The Perils of Indeterminate LLC Membership Interests
October 14, 2019
Here we go again — and again and again.
On numerous prior occasions I’ve written about judicial dissolution cases and other infighting among LLC members featuring disputes over membership percentages. The disputes may involve voting rights, management rights, profit shares, buyout, or distributions upon liquidation.
In some cases, the parties fail to document properly — or at all — their respective membership interests. In others, the operating agreements state initial membership percentages but make them subject to future adjustment based on changes in the members’ capital accounts.
In the latter instance of indeterminate or floating interests, the operating agreement can become a curse if eligible capital contributions aren’t adequately defined and/or it establishes no reliable mechanism for recording them, especially non-cash contributions such as services or property. It becomes a double curse when the parties opt to forego legal counsel and use one of the notoriously unreliable, free or cheap, one-size-fits-all, online operating agreements.
The double curse was at work in Roy Food and Wine LLC v Meregalli, 2019 NY Slip Op 32875(U) [Sup Ct NY County Sept. 25, 2019], decided last month by Manhattan Commercial Division Justice O. Peter Sherwood, in which the parties litigated among other issues their respective membership interests, including a claim that the managing member misrepresented his capital contributions.
In 2013, a restauranteur named Paolo Meregalli formed an LLC and brought in several silent-partner investors to open an Italian restaurant in Manhattan’s Meatpacking District named Mulino a Vino.
Meregalli, as the LLC’s sole managing member, conveyed 20% and 15% membership interests to the two plaintiffs for their respective $200,000 and $150,000 capital contributions, as well as a 5% interest to a third, non-party member for $50,000. The plaintiffs allegedly made their investments in reliance on Meregalli’s promise to contribute $600,000 capital proportionate with his 60% interest.
The restaurant opened in 2014 and closed in 2018 amidst financial woes and eventual litigation between Meregalli and the investors who claimed that he never contributed the capital required of him. Allegedly, Meregalli falsified the LLC’s financial statements and tax returns to reflect as his own contributions over a half million dollars that, in fact, consisted of LLC funds and build-out funds advanced by the restaurant’s landlord.
The plaintiffs’ complaint, among other allegations of wrongdoing, accused Meregalli of misappropriating LLC funds and opening a competing restaurant using the LLC’s menu and other intellectual property.
The Operating Agreement
Meregalli’s disputed capital contributions also were the key to the plaintiffs’ claim that he wrongfully refused to comply with their vote, as members allegedly holding a majority of the LLC membership interests, to remove him as managing member.
The removal provision is found in an exhibit to what appears to be an all purpose, seven-page, bare-bones, fill-in-the-blank operating agreement prepared when Meregalli was the sole member. The exhibit identifies Meregalli as “Sole Manager” and states that he “will serve in [his] capacity until [he is] removed for any reason by vote of the Member/s holding a majority of the capital interest in the Company.”
Members’ capital interests are addressed in Articles II and VI of the operating agreement. Article II (“Capital Contributions”) consists of four lines of text that merely reference a nominal total capital contribution of $100 and disclaim any obligation for additional capital contributions .
Article VI requires the manager to maintain capital accounts for each member in the manner set forth in Treasury Regulation 1.704-1 reflecting their initial capital contribution increased or decreased for additional contributions, the member’s share of losses, etc. Therein lies the basis for the plaintiffs’ contention that they possessed the requisite majority voting power to remove Meregalli as manager since, allegedly, he did not make his claimed $600,000 capital contribution.
The Court’s Ruling
The plaintiffs sought partial summary judgment on their breach of contract and breach of fiduciary duty claims based on Meregalli’s alleged failure to make his proclaimed $600,000 capital contribution.
Meregalli opposed the motion, asserting that his capital contributions “were not limited to cash injections only” and that “capital contributions can be in the form of cash, services, assets, or payables.”
Justice Sherwood denied the plaintiffs’ motion. “As far as plaintiffs claim Meregalli held himself out to have made contributions he didn’t or that he does not own as much of the Company as he claimed, for voting purposes,” the court wrote, “that conduct does not appear to be a violation of a provision of the Operating Agreement.” While Article VI arguably supports a breach of contract claim based on the manager’s express duty to maintain accurate books, Justice Sherwood continued, the evidence including Meregalli’s supposed admissions at his deposition did not “make a prima facie case for a prospective claim for breach of contract.”
As for the breach of fiduciary duty claim, Justice Sherwood found that “the claim against Meregalli fails for the same reasons as the ersatz breach of contract claim.”
Fixed or Floating Membership Interests?
Most LLC agreements that I encounter utilize fixed membership interests expressed either as a percentage or by number of units. A fixed membership interest eliminates potential disputes such as the one raised in Roy Food and Wine concerning voting power, yet still allows differences in the members’ capital accounts to be addressed appropriately, for instance, upon liquidation.
That is not to suggest that floating membership interests are inherently bad. There may be perfectly good reasons for members of an LLC to agree in advance that the voting power or other attributes of ownership of those whose “skin in the game” proportionately increases or decreases over the life of the LLC likewise should increase or decrease.
But if members wish to utilize floating interests, it must be done carefully in the operating agreement. Among other things, the members need to agree upon the recognition (or not) and manner of quantifying capital contributions in a form other than cash.
Drafters of New York LLC agreements must keep in mind LLC Law § 501’s default rule stating that “the contribution of a member to the capital of a limited liability company may be in cash, property or services rendered or a promissory note or other obligation to contribute cash or property or to render services, or any combination of the foregoing.”
That is the provision Meregalli implicitly relied upon in arguing that his capital contribution was not limited to cash. If non-cash contributions are to be allowed, the LLC agreement must include language adequately addressing the valuation and recognition in the books of account of such contributions, and should also address any self-interested transactions of the sort by managers.
Not surprisingly, the fill-in-the-blank form operating agreement in Roy Food and Wine included none of the above safeguards, proving once again the maxim, penny wise, pound foolish, when it comes to buying online form operating agreements or, worse yet, using free online forms, in lieu of using experienced legal counsel to assist in preparing and customizing the entity’s organic documents.