When reading a recent New Jersey court’s opinion regarding an employee of an LLC claiming to have been given a share of ownership of the company by its sole owner, I couldn’t help but think of method acting – the technique in which “an actor aspires to encourage sincere and emotionally expressive performances by fully inhabiting the role of the character.” (Cite). Dustin Hoffman, Heath Ledger and Daniel Day-Lewis all used method acting to deliver outstanding performances. Although a putative LLC owner doesn’t need an agent, “fully inhabiting the role of” an LLC owner is a critical part of getting a court to recognize an ownership interest in the event of a dispute.
The murkiness of employees being offered ownership in the LLCs they work for
Before we look at that New Jersey case, let’s talk about LLC ownership for a moment.
It would probably not surprise you to learn that LLC ownership is not always cut and dry. I frequently receive calls from potential clients who claim they were promised equity in a company they have been working at, only to come to realize that the company did not and does not recognize their ownership interest.
(When I receive these calls, one of my first questions is, “Were you given a K-1 earlier this year?” As I have previously discussed, Schedule K-1s are helpful in identifying the owners of a business because entities taxed as partnerships or S-corporations must prepare a Schedule K-1 for each of their owners.)
Obviously, whether someone is an equity owner of an LLC is a big deal on its own in terms of compensation and power. But in the context of Pennsylvania business divorces and the litigation that often accompanies them, equity ownership of an LLC confers certain rights and privileges on owners that non-owners do not have. For example, LLC owners can file derivative claims against their LLC for breach of fiduciary duty. They can also demand the LLC’s books and records for inspection.
Things tend to get murky when employees of an LLC claim to have been given equity in the company. That’s because many employment arrangements have profit-sharing provisions that are designed to provide the benefits of ownership without actually giving an employee ownership. When you add in the fact that these relationships are not always well-documented or are captured in DIY-ed agreements penned (i.e. downloaded from the Internet) by business people, it is easy to see how confusion can reign.
Two guys, an email, and an unchanged LLC operating agreement
Interestingly, there have not been recent notable Pennsylvania court decisions on this issue. But thankfully, judges in the Commonwealth’s neighbor to the east recently decided a case that shows why supposed grants of LLC ownership to an employee can easily become murky.
In Funsch v. Procida Funding, LLC, et al., No A-3899-18T4 (N.J. Super. Ct. Dec. 3, 2020), Kyle Funsch sued his former boss Billy Procida, Billy’s real estate investment company, Procida Funding, LLC, and another employee, John Mullane. Billy was the sole member of Procida Funding.
At the heart of the case was what Kyle believed was an equity share of Procida Funding that he claims Billy promised him in May 2011 but never gave him by the time he left the company in December 2015.
A trial court ruled against Kyle in April 2019. According to the court, the evidence showed that he did not have and knew he never had an equity interest in Procida Funding. Kyle appealed the ruling to the New Jersey Superior Court.
As proof that he was given an equity share of Procida Funding, Kyle relied heavily on a May 2011 email from Billy to him and another employee (the other defendant, John Mullane) that said:
[Y]our work to date has been admirable and your skill sets improve daily. I am proud to work with you both (despite that I beat you to the office today) therefore I am making you partners. [T]he terms of which are as follows: for as long as you work here, you will each own and be entitled to 12.5% of the combined companies [sic] net earnings. [Y]ou will receive a draw against those earnings . . net income will be calculated by all income less all expenses exclusive of interest income on my investments. [S]hould either of you leave the firm you will forfeit any rights to future earnings or ownership. [S]ince talk is cheap I wanted to put something in writing, so we can consider this legally binding. [A]s we’ve got many things to do save this email.
[I]f I die or become disabled it is my wish that you guys own 50% and send the balance to my kids. [Y]ou are now to refer to yourselves as my partners. [W]e will fine tune this over time. [W]e will do a press release to announce this shortly.
Seems like reasonably strong evidence of ownership. Kyle claimed further support for Billy giving him an ownership share by pointing to Procida Funding’s public announcements regarding his becoming a partner, as well as references to him being a partner on Procida Funding’s website, a private placement memorandum, in Billy’s emails to clients and to a Procida Funding attorney, and in a business magazine story.
