Many people are familiar with capital calls as common aspects of venture capital and equity investment funds. As an example, Investor A commits to help fund a $20 million investment by contributing $1 million, but only 10% is due at the start. As time passes, the investment fund managers send out written capital calls which, in this context, are also called drawdowns. Maybe an additional 10% is demanded, maybe more. The specific rules with respect to capital calls are established in the relevant governance documents for the investment fund.
Depending on the governance documents, failure to contribute as required by a capital call can be expensive. For example, the governance documents might “punish” a defaulting non-contributing investor in one or more of the following ways:
- Assessing default penalties
- Limiting the defaulting investor’s right to make other capital contribution — effectively, this caps the defaulting contributor to their then-current paid-in percentage investment
- Decreasing the non-contributing investor’s share of fund distributions
- Requiring a sale of the non-contributing investor’s stake in the fund under various possible terms
- Demanding reimbursement of damages suffered by the fund caused by the failure to meet the capital call
Corporate entities, capital calls, and dilution of ownership rights
It is less well-known, but capital calls can also be a feature of small to mid-sized closely-held business entities like corporations, general and limited partnerships, and limited liability companies. Again, whether capital calls can be issued and under what conditions will be set forth in the entity’s governing documents. It is important to note this since capital calls can be surprising and worrisome if a business owner is unaware that capital calls can be issued.
Aside from worries created by the need to accumulate capital to be given over the corporate entity, capital calls can be worrisome because they can be used by majority owners of a closely held corporate entity to dilute ownership percentages and the attendant rights. Take, as an example, a closely held corporation with two owners at 60% and 40%. The owners are in dispute about some matter relevant to the company. If permitted by the governing documents, the majority owner could issue a capital call. If the minority owner cannot come up with the funds in the time specified, the typical result is that the percentage ownership share will change. The majority owner — who was able to meet the capital call — will increase in ownership to, say, 70%. That level of ownership might be very important since the governing documents might require a 2/3 majority vote of the shareholders for the corporation to take certain actions. Indeed, maybe these are precisely the corporate decisions about which the owners are arguing.
How can minority-level owners defend themselves?
Those with minority-level ownership interests can defend themselves to a certain extent. First, if possible, the governing documents should regulate capital calls in such a manner as to eliminate dilution effects. Second, when there seems to be a danger that a capital call will be issued, minority-level owners should be prepared and proactive with sources of capital funding. Finally, it is possible to litigate the issue with various claims and causes of action related to the capital call. If the facts are clear that the capital call was issued for the purpose of diluting ownership rights, it can be argued that the majority owners have breached various duties that they owe to minority-level owners. These include duties of fairness, loyalty, and the duty to avoid self-dealing. Likewise, the majority owners can be deemed in violation of the covenant of good faith and fair dealing.
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