation with doubtful future prospects, then perhaps no member will want to be liable to make any additional capital contributions. Attorneys should help members consider whether they want to be liable to make additional capital contributions to a failing entity. At the start of a venture, the members would not foresee the venture failing, but they should be able to appreciate that they would not want to throw good money after bad and would want a mechanism in place that would limit their liability for making additional contributions to a failing entity. Thus, contrary to the Skyscapes court’s view that the members will not be too happy if interest-dilution is the exclusive contribution-default remedy, one could understand why, at the time of formation, the members would agree to interest-dilution as the exclusive remedy. The Skyscapes court may have been presumptuous in focusing solely on the state of mind of the members when the entity was failing. Their preference most likely would have been quite different at the time of formation.

One must also question the contributing members’ motive in bringing a claim for damages instead of opting for interest-dilution. Making interest-dilution the sole remedy could be a form of Ulysses pact. The members in both Skyscapes and Vinton opted to bring damages claims against the defaulting members instead of applying interest-dilution. Those members may be kicking themselves now. The value of real estate in many markets across the country has increased in value significantly since the financial crisis. Members who contributed to a losing venture during the crisis and awaited the market upswing should have profited significantly from an interest-dilution remedy. As the market rebounded, the contributors owned property that they acquired at a low price. In the midst of a crisis, they may not realize that interest-dilution will be their best alternative. If they recognize this possibility at formation, they can include interest-dilution as the sole contribution-default remedy to ensure that they benefit from the cheap membership interests instead of seeking damages from defaulting members.

Members may have additional interests to address in choosing default remedies. If only certain members are personally guaranteeing the bank debt, they are especially incentivized to have the entity collect contributions and apply them to pay down the bank debt. Even if all of the members have guaranteed an entity liability, as appeared to be the case in Skyscapes, the contributing members would most likely prefer that the defaulting member be obligated to make the additional contribution to avoid legal action from the lender. The preference could be practical or perceptional. As a practical matter, the contributing members may have deeper pockets, and if the guarantors are jointly and severally liable on the guarantee, the lender could collect the entire balance from them. From a perception standpoint, the contributing members may prefer not to be named in legal action by the lender. Their concern may be multidimensional. As members of the entity, their identities may not be publicly known. Legal action by the lender to collect on the guarantee would publicize their identities. A public legal battle about an unpaid debt could also harm the reputations of the members and make them less attractive as investors in other deals. Consequently, the existence of guarantees on an entity’s liability may incentivize contributing members to have the entity proceed against the defaulting member under a breach-of-agreement theory.

A challenge members will face with interest-dilution remedies in failing LLCs or partnerships is computing the interest adjustments when at least one member defaults and at least one other member acts on a capital call. The dilution denominator will affect the adjustments and in some situations could make the computations of adjustments challenging. Examples of contribution-denominated adjustments and value-denominated adjustments illustrate the challenge of adjusting interests in loss LLCs or partnerships that have negative value. The agreements in Canyon Creek and Skyscapes, see Brief of Appellee, 2014 WL 2113037 (Kan. App. Apr. 7, 2014), provided for contribution-denominated adjustments, computing a member’s percentage interests by dividing the member’s total contributions by the total contributions to the entity. Thus, if a member has contributed $250,000 to an LLC, and the total contributions to the LLC equal $1,250,000, the member will have a 20-percent interest in the LLC ($250,000 ÷ $1,250,000). If that same member contributes another $500,000 to the LLC and no other member makes a contribution, the member’s percentage interest will become about 43 percent ($750,000 total member contributions ÷ $1,750,000 total contributions to entity). The value of the entity does not affect a member’s interest if percentage interests are contribution-denominated. Although contribution-denominated interest adjustments raise interesting and challenging tax and financial questions (e.g., is there a taxable capital shift if value differs from contributions, and does the contributor pay a premium or receive a discount on the additional interests acquired?), they are easy to compute.

Value-denominated interest adjustments, on the other hand, use the members’ share of the value of the entity’s assets to determine their percentage interest. For instance, if a member has a 20-percent interest in an LLC that has assets valued at $1,500,000, the member’s share of that value would be $300,000. If the member makes a $500,000 contribution, and no other member makes a contribution, the value of the LLC’s assets will increase to $2,000,000. The value of the member’s share in those assets will be the member’s $300,000 precontribution value plus the member’s $500,000 contribution, or $800,000. Thus, the member’s post-contribution interest will be 40 percent ($800,000 member’s precontribution value + additional member contribution ÷ $2,000,000 entity precontribution value + additional member contribution). Determining the value of an entity’s assets could be difficult, but once the members know that value, they can easily determine their interests in the entity using value-denominated adjustments.

