In Thompson v. Davis, an LLC dispute case, the Court of Appeals of Tennessee issued an opinion that is informative on two different fronts: (1) An LLC member’s obligation to contribute his pro rata share to repay loans taken for the benefit of the LLC, but for which all members are personally liable; and, (2) under what circumstances a member can reduce the amount of his pro rata obligation based on alleged distributions received by the other members, but not by that member.
Before diving into the facts of, and result in, that case, it is helpful to review a couple of provisions of the Tennessee Revised Uniform Limited Liability Company Act (the “Act”) which come into play with some frequency, as well as the Tennessee statute requiring contribution by a party who is liable on a debt. First, under the Act, when an LLC is not successful, and is dissolved and liquidated, its assets must be distributed first to creditors. (Creditors, critically, includes members who have made loans to the LLC.) If there are any assets left to distribute after creditors are fully paid, which is infrequent in my experience, they must then be distributed to members who did not receive distributions to which they were entitled. If there are assets left over after those distributions are made, they must be distributed to members first for the return of contributions, and second, for their membership interests in the LLC. The statute that controls distributions upon liquidation is T.C.A. §48-249-620.
The Act also has its own fraudulent transfer provision embedded in it at T.C.A. §48-249-306. That statute provides that members may be liable for distributions which left the LLC unable to pay its debts as they became due in the ordinary course of business or which left it in the red, so to speak. (The preceding is a generalization, so review the statute for the details).
Apart from the Act, and also at issue in the Thompson v. Davis case, was the Tennessee contribution statute related to instruments, T.C.A. §47-3-116. That statute provides that a party who pays an obligation on an instrument, such as a bank note, is entitled to seek contribution from others who were also liable for the payment of the note. The statute provides that those others must contribute their pro rata share. For example, if A, B, and C borrow $750,000, interest free, and agree to be jointly and severally liable to the lender for the obligation, and A pays off the obligation, A is entitled to file suit against B and C and collect $250,000 apiece from B and C. A does not have to sue both for contribution, but A cannot collect more than $250,000 from either.
Here are the key facts of the case:
- The two plaintiffs (“Plaintiffs”) and defendant (“Defendant”) formed an LLC with each owing a one-third interest
- The LLC needed money so Plaintiffs and Defendants, individually, borrowed money pursuant to two different notes for the benefit of the LLC (It was not the LLC that was liable to the bank on the notes – an important distinction)
- The LLC was obligated to the members, Plaintiffs and Defendant, for the money they borrowed and loaned back to the LLC
- During the operation of the LLC, the Plaintiffs contributed over $2.5 million each to the LLC for its operations, while the Defendant contributed only about $1.6 million
- According to the Plaintiffs, the Defendant claimed that he could not contribute amounts equal to what the Plaintiffs contributed, but was aware of what the Plaintiffs were contributing
- The Plaintiffs took distributions from the LLC which amounted to only about 10% of what they had contributed to the LLC
- The Plaintiffs contended that the distributions they took were for the repayment of the contributions they had made, which contributions were loans
- The Plaintiffs, who, along with the Defendant, were personally liable for the two notes, paid the notes off with their own funds, but Defendant did not contribute
The Plaintiffs filed a contribution suit against the Defendant claiming that he should pay his pro rate share, or one-third, of the total amounts which they had paid on the notes. The trial court agreed, and the Court of Appeals of Tennessee affirmed the trial court in all respects.
The Defendant argued, unsuccessfully, that the Plaintiffs were not entitled to take distributions from the LLC. Thus, he argued, what distributions they had taken should be offset against what his one-third share of the obligations on the notes was. He argued that the Plaintiffs were not entitled to take distributions because the monies they had contributed to the LLC were not loans, but capital contributions. The trial court determined that the contributions were loans based, in part, on the fact that the Plaintiffs received no increase in their ownership interests in the LLC for making the contributions. It reasoned that, had the contributions been capital contributions, it would have been expected that the Plaintiffs would have received a corollary ownership increase.
The Defendant also argued that he should receive a set off from his pro rata share of the amounts owed on the notes because the distributions taken by the Plaintiffs left the LLC unable to pay the bank notes. This argument did not work because the relevant statute applies only where LLC members receive distributions arising from their ownership, not for the repayment of loans made by members. (This case was decided under the Tennessee Limited Liability Company Act and not the Revised Act, but both define “distribution” as being a payment made “in respect of membership interest.”) In other words, the fraudulent conveyance statute which is part of the Act does not apply to monies paid to members for legitimate loan repayments. (In many cases, like in Thompson v. Davis, there will be a dispute about whether such distributions were, in fact, legitimate loan repayments).
For Tennessee lawyers who handle LLC cases, this case is worth understanding.