Unfortunately for Kyle, both the trial court and the New Jersey Superior Court found what happened after the May 2011 email, or perhaps more accurately, what didn’t happen, to be more persuasive. The Superior Court affirmed the trial court’s ruling against him.
First and foremost, Billy provided Kyle with four proposed amendments to the Procida Funding LLC operating agreement. Kyle rejected each one. Had he signed one of them, the agreement would have admitted him as a member. According to both courts, this was an indication that Billy and Kyle never came to an agreement about Kyle becoming a co-owner of Procida Funding.
Second, the May 2011 email lacked “core, basic, and material terms” related to Kyle’s claimed co-ownership that would have been expected in a document admitting a new LLC member. The email did not address important co-owner responsibilities and obligations such as capital contributions and loss sharing. The May 2011 email was deemed by the trial court to be merely a notification to Kyle about his promotion and the new way his compensation would be calculated. According to the courts, further supporting the fact that the May 2011 email did not grant co-ownership to Kyle was an email Billy sent just two months later to Kyle and others outside of the company in which Billy stated he was the 100% owner of Procida Funding and referred to Kyle as a “cash flow partner.”
Third, Kyle testified that he was paid as a W-2 employee and did not receive any Schedule K-1s reflecting owner distributions.
Finally, both courts did not view Billy’s references to Kyle as a “partner” as an indication that Kyle was a co-owner. They relied on Billy’s testimony that he used “partner” imprecisely to give Kyle authority for negotiation purposes—not to confer LLC ownership on him.
As a result, Kyle was unable to use the court system to do what he could have done with a stroke of his own pen if he signed one of those four amendments to Procida Funding’s operating agreement: create an ownership interest for himself in Procida Funding.
Sign the darn papers, or at least, walk the walk
As the Funsch case shows, whether someone is an owner of an LLC is ultimately a question of contract law. When deciding a case involving an employee claiming to have been given an ownership interest in an LLC, the first place a court will look will be the LLC’s operating agreement. If it was amended to include the employee as an owner, and signed by the required parties, a court would almost certainly rule in favor of the employee because the signed agreement shows the parties had a “meeting of the minds” regarding the employee’s newfound ownership.
But what about when an LLC does not have an operating agreement? Pennsylvania, for one, does not require an LLC to have a written operating agreement in order for the LLC to be officially formed in the Commonwealth. (New Jersey also does not have such a requirement).
In those situations, any oral agreement regarding an employee supposedly being given an ownership interest, and the employee’s subsequent conduct after any agreement, will be closely examined. In the absence of an amended written operating agreement, a court is going to want to see whether the supposed new owner took on the responsibilities and obligations an owner would take on. In other words, did the new owner walk the walk?
If Billy Procida’s LLC was a Pennsylvania LLC without an operating agreement, and Kyle Funsch brought a similar case against Billy in a court that applied Pennsylvania law to the dispute, chances are good that Kyle would lose that case as well. He did not walk the walk.
According to the New Jersey Superior Court’s opinion, Kyle:
- Received W-2s from Procida Funding and never any Schedule K-1s—which would have provided a record of his share of Procida Funding’s profits;
- Never asked why he did not receive Schedule K-1s;
- Never received membership certificates;
- Never made capital contributions to the company;
- Never shared in the company’s losses;
- Never possessed any voting rights; and
- Never managed the company.
In other words, he did not act like a co-owner of Procida Funding.
For Pennsylvania LLC owners and would-be owners alike, when a question arises over whether an employee was actually granted ownership of an LLC, Kyle Funsch’s failed legal campaign provides a clear takeaway.
If there are changes in the ownership of an LLC that has an operating agreement, the operating agreement should be amended to reflect the change and then signed by all of the LLC’s owners.
When an LLC has no such agreement, the would-be owner must show by their subsequent actions after supposedly being granted the ownership share that they walked in the shoes of an owner.
In other words, if they want to be treated like an LLC owner, they need to have acted like one.