Probably the most litigated issue in my practice involves the expulsion of a member of a limited liability company in response to some wrongful conduct or breach of the operating agreement. We represent majority owners when they are trying to remove a member and we represent the minority member who is fighting removal. Not all states permit removal or expulsion – known as involuntary dissociation – for misconduct and some recent decisions indicate that in the states that do, it may be harder than once thought.
Involuntary Dissocation of a Limited Liability Company Member
There was a belief, perhaps unreasonably so, that Courts were unwilling to keep people in business together when plainly the owners were no longer capable of maintaining a working relationship. The New Jersey Supreme Court, in the first decision by any state supreme court on the topic, held that the concept of “not reasonably practicable” to stay in business together means more than a personality conflict. It requires a structural inability to act, such as ongoing deadlock or significant wrongful conduct.
In fact, the circumstances in which a court will intervene to remove a member or, in perhaps a more extreme circumstance, to dissolve the entity fall into a number of categories. First, it is important to note that the owners of a limited liability company can incorporate standards for the removal of members in their own operating agreement. These standards should govern except in the most extreme circumstances.
Members can also voluntarily dissociate themselves by giving “notice of the person’s express will” to withdraw as a member. Usually, this is a written notice of withdrawal, but it can take other forms such as the approval of an amendment to the LLC’s certificate of formation.
Even without an express provision in the operating agreement, a member may be dissociated from the limited liability company if there is a change in its status. These status-based changes vary by state and include the bankruptcy or other actions seeking protection from creditors, receivership, transfer of all of the member’s interest to a third party (other than as security or under a court’s charging order), death, merger or the dissolution of a trust that holds the membership interest. Some states permit the dissociation of a member by vote of the members when it has become unlawful to continue the LLC with that person as a member.
Courts May Order Expulsion of LLC Member
These status-based criteria for dissociation generate less controversy than the cases involving the bad behavior of members. Events like bankruptcy or dissolution of a trust are circumstances for which it is relatively easy to plan. Operating agreements also typically include boilerplate provisions that give the members little discretion about how to respond.
The conduct-based grounds for dissociation, which commonly involve some claim of a breach of duty, wrongful conduct or a deadlock that prevents the LLC from continuing normal operations, tend to be far more controversial. These are the circumstances that will pit family members against family members, disrupt long-time business relationship and often make it difficult, if not impossible, to continue the status quo.
Assuming that there is no express language in an operating agreement governing the standards for dissociation based on alleged misconduct – and there rarely is – the parties must be guided by statutory standards.
Standards for Involuntary Dissociation from a Limited Liability Company
These standards come from the Uniform Limited Liability Company Act. For example, New Jersey’s statutory criteria are set out in N.J.S.A. 42:2C-46 and provide three circumstances in which the court, on application by the LLC, may order the expulsion of the LLC member.
- Wrongful conduct. The individual’s wrongful conduct has “adversely and materially” affected, or will adversely and materially affect, the company’s activities;
- Breach of contract. The individual has “willfully and persistently” or is willfully and persistently committing, a material breach of the operating agreement or their duties or obligations as a manager or member of the LLC;
- Not reasonably practicable. The individual has engaged, or is engaging, in conduct relating to the company’s activities which makes it not reasonably practicable to carry on the activities with the person as a member.
The New Jersey statute adopts the criteria of the Revised Uniform Limited Liability Company Act (RULLC) § 601. The RULLC has been adopted in 17 state jurisdictions and the District of Columbia.
Other limited liability company statutes do not provide for the expulsion of individual members. These statutes, Delaware and New York being the best-known examples, provide for the dissolution of the LLC as the sole remedy when it has reached a level of dysfunction that impairs its operations. New Yok courts, however, have found that if there are grounds to dissolve the entity, then the court has the option, if the circumstances so merit, of ordering the sale of a membership interest.
There are similarities and differences in both approaches. New York and Delaware do not provide an oppression remedy (By oppression, I include the broad category of wrongful conduct that majority owners may inflict on minority owners.)
On the other hand, all of the other statutory schemes permit a Court to intervene when the company has ceased to function in an acceptable manner. The difference is that the limited remedy states permit Courts to compel the company to dissolve, i.e., to cease normal operations, and to begin winding up its affairs. (The general topic of judicial dissolution is beyond the scope of this article.)
The states applying the Uniform Limited Liability Company Act are modeled on partnership law and permit the removal of one of the members in the right circumstances. They also grant the courts very broad discretion to find a remedy that suits the circumstances of the case.
Wrongful Conduct as Grounds for Dissociation
The Revised Uniform Limited Liability Company Act (RULLCA) provides that a person may be dissociated if they have engaged in wrongful conduct that has adversely and materially affected, or will adversely and materially affect the company’s activities. The scope of conduct that has been included in the purview of the act has included such things as misappropriation of assets or opportunities, competition with the company, or generally a breach of the duties of loyalty or care. It could involve, for example, a one-sided transaction favoring a controlling member or manager. Or it might involve the misuse of proprietary information.
