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Who Has the Biggest Slice?

In a California Club, Some Members’ Holdings Exceed the Limit

 Douglas  Gerlach Bookmark and Share

Anyone who grew up with a sibling knows all too well two of the primary causes of intrafamilial arguments: “He won’t stay on his side!,” commonly arising from automobile backseat territory disputes, and “Her piece is bigger than mine!,” caused by the minute differences in size resulting from the slicing of cake, pie, pizza and the like.

For grown-ups, these two sources of conflict are less of a concern, though I myself will admit to coming close to a skirmish as a result of an airplane seatmate taking too much liberty with a shared armrest. In investment clubs, however, questions about the size of a member’s capital account, particularly when the size of that account breaches the club’s defined maximum, often do arise.
Annie T. of the Women’s Invest­ment Network of Scotts Valley, Calif., writes to ask: “We have two members whose valuation ex­ceeds the 20 percent maximum ownership of club assets as required by our standing rules, at 20.7 percent and 21.6 percent. Do you have a recommendation for reducing their ownership?”
Before I respond to Annie’s question directly, let’s take a look at the common practices regarding maximum ownership. It’s not uncommon for investment clubs to have a rule limiting the maximum ownership
of any individual member, typically setting a cap at 15 ­percent or 20 percent of the club’s total assets.
I think the idea behind the maximum ownership rule is to prevent any one person or group of people from exercising too much “control” of the club. For instance, two members who each owned 20 percent of the club could solicit the support of a member who owned just 10 percent and establish a voting bloc that could constitute a majority in most actions before the club.
The idea that just three members could monopolize business decisions seems to be a scary proposition for many clubs. Some clubs attempt to minimize this possibility by restricting voting, allowing each member just one vote in all matters instead of allowing weighted votes by capital percentage. This is a very bad practice, however, since it deprives those with a greater financial interest in the club a proportionate say in the club’s operations and investment decisions.
Can you imagine Warren Buffett endorsing a shareholder proposition that would allow each shareholder (including himself) a single vote regardless of whether they owned 33 percent of the company (as Buffett does) or a single share, which is approximately 0.00006 percent of outstanding stock?
Yet this is what clubs do when they restrict voting to “one person, one vote.” Members with the most at risk in the club, often those with the longest terms and greatest amount of experience, are rele­gated to a minority position. By and large, what’s good for these members is good for the club, and I’d never join a club where new, less-experienced club members could have a greater say in the club’s investments.

I do, however, endorse a compromise whereby voting is conducted on a “one-person, one-vote” basis by default, provided that any member can call for a vote weighted by capital accounts if desired. This accommodates ease of tallying votes in a meeting but allows members with a greater interest in the club the protection they deserve.
But how much is too much? The 15 percent or 20 percent maximum ownership rule is adopted by many clubs without too much thought. But another way of calculating the maximum allowable ownership in investment clubs is like this:

200% / No. of club members = Maximum ownership %

For a club of 10 members, then, 200%/10 = 20% maximum ownership. For a club of 25 members, 200%/25 = 8% maximum ownership.
Jim Thomas, a director with BetterInvesting’s Puget Sound Chapter, describes this guideline as being par­ticularly suited to new clubs rather than clubs with a ­mixture of recent and long-term members.
“The thinking is that no member would own more than double what would be the case if every member owned an equal share,” he says. For members to exceed the maximum percentage of the club, they’d have to make greater member payments than other partners, which is not all that common, or other members of the club would withdraw, thus driving up the ownership levels of all remaining partners. The latter case is usually how this situation arises.
Even so, the currently recommended sample partnership agreement doesn’t state that members may not own more than 20 percent, only that they may not make a ­payment to the partnership that causes their account to exceed 20 percent:
“No partner shall make a con­tribution that would cause that ­partner’s capital account to exceed twenty percent (20 percent) of the capital accounts of all the partners. In the event that a partner’s capital account does exceed twenty percent (20 percent) of the capital accounts of all the partners, then that partner shall make no more than the monthly minimum contribution until the ownership level falls below 20 percent.”
Under this provision, a club isn’t required to act if a member exceeds the maximum allowable ownership. It keeps the member from accumulating a greater share of the club — so long as there are no other withdrawals and other members keep contributing as they have done.
It won’t do anything significant to reduce the member’s current ownership level below the 20 percent level, unless you have new partners coming in or existing members increasing contributions pretty significantly. Importantly, the provision keeps a most enthusiastic or long-standing member engaged in the club’s business, whereas prohibiting further contributions would most likely discourage that person’s participation.
If the partnership agreement adopted by Annie’s club doesn’t allow any member to own more than 20 percent, the club will have to make mandatory distributions to those members in the form of partial withdrawals.
In the case of the Women’s Invest­ment Network, the club treasurer should note that the amount of the withdrawals may need to be greater than 0.7 percent and 1.6 percent for those members in order for their capital accounts to actually fall be­low 20 percent.
Each member’s ownership in the club is made up of a unique mix of units purchased at different unit ­values. When the club pays off a member withdrawal, it’s returning some paid-in capital to the withdrawing members and the total value of the club decreases; thus, the percentage ownership of each member will change accordingly.
The better (and simpler) alternative, however, is for the club to mod­ify the partnership agreement as described in the sample agreement to allow these committed partners to keep their assets working for the benefit of themselves and the rest of the club membership.
In this way, clubs can keep disputes about whose piece of the pie is larger relegated to the tasty snacks portion of the monthly meeting.

Douglas is ICLUBcentral's product manager, helping develop the company's programs including Toolkit 6, myICLUB.com, and the Investor Advisory Service. He is also the author of several investing books, including The Pocket Idiot's Guide to Direct Stock Investing, The Complete Idiot's Guide to Online Investing, The Armchair Millionaire, and Investment Clubs for Dummies.

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