How partnerships and LLCs can avoid pitfalls that lead to litigation

Cash investors can get upset and file lawsuits when they learn that others involved in a partnership or limited liability corporation haven’t risked as much capital in a failed venture.
“It really comes down to not having the operating agreement and the prospectus adequately explaining all of the moving pieces and what different people are putting into the project,” says Stephen J. Erigero, a partner at Ropers Majeski Kohn & Bentley PC. 
Smart Business spoke with Erigero about the legal needs of LLCs and partnerships and how to avoid situations that lead to lawsuits.

What issues need to be addressed when forming the company?

The issues at the formation stage are:
■ Adequate capitalization.
■ Full disclosure of capitalization by formulative partners or managing members.
■ Adequate preparation of an operating agreement.

Litigation arises later because of situations such as an idea person coming into an LLC without any money. Their capital contribution is premised on the intellectual property and management skills they bring. That must be fully disclosed to the passive managing people, who are often the ones who provide the starting capital. Disputes happen when you have one member of an LLC contributing real estate, and other members contributing capital. Without full disclosure and an explanation of roles and duties, there can be problems when the venture doesn’t work out as anticipated. Or, if there is a lot of profit, disputes about how it is distributed.

So a specific value should be placed on everyone’s equity, including IP?
Yes, you have to have some value placed on that, and people need to understand in the beginning, through the operating agreement and prospectus, how everything will be allocated. There are cases when it’s not spelled out in the LLC operating agreement that some members are cash investors and others are not. Perhaps $10 million is needed for a development and $2.5 million comes from cash investors, while $7.5 million is from a bank. The development goes sideways and the property is worth $7 million.

The property is sold, the bank writes down the loan a little, and the nonmonetary investors go away. The only people who lose money are the ones who made the $2.5 million cash investment. That can happen on a much larger scale, and the problem can be avoided if managing members spell out everything in an operating agreement that all members sign. The allocation of risk needs to be disclosed so cash investors understand they are in second position to the financing company that has a secured interest.

What other problems arise that can lead to lawsuits?
It’s important that the managing member is not involved in any other aspect of the deal in a way that could create an allegation of self-dealing. For example, a company didn’t have sufficient cash to close on a property so the managing member lent money without disclosure to the limited members. He took a priority position in lending money and that could be construed as a self-dealing transaction, even though he probably thought he was being a good guy by putting extra cash into the deal.

That also occurs when managing members provide a service, by being the contractor, accountant or lawyer for the project. There has to be clear value placed on those services and there may be situations in which you need to change managing members to avoid the appearance of a conflict. Lawsuits can be filed even after the entity is dissolved, so you need to maintain insurance for some time thereafter, especially if it’s a LLC that failed. Investors have moved on, there’s no money left, so plaintiffs with claims will go after the members or shareholders directly.

There will always be unforeseen circumstances, but full disclosure, following general accounting principles and the proper insurance, will go a long way to ensuring you’re protected.
Stephen J. Erigero is a Partner with Ropers Majeski Kohn & Bentley PC. Reach him at (213) 312-2013 or [email protected]
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