The key issue in considering the “wrongful conduct” that would constitute grounds for dissociation is that the offending member or manager had some control over the interests or welfare of others. Members in a manager-managed limited liability company, like shareholders in a corporation, have now inherent right to participate in the decisions or day-to-day activities of the business. It is only when management is vested in the owners, whether managers or shareholders, that they are required to look after the interests of others. In other words, when a member (or member acting as a manger) has a fiduciary duty to the company or the other members, his wrongful conduct may be grounds for dismissal.
The reason for this is that the modern presumption for a limited liability company is that if the company has managers who have responsibility for the business decisions, then the members as members have a legal right not to trouble themselves with the interests of the other owners. A limited liability company is, after all, a creature of contract and we do not presume that the parties to a contract owe each other any duty other than to fulfill their obligations under the contract according to the letter of the agreement.
Breach of Contract as Grounds for Dissociation
A limited liability company is, as we often write, a creature of contract. One of the fundamental principles underlying the law of LLCs is that the members of a limited liability company should be free to order their own affairs as they see fit, and that whatever agreement they may reach should be put into writing. That being the case, it should not be too surprising that a past or present breach of the agreement of the parties may well be grounds to expel the offending member.
In many jurisdictions, the agreement has been defined by the written agreement that the parties themselves have executed. In New Jersey, for example, there was good authority that a claimed oral agreement between the parties was of no effect; only written agreements mattered. That model went out the window with the RULLCA’s acceptance of any agreement or course of conduct as binding the parties.
We have litigated persistent breach cases that involved a failure to repay loans, not honoring capital requirements and not honoring commitments to segregate responsibilities among the members. Here again, a court will look at the materiality threshold and the effect on the other members.
Not Reasonably Practicable
The final statutory grounds for expulsion is what is arguably a catch-all provision, but which in fact seems to encompass much of the messy, human behavior that can bring an end to a working relationship among the co-owners of a business. The RULLCA, for example, provides that past or present conduct that makes it not “reasonably practicable” for the LLC to continue with that person as a member is grounds for involuntary dissociation.
Courts have been relatively uniform in holding that the “not reasonably practicable to stay in business together any longer” criteria does not require culpable conduct. Deadlock for example, may be the result of two competent, well-meaning owners who are at loggerheads over some issue. We have seen it when one side refuses to participate in a capital call, or to honor an agreement, or to participate in management.
But what is not reasonably practicable? Does it mean that the parties don’t speak anymore, that they no longer rule by consensus? Does it apply, for example, to a refusal to accept – or share – management authority? Or does it require more?
Not Reasonable Practicable is a Structural Impediment
We generally will see the not reasonably practicable standard invoked in two circumstances. The first is in connection with the potential judicial dissolution. The second is in connection with the removal of a member. I thought they were different, but it is turning out that not reasonably practicable has a more uniform interpretation that I thought.
Delaware and New York, for example, allow a court to order the dissolution of a limited liability company when it is “not reasonably practicable to carry on the business in conformity with a limited liability company agreement.” Del. Limited Liab. Co. Act. § 18-802. New York law is similar. In the seminal case under New York law, In re 1545 Ocean Ave., LLC, 72 A.D.3d 121 (2d Dep’t 2010), the court held that judicial dissolution was an extreme remedy that was not triggered by the exclusion of one member from the management of the company – at least not as long as the company continued to operate successfully.
The standard is that the limited liability company is either unable to function – as in the case of deadlock – or it is failing financially. The Ocean Avenue court articulated the standard as “for dissolution of a limited liability company pursuant to Limited Liability Company Law § 702, the petitioning member must establish, in the context of the terms of the operating agreement or articles of incorporation, that (1) the management of the entity is unable or unwilling to reasonably permit or promote the stated purpose of the entity to be realized or achieved, or (2) continuing the entity is financially unfeasible.”
Some courts saw it as a looser standard when it came the dissociation of a member. The two decisions that have considered the issue have looked at the reasonably practicable as meaning not feasible despite reasonable efforts. Disagreements, disputes and even deadlock that do not prevent decision making on key issues were insufficient. See Supreme Court Sets Standard to Expel Member from Limited Liability Company.
Equitable Dissociation of an LLC Member
New York courts have fashioned a hybrid remedy under which a court may, in its equitable discretion, force out a member of the limited liability company. It is a two-step process. When the plaintiff has established grounds for judicial dissolution, the court may order the sale by a minority to the majority members.
Exactly what circumstances would justify a sale are not clear, but it is likely that the threshold issue is whether there is otherwise good ground to dissolve the company. Such sales are referred to as being in aid of dissolution or a means of dissolution.
After Dissociation, what are the Former Member’s Rights?
Dissociation as a member does not automatically entitle a member to sell his or her shares. On the contrary, unless a court orders otherwise, under the RULLCA, the member becomes a transferee. What that means is that the former member still has a right to maintain their economic interest and receive distributions when they are made.
The former member, as transferee, has no management rights, however, no right to receive information and quite possibly no right to object to changes to the operating agreement that dilute their interest.
The RULLCA provides that a court may order the dissociated member to sell his or her interest at a value determined as of the day before the effective date of the dissociation. The statute also provides that in cases of oppressive conduct, the court may order any party, at any time, to sell to any other party.
The fact is that most serious business divorces end with one side purchasing the interest of the other side, usually at something known as fair value. The question, almost invariably, is what is a fair price.
If you have a question on the expulsion or removal of a member or manager, please feel free to contact us.