California limited liability company disputes | Courtroom war stories and lessons learned

Determining Membership in an LLC: sometimes it’s not as easy as it should be

LLC membership interests are usually straightforward and can determined by simply reviewing the LLC’s operating agreement.  The operating agreement typically lists the members.  Sometimes the operating agreement will impose certain “conditions precedent” on membership — e.g., if a person fails to make their initial capital contribution by a specific date, they are not a member.

But operating agreements are not always clearly written, and the “membership” question can sometimes get muddy.

A recent unpublished opinion by California’s Fourth Appellate District — Pak v. Joo — sheds light on how courts will evaluate disputes regarding LLC membership.

Facts: LLC formed; membership interests disputed

Plaintiff Helen Pak contended she attained membership in several LLCs by agreement with others: Dr. Jae Chon, “Tammy” Joo, and Paul Joo.

After Tammy Joo had worked for two years as an administrator in an assisted living facility in which Pak had an ownership interest, Pak suggested that they invest together to purchase another assisted living facility.  The two women and their husbands had been longtime friends outside of work.  Pak also approached Dr. Jae Chon to make a substantial investment in the venture.  They anticipated that Pak, Chon, and the Joos would each have a one-third membership interest.  But the LLC governing documents were apparently not finalized.

The group made an offer of $10.2 million to purchase two assisted living facilities ($2 million down payment plus $8.2 million in financing), which was accepted by the seller.  Funding the purchase proved to be more difficult than expected — at least, for Pak.

The parties’ agreement for funding the purchase “went through several iterations” during escrow.  They eventually agreed that their respective funding percentages would dictate their ownership interest in the LLCs, with the expectation that Chon would contribute 62.5 percent, Pak 25 percent, and the Joos 12.5 percent.

Pak failed to come up with the money for her contribution.  The LLCs persuaded the seller to accept carry back financing for Pak’s portion of the down payment to “save the deal.”  The LLCs signed promissory notes as the borrowers, with the expectation that Pak would pay the notes.  With those notes in place, the purchase closed.

Pak failed to timely pay the notes.  The Joos and Chon resolved to pay off the notes, and informed Pak that she owned no interest in the LLCs as a result of her failure to make her contribution.

Pak sued for breach of contract and breach of fiduciary duty, contending that she was a 25 percent member of the LLCs since their inception.

Trial court: Pak is not a member

After a ten-day trial, the jury rejected Pak’s claims and found that she was not a member of the LLCs.  The trial court entered a judgment against Pak based on the jury’s verdict.

Pak appealed, contending that the trial court erred by refusing three of her proposed special jury instructions regarding LLC membership.

Court of Appeal: affirmed

The Court of Appeal affirmed the trial court’s judgment.

Pak’s main argument on appeal was that the trial court erred in declining Pak’s request to give the jury three proposed “special instructions.”  However, the Court of Appeal found no error.  Special jury instructions must be supported by “substantial evidence” and must “correctly and completely state the law relevant to the issues in the case.”  The Court of Appeal held that Pak’s proposed special instructions failed to do so, and therefore the trial court properly rejected them.

The first of Pak’s proposed special instructions would have “supplemented” the trial court’s existing instruction, which stated the basic principle that when an LLC is to have more than one member, “those persons become members as agreed by the persons before the formation” of the LLC.  Pak’s proposed special instruction would have added the following: “A person may become a member of a limited liability company without making any contribution.”  The trial court refused to give this special instruction because there was “no evidence in this case whatsoever that that was ever agreed to.  They were expecting a contribution” from Pak for the down payment on the assisted living facilities.

The Court of Appeal found no error in the trial court’s reasoning.  While the Revised LLC Act allows for someone to have a membership interest separate and apart from a transferable (economic) interest, no evidence supported that type of arrangement here.  In fact, the goal of Pak’s lawsuit was to establish her economic interest in the LLCs.

The Court of Appeal similarly upheld the trial court’s rejection of Pak’s other two “misleading” proposed special jury instructions.  Both of those proposed instructions, the court held, would have allowed the jury to conclude “a person could become a member of an LLC at any time, even if that was not part of the parties’ agreement.  Both instructions obscured rather than clarified the critical question presented to the jury: whether or not the parties’ agreement required Pak to make her contribution by a deadline in order to become a member.”

While Pak’s proposed special instructions may have been stated legal principles that could be “correct in the abstract,” the trial court properly rejected them because they were “misleading or irrelevant to the issues or evidence in the case.”

Lesson

Ideally, LLC membership interests — and any conditions attached to them (such as the timing and amount of capital contributions) — are clearly set forth in the LLC’s operating agreement.

If the operating agreement does not clearly address membership interests, it will be up to a judge or jury to figure out what the parties intended.

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