It is easy to “forget” about the formalities of a properly documented loan when a related party loan is made, especially if the lender is representing and acting on behalf of both the borrower and lender. This situation can set the stage for unintended consequences.
Mr. Jones is a successful real estate investor and over many years has had other investors approach him about investing with him. He has formed several LLC’s for the various real estate projects he has invested in. Mr. Jones is the managing member of each LLC. Some of the same investors are members of one or more of the LLC’s but not all of the LLC’s and not all in the same percentages.
Of the several LLC’s that Mr. Jones formed, White Acre LLC experienced a cash flow problem. White Acre LLC acquired a 20 unit apartment building with the expectation of performing some exterior updating and rehabilitation of the common areas. This would be followed by a unit by unit refresh of each apartment as they became vacant. The project had reserves to cover the projected improvements after putting 20% down on the purchase of the property and obtaining an 80% loan for the balance. The projected rents and debt service would generate positive cash flow after paying all expenses. A month after completing the exterior renovations and interior common area refresh work, the building experienced an infestation of bed bugs that quickly moved from unit to unit in the building. The common area work had eaten into a significant amount of the reserves that had been set aside from the initial LLC member investment. Tenants started leaving the building in a panic after one particular tenant was particularly vocal with his neighbors. The tenants also took to Yelp to give a dozen bad reviews of the building. Over the course of six weeks, the building had 10 vacancies and the property management company was having difficulty filling even one apartment. Cash flow went from positive to negative within two months in order to meet debt service and operating costs.
Mr. Jones knew that Green Acre LLC had accumulated some reserves over several years of successful operation. As managing member of Green Acre LLC, Mr. Jones provided a loan to White Acre LLC. Mr. Jones recorded the loan as an account receivable on the books of Green Acre LLC and as a loan payable on the books of White Acre LLC. Mr. Jones did not execute a formal note or any written agreement to indicate what interest rate would be paid, if any, or when the funds would be repaid to Green Acre LLC. It turned out this initial “loan” was the first of many similar loans from Green Acre LLC to White Acre LLC. It took a few weeks to eradicate the bed bug problem and several months to fill the vacant units due to the unfavorable internet comments and the investment put into refreshing each unit. During the months that Mr. Jones and White Acre LLC were putting the ship right, a buyer approached Green Acre LLC to acquire the Green Acre LLC property. The Green Acre LLC members approved of the sale. When they closed the sale and the Green Acre LLC was to be terminated, the loan from Green Acre LLC to White Acre LLC came to light. Green Acre LLC did not have the cash to distribute to the members because a significant amount of cash had been provided as loans to White Acre LLC and White Acre LLC did not have the cash to repay the loan. White Acre LLC did not have enough equity in the property to refinance the loan to repay Green Acre LLC. Mr. Jones was embarrassed and the Green Acre LLC members were a bit upset at what had been done.
Mr. Jones forgot he had a fiduciary duty to the members of both White Acre LLC and Green Acre LLC even if some of the members were in both LLC’s. The loan was made without oversight and approval of the members of Green Acre LLC. An investor should be aware of the terms in the LLC management agreement. Does the agreement allow the managing member to borrow funds or to lend funds without the approval of a majority of the LLC members? What is the security for the loan? The loan Mr. Jones approved on behalf of Green Acre LLC was unsecured. The bank had the first position and mechanic’s liens could have been filed for the work done to refresh the building and the units, although we assume most of that work was paid for with the advances from Green Acre LLC. It is possible the loans from Green Acre LLC went for debt service payments and some portion of the refresh work had not been fully paid.
Best practice would include LLC member approval of all borrowing above a predetermined threshold amount. Adequate terms of repayment and a reasonable interest rate should be provided in writing. Security for the loan should be put in place similar to an arms-length loan. There should be consequences for failure to make the scheduled payments and provisions for collection and collection costs in the note agreement. Don’t arrange the loan with yourself if you are in a position of authority as a managing member of an LLC, a general partner, or a trustee. If a related party loan is beneficial to all parties, then consider asking an independent party to “stand in” as one party in the establishment of loan terms and security to help avoid taking too loose an approach to terms and documentation.