Computing value-denominated adjustments becomes more challenging if an entity has negative value. To illustrate, an LLC might burn through all member capital contributions and borrow $1,000,000 to fund operations. After that money is spent, the entity would owe $1,000,000 and have no assets, so its value would be negative $1,000,000. Assume a member makes a capital contribution of $500,000, no other member makes a contribution, and the operating agreement provides for interest-dilution as a remedy in such situations. If the LLC provides for contribution-denominated adjustments, then computing the adjustment will be straightforward, even though the entity has negative value.

The contributing member may, however, be disappointed to find that the contribution, which provides the entity its only capital, might have nominal effect on the interest adjustment. If the operating agreement provides for value-denominated adjustments, then computing the adjustments will be a challenge. If, prior to the contribution the contributing member’s percentage interest was 20 percent, then the value of that interest would be negative $200,000. Following the contribution, the LLC’s value would be negative $500,000. The member’s share of that value depends upon the member’s percentage interest, and the member’s percentage interest depends upon the effect that the member’s contribution has on the value of the LLC and the value of the member’s interest. The contribution would appear to change the value of the member’s interest from negative $200,000 to positive $300,000, and change the value of the entity from negative $1,000,000 to negative $500,000. Imagining how a member’s interest in an entity could be positive while the entity’s value is negative is a challenge. Computing the members’ interest in the entity following the contribution to a negative-value entity is also a challenge. Given that math does not appear to provide an obvious answer, members should consider how they will address interest adjustments in entities that have negative value if they do not provide for damages as a remedy.

Last, consideration must be given to the capacity to enforce whatever rights remedy may be provided for in a particular entity agreement. In both Canyon Creek and Skyscapes, the manager-managed LLC was the plaintiff against the defaulting member. In contrast, Vinton was brought by the members who had satisfied their respective contribution obligations against the member who had not; the LLC itself does not appear to have been a party to the action. This raises the question of standing. The operating agreement is a contract to which each of the members and the LLC are parties. See, e.g., Elf Atochem N. Am., Inc. v. Jaffari, 727 A.2d 286, 287 (Del. 1999). There is no dispute that the obligation to contribute capital is for the LLC’s benefit; members do not contribute capital to other members. For example, section 18-502 of the Delaware LLC Act refers to how a member “is obligated to a [LLC]” and the “right of specific performance that the [LLC] may have against such [defaulting] member.” The defendant, Grayson, argued in the Vinton case that only the LLC, and not the other members, could bring an action to enforce his capital contribution obligation. Applying the “Rights and Remedies Cumulative” provision of the operating agreement at issue in the Vinton case, namely:

[t]he rights and remedies provided by this Agreement are given in addition to any other rights and remedies any Member may have by law, statute, ordinance or otherwise. All such rights and remedies are intended to be cumulative and the use of any one right or remedy by any Member shall not preclude or waive such Member’s right to sue any or all other rights or remedies[,]

the court held, “Here, as signatories to the Route 9 Agreement, each of the Member Plaintiffs has standing to sue Grayson for his breach.”

Reasonable minds may differ as to whether the Vinton court properly characterized the claims as direct. Regardless, the decision is the decision. Going forward, drafters must consider and address who does (and does not) have standing to enforce (and collect upon) defaulted capital-contribution obligations.

An LLC’s management structure may also affect whether the entity makes a capital call and whether it brings a cause of action against the defaulting members. In Canyon Creek, the contributing members obtained control of the entity following their contributions and the resulting interest adjustment. If they had successfully caused the LLC to obtain an award for damages, presumably Fox’s contribution would have realigned the members’ interests to the predefault percentages. At those percentages, the contributing members would not have a controlling interest. If the interest adjustment is retroactive, the members would not have had authority to issue the capital call. That dynamic creates interesting management considerations. Can members use contribution-default remedies to obtain temporary control, only to use that authority to obtain a contribution that effectively causes the contributing members to cede control? Such dynamics may affect whether contributing members bring a direct action against the defaulting member or cause the entity to bring the action.

Contribution-default remedies appear in most entity agreements and partnership agreements. The three cases discussed in this article consider the enforceability of contribution-default remedies in ventures that were losing money and appear to have had negative value. The issues raised in such situations may differ from issues that arise in ventures that have positive, increasing value. This article scratches the surface of legal, financial, and tax issues that contribution-default remedies raise. The questions raised but unanswered in this article are some of many that warrant detailed consideration. Advisors must begin to carefully account for these and other questions, and commentators should continue to research and explore the nuances of these provisions.

ABOUT THE AUTHORS

Brooklyn, NY

Bradley T. Borden

Professor Borden’s research, scholarship, and teaching focus on taxation of real property transactions and flow-through entities (including tax partnerships, REITs, and REMICs). He teaches Federal…

Louisville, KY

Thomas E. Rutledge

Tom is a Member in Stoll Keenon Ogden’s Louisville office and has been with the firm since 1990. He is a member of the Business Services practice with a focus on Mergers & Acquisitions and…

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