Edward Robson of Robson and Robson Edward Robson of Robson and Robson

There are many ways that an owner of a closely held business can use their superior financial resources to gain an advantage over their co-owners in a dispute. One common way is the use of a capital call provision to dilute the interest of minority owners or to create off-setting claims against them. “Weaponizing” capital call and dilution provisions can be an effective sharp elbow tactic in business divorce situations, but practitioners should be wary of the risks that come with it.

Weaponized capital calls are typical in situations where there are claims of shareholder oppression and where there is a significant disparity in financial resources between owners. Such a strategy usually is in response to a claim by a minority owner that the majority owner has breached their fiduciary duty to the minority owner, the company or both. Faced with the prospect of litigation from the minority owner, the majority owner causes the company to exercise a right provided in the entity’s governing documents to demand that each of the owners contribute additional capital to the company. In initiating the capital call, it is the expectation of the majority member that the minority member will have insufficient financial resources to make the necessary capital contribution within the time specified in the operative documents. Failure to make a timely contribution could result in dilution of the minority’s interest, trigger a mandatory sale of their interest to the majority or, minimally, create a counterclaim against the minority owner that would act as a setoff against any amounts that might be awarded to the minority owner.

Majority holders considering a capital call in the context of a dispute with a minority owner should exercise caution. Even when expressly permitted by the governing documents, using capital call provisions in bad faith can give rise to claims for breach of fiduciary duty and the implied obligation of good faith and fair dealing.

Improper exercise of capital call provisions may breach the fiduciary duty of loyalty. By setting the terms of the capital call that he will have to answer, a majority owner is engaged in self-dealing. Absent a provision in the company’s operative documents to the contrary, courts evaluate self-dealing transactions using an “entire fairness” analysis. Under this approach, the majority owner has the burden to show that the transaction was objectively fair to the company. A majority owner that is unable to meet this high bar will have breached their fiduciary duty to the company.

Weaponizing capital call provisions also risks breaching the implied duty of good faith and fair dealing. Operating agreements, partnership agreements and shareholder agreements are contracts and are subject to the duty of good faith and fair dealing. Just as in any other agreement, courts will not permit a party to a contract to exercise its contractual rights in such a way as to deprive the counterparty of the benefit of its bargain. Contractual provisions that provide an unfettered right to make a capital call invite court scrutiny as to whether the capital call was made in good faith. In evaluating whether a majority owner has complied with its obligations to act in good faith, courts perform a fact-intensive inquiry about the circumstances and the motivations surrounding the exercise of the contractual right and the reasonable expectations of the parties as reflected in the agreement.

There are several strategies for reducing the risks associated with making a capital call. Majority owners can address the risk prospectively by taking the time to create robust operating documents. Fiduciary duties can often be modified or eliminated in operative documents, thereby creating predictability for the majority when engaging in corporate transactions.

Even with the existence of supportive documents, proper exercise of a capital call requires a bona fide business need for capital coupled with a reasonable exercise of the right. Whether a bona fide need exists and whether the capital call was reasonable is a fact-intensive inquiry. Courts will evaluate the timing of the capital call, the capital needs it purports to address, the treatment of past capital calls and the motivations of the majority in making it. Notwithstanding the unpredictability associated with such an inquiry, certain practices can help a majority act with confidence in causing a capital call.

Seeking the assessment of independent directors or managers involved with the company may buttress assertions that the capital call is being made in good faith and may avoid application of the “entire fairness” analysis.  If there is no way to avoid the entire fairness standard, the majority owner should be prepared to demonstrate and substantiate a bona fide business purpose that justifies a demand for additional capital. This might require the use of business valuation or accounting experts ready to explain cash flow or other financing issues. At a minimum, the majority should be ready with clear documentation of the need for capital and the amount required. Capital calls for excessive amounts smack of bad faith and suggest that the majority is attempting to exploit the minority owner.

The majority should also be ready to explain why it caused the company to raise money with a capital call rather than other financing sources that would not require additional money from the owners. Well-documented and unsuccessful efforts to obtain bank or other third-party financing before resorting to a capital call can provide helpful justification. Majority owners should be especially wary if the new capital is being used to retire loans or pay debts owed to the majority owners or their affiliates. In such cases, a capital call might only compound claims of self-dealing.

Lastly, majority owners should be prepared for the prospect that a minority owner may, through strategic alliances with other investors or lenders, make a timely contribution, potentially maintaining the status quo ante.

Majority owners do well to remember that no matter how favorable the language of the governing agreements, courts exercising equity powers may not look kindly on capital calls whose purpose is strategic rather than operational.

Edward S. Robson is the co-founder and managing shareholder of Robson & Robson and focuses his practice on commercial litigation, corporate law and mergers and acquisitions. He litigates a variety of commercial disputes, including those arising from shareholder conflicts, breach of contract, unfair competition and real estate transactions.