Part 3 of 3
Welcome back to the wild world of Luis Lucky and his adventures in business ownership! Specifically, over the last two weeks we’ve watched as four “Friends,” Fred Watson, Oliver Sherlock, and Oriel Smith, and the ever not so lucky, Luis Lucky, stumbled through the pitfalls of starting operating and ruining an LLC.
Bonus points to those of you who have figured out the first name of each of the friends spelled out F O O L. Jump down to the next subheading if you’re all caught up, otherwise to recap; last week, we reviewed Florida law as it applies to law suits between members of an LLC.
Specifically, we discussed how in Florida, when alleging damages stemming from membership or ownership in an LLC, said members lack standing to bring a cause of action directly, and must instead bring a derivate suit on behalf of the LLC itself. Dinuro Investments, LLC v. Camacho, 141 So. 3d 731(Fla. 3d DCA 2014).
However, a member or shareholder may bring a direct action but, “only if (1) there is a direct harm to the shareholder or member such that the alleged injury does not flow subsequently from an initial harm to the company and (2) there is a special injury to the shareholder or member that is separate and distinct from those sustained by the other shareholders or members.” Dinuro. At 739-40. Jump back to Part II for a more in depth analysis of that issue.
Part III Debt, Deadlock, and Judicial Dissolution: End Game
It’s mop up week here at the Willbur Law blog, so let’s clean up some of the mess Luis Lucky left behind. As you’ll recall Luis Lucky was sued by the other members of the LLC, they prevailed, and we’ll assume they voted Luis Lucky out as a member of the LLC. Where does that leave him?
Back in Part I, the Friends elected to form their LLC without the aide of legal counsel, and further drafted their own by-laws, often times called an operating agreement. The answer to the question of what happens when a member is involuntarily expelled from an LLC by a majority of votes from other members would be governed by the operating agreement of an LLC. However, the Friends forgot to address this issue.
The default consequence is that Luis Lucky it out as a Member, of the LLC; however, and significantly, what that does not mean that Luis Lucky is divested of his ownership interest in the LLC. Meaning, he is still entitled to a share of the profits of the LLC even if his ability to meaningfully participate in its operation has been eliminated.
Speaking of the LLC and money, you may also recall that Luis Lucky gave the LLC a significant sum of his own money to support the LLC during down economic times. What happens to those funds now that he is out as a member? This time, Luis Lucky is in Luck. Kind of.
When a member of an LLC contributes their personal financial resources to that LLC, it can be treated in one of two ways. First, the contribution can be seen as a “capital contribution.” This is significant. A capital contribution by a member of an LLC typically is associated with an increase in ownership rights by that member. Said another way, when a member of an LLC provides a capital contribution to the LLC they are purchasing a greater ownership share of the LLC than they previously had. At what rate and how much is one of the many critical variables any LLC operating agreement worth its salt should address.
Here, because the Friends LLC has a poorly drafted operating agreement which neglects to address how to treat an influx of cash form a member, the nature of Luis Lucky’s contribution is ambiguous. So, what happens?
Because the other members of the LLC ownership interest would be affected if Luis Lucky’s cash contribution was treated as a “capital contribution,” a court would likely deem the influx of cash as a bona fide loan from Luis Lucky. Thus, Luis Lucky’s ownership interest would not increase; however, he would be entitled to be paid back and with some reasonable amount of interest.
If We Could Turn Back Time
Let’s suppose the events of Part I, and II went a different way. Suppose then, that each Friend did their best to move the LLC forward, but a division came about as to which direction, or opportunity the LLC should take. Let’s further suppose that, two Friends think “X” is the best move for the LLC, while the other two think “Y” is the better move. If you recall, the Friends have equal ownership, and pursuant to their poorly drafted operating agreement, each of the four have equal voting rights. How is the deadlock broken?
Deadlock is one of the most dangerous, and equally easily avoided, conundrums an LLC can face. Why? Because deadlock is one of the very few scenarios where the Florida law takes over where a disagreement amongst business owners began.
Specifically, Florida Statute 605.0701, Grounds for judicial dissolution, subsection (1)(b)(5), sets forth that an LLC may be involuntarily dissolved if “the members of the limited liability company are deadlocked in the management of the limited liability company’s activities and affairs, the members are unable to break the deadlock, and irreparable injury to the limited liability company is threatened or being suffered.” Fla. Stat. 605.0701(1)(b)(5).
Yet, with a properly drafted operating agreement, which contemplates how to navigate a tie or deadlocked membership, the danger of involuntary judicial dissolution is avoided all together.
Said another way, don’t go it alone, it’s dangerous out there! Contact a Florida lawyer for legal counsel before there’s a problem. I’ll end where I began in Part I. This whole tale of woe is based on something my grandmother taught me; an ounce of prevention is worth a pound of cure, and a lot cheaper too.