Limited liability companies (LLCs) have become popular for holding title to real estate, with one of the goals being limiting liability for the members of the LLC. Recently, however, the Second Appellate District in the case of Triyar Hospitality Management, LLC v. Steven Yari, et al. dramatically illustrated some of the pitfalls of undercapitalization of an LLC.
The facts of this case are straightforward. The LLC entered into a contract to purchase a hotel from the seller for $39 million. The purchase contract disclosed that the hotel was subject to a management agreement in favor of the Hyatt Hotel chain.
During the buyer’s due diligence period, Hyatt’s operating agreement was terminated. The buyer was unaware of the termination of the Hyatt agreement and decided to not go forward with the purchase contact and let the contract expire pursuant to its own terms.
After the contract had expired, the buyer learned that the Hyatt management agreement had in fact been terminated. The buyer claimed that this increased the value of the property by $11 million. Thereafter, the buyer sued the seller on a number of legal theories, including fraud and specific performance (wherein the buyer asked the seller to perform the contract and close escrow).
The trial judge found that the seller had not breached the contract and that it was the buyer’s fault that it had not learned about the termination of the Hyatt agreement during the due diligence period.
There was a prevailing party attorneys’ fees clause in the purchase contract. Therefore, in the second phase of the trial, the court awarded the seller $2,142,615 in attorneys’ fees and costs. After an unsuccessful appeal, the trial judge ordered an additional $193,273 in fees and costs to be paid to the seller as the prevailing party under the contract.
Surprise, surprise – the seller found it impossible to collect any judgment from the LLC. The buyer’s LLC did not even have the ability to pay the attorneys’ fees of over $2 million, let alone the purchase price of $39 million.
Upon giving up on collecting from the LLC, the seller asked the court to amend the judgment to add the two individual brothers who owned and controlled the LLC.
Interestingly enough, in the specific performance trial, the buyer had the obligation to prove that they were ready, willing, and able to buy. In order to do so at trial, since no financing had been obtained, the buyer’s two principal brothers introduced their own personal financial statements and the financial statements of other entities they owned or controlled, showing that they had $52 million in available cash – enough to buy the hotel property. They also testified that their individual funds were available to purchase the property.
This is one of those cases where in order to win their case for specific performance, the buyers testified that they had the personal ability and the financial means to purchase the property. Without such testimony, they never could have had the chance to win for specific performance. The brothers testified regarding their ability to withdraw money from their various family entities, and their testimony was “It’s not as formal as, you know, having to abide by some operating [document] – these are family entities that – and once again, we borrow from these family entities quite often and repay.”
The court observed that all of the various entities had the same address. The court also found that the two brothers personally financed the litigation against the seller.
The trial court held that the buyer LLC was not sufficiently capitalized to purchase the hotels and, therefore, found the two brothers to be the alter egos of the LLC and personally liable under the alter ego doctrine. The judgment was revised to add the two brothers as judgment debtors. The court opined that there were three factors involved in making this decision: (1) the two brothers had control of the underlying litigation, (2) there was a “unity of interest in ownership” and the separate personalities of the entities and owners no longer existed, and (3) there would be an inequitable result if the various acts were treated as only those of the LLC alone and not the two brothers.
On the first factor, the brothers admitted that they had control of the underlying litigation.
On the second factor (unity of interest and ownership), the court found that the brothers controlled the LLC and could fund the LLC (or not) as they pleased, and therefore there was no real legal difference between the LLC and the two brothers. The court also capitalized on the testimony quoted above establishing that the brothers were willing to disregard the corporate formalities in order to purchase the hotel and that they could freely transfer money between the various entities and commingle funds to accomplish “whatever purpose they wish[ed].” The court found that the LLC never had sufficient capital to purchase the hotel or, for that matter, even to pay the judgment for attorneys’ fees.
The third factor the court considered in rendering a final opinion was whether it would be inequitable or unjust for the brothers to not have to pay the seller’s prevailing party attorneys’ fees. The court found that the seller did prove that the result would be inequitable if the two brothers could escape personal liability for the attorneys’ fees they owed the seller. In other words, if the brothers, thanks to their family holdings, supposedly had the ability to buy the hotel for $39 million but then they lost in litigation, why wouldn’t they have to pay the seller’s attorneys’ fees?
Finally, the court reasoned, “We know what would have happened if the purchase went through, the money would have been forthcoming. Is this money going to be forthcoming?” Incredibly, the brothers’ counsel replied, “They did agree to personally be on the hook for the [$]39 million, but not for the attorney fees.” It would be hard to come up with a more straightforward summary of the inequities of the LLC’s position.
Many folks who buy real estate form their own LLCs without the aid of qualified California real estate attorney. Most do not understand the issue of capitalization of the LLC, which is important when it comes to avoiding situations like the one in the Triyar case. They go on their merry way, thinking that they have no personal liability and that the only liability involves the assets of the LLC (which are minimal in many cases).
Knowledgeable transactional attorneys go to great pains to make sure that those who form LLCs understand the issue of adequately funding the LLC. Those folks who form their own LLCs to save a few dollars can find out the hard way that the protection they assumed they had is illusory and will evaporate like water when the LLC is faced with a situation like the one in this case.
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