- The Importance of Defining Capital Contributions in the LLC Agreement
- March 7, 2012 | Author: Peter A. Mahler
- Law Firm: Farrell Fritz, P.C. - New York Office
I don't know Mr. Duff or Mr. Curto. I do know they went into business together to develop real estate and formed a limited liability company for that purpose. I imagine Mr. Duff and Mr. Curto were friends, neighbors or business associates when they decided to start their relatively modest venture. I imagine their prior social or business relationship fostered a sense of mutual trust, confidence and enthusiasm for the project, along with a casual attitude toward documenting the economic and management rights and obligations owed one another. I imagine they found online or otherwise obtained and signed a one-size-fits-all form of LLC operating agreement without consulting an attorney, before they made provision for financing their business plan.
I do know that Mr. Duff sued Mr. Curto after the business venture failed, alleging that Mr. Curto did not put in his pro rata share of capital contributions. I do know that Mr. Duff lost his suit because he and Mr. Curto left blank the space in the operating agreement where they were supposed to fill in their required capital contributions, and because the agreement did not otherwise address disparate member financing. I do know that this kind of costly oversight happens all too frequently with new business partners who fail to appreciate the insurance value of seeking out competent legal advice to assist them in crafting a partnership agreement that adequately addresses the partners' financial responsibilities.
Duff v.Curto, 2012 NY Slip Op 30264(U) (Sup Ct Suffolk County Jan. 25, 2012), decided earlier this year by Suffolk County Commercial Division Justice Emily Pines, results from a perfect-storm confluence of poor legal planning and the real estate market downturn. At the top of the market in 2006, Duff and Curto as 50/50 owners formed Fairlea Court Holdings, LLC to acquire land in North Haven, New York for construction of a single-family home. When the improved property was sold in the down market in 2009, the sale proceeds were insufficient to cover the mortgage, construction loan and expenses.
In his lawsuit, Duff contended that he made a $300,000 capital contribution when the LLC was formed, another $173,000 during the project, and another $50,000 to cover the shortfall upon the property's sale. Duff claimed that the LLC's operating agreement required each member to provide 50% of the capital contributions to fund the land acquisition and construction. Duff alleged that Curto made no capital contributions, and that Curto therefore was liable for breach of contract, unjust enrichment and other claims.
Section 3.1 of the operating agreement, captioned "Initial Contributions," provided that "[u]pon the execution of this Agreement, each Member shall contribute cash and/or property to the Company as set forth opposite their names in Exhibit A". Based on the description in the court's decision, here's a reasonable facsimile of what Exhibit A looked like:
Initial Cash Contribution
Description of Property Contributed and Adjusted Basis (AB), Liability Subject to (LS) and Agreed Value (AG) of Property
Notwithstanding that the columns for cash and property contributions were left blank, Duff argued the Section 3.1 required matching capital contributions by Curto who, Duff further alleged, gave Duff "assurance" upon which he relied that Curto would equalize the contributions. Duff alternatively argued that the operating agreement's provision for capital contributions was ambiguous and that a question of fact existed regarding its construction.
Curto contended that he was entitled to summary judgment dismissing the complaint. Curto argued that he had no obligation to make any capital contribution because Exhibit A did not list any capital to be contributed by either member. Curto alleged that the funding provided by Duff was in the form of loans, not capital contributions, as demonstrated by the LLC's 2007 and 2008 tax returns listing a loan payable to Duff of approximately $309,000.
Justice Pines agreed with Duff that the operating agreement is ambiguous as to whether initial capital contributions were required by both Duff and Curto. "The first sentence of section 3.1 of the Operating Agreement," Justice Pines wrote, "appears, on its face, to mandate initial capital contributions by each Member" but "Exhibit A does not set forth the amount of any such initial contribution." The court therefore "may consider extrinsic evidence of the parties' intent." The tax returns showing loans and Duff's deposition testimony, in which he admitted that he reported a recourse loan to the LLC on its tax return, "demonstrate as a matter of law that Duff loaned the funds to [the LLC]."
Based on this finding, Justice Pines granted Curto's summary judgment motion and dismissed all of Duff's claims with the exception of a claim for conversion which was not part of Curto's dismissal motion.
As I've previously written, §502 of the LLC Law authorizes provision in the operating agreement for compulsory capital contributions. Business partners forming an LLC must carefully consider the immediate and future capital needs of the venture, and they must include in the operating agreement a provision that meets those needs. The provision also should spell out the consequences when a member fails to contribute his or her share, such as dilution or even forfeiture of membership interest. Provision also can be made for member loans to the LLC in lieu of capital contributions. Under no circumstances, however, should the parties sign an operating agreement such as the one in Duff with missing entries for the capital contributions.