Transcript

I focus my practice on commercial litigation and in particular on representing business owners in disputes with their business partners. As part of my job I get to see a whole variety of ways that business people attempt to rip off their business partners. And today I want to share with you one of those techniques—not so you can use them in your business partners but so that you might be better able to see it and prevent it in the event that it’s happening to you.

The technique I want to talk about today is the bad faith exercise of a capital call. Let’s start by thinking about what a capital call is. In most closely held companies, when you form the company you invest some money in exchange for an interest in a company, whether that’s a share of stock, a membership interest, or a limited partnership interest. Typically, the amount of money you invest in the company is all that you’ll have to invest in the company—in other words if the company goes belly-up, your losses are going to be limited to the amount that you initially invested. 

Generally, the company cannot come back to you and ask you for more money. Some companies, however, are set up different. Some companies have a provision in either their operating agreement or their partnership agreement known as a capital call. A capital call provision allows the company to come back to its owners and require them to contribute additional money to the company. For example: If the company needs a million dollars in cash, it may make a capital call of a million dollars; if you own 40% of the company, you’ll have to come up with $400,000. Now, most capital call provisions provide that if an owner is unwilling or unable to contribute capital in response to the capital call, then their interest in the company is diluted.

There’s a variety of good reasons to include a capital call provision in the organization documents, but once that provision is in there, it can be a powerful weapon that a ne’er-do-well owner can yield against their business partners.

The typical situation goes something like this: A company has a capital call provision in their organizational documents that provides that a shareholder or an owner’s failure to answer the capital call will result in the dilution of that owner’s interest. There’s a majority shareholder who has the ability to exercise the capital call. The company may have incurred debt to a third party—to a bank, for example—and the majority owner knows that the company is doing well and is going to do well in the future, and wants to keep more of the anticipated profits for him or herself and not have to share it with their business partners. They decide to repay the company’s debt, even though it’s not due—they decide they’re going to prepay the bank, to pay off the loan, and the way they’re going to do that is they’re going to make a capital call. They know that the minority owners can’t answer that capital call, so by making that capital call they intend to dilute the minority owners of the company.

When the majority owner makes the capital call, the minority owners are unable to make the call and have their interest diluted. When the business does well in the future, those minority owners have been diluted and are unable to share in the upside that they would have been able to share in but for the majority owner’s bad faith exercise of the capital call.