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NY Business Divorce Information on Dissolution and Other Disputes Among Owners of New York Corporations, LLCs and Partnerships

“But I Did Nothing Wrong!” No Defense to Involuntary Dissociation of LLC Member

Posted in Compulsory Buyout, Expulsion and Removal, Grounds for Dissolution, LLCs

My recent post about New Jersey’s adoption of the Revised Uniform Limited Liability Company Act (RULLCA) highlighted the statute’s new provisions for judicial dissolution of LLCs under which the controlling members’ oppressive conduct is grounds for relief, and authorizing the court to order a buy-out in lieu of dissolution.

One aspect of the new law that remains substantially unchanged, and which also can become a weapon when LLC members have a falling out, is its provision for judicial ”dissociation” of a member, i.e., the involuntary expulsion of one member of an LLC upon application to the court by another or by the company. The LLC statutes in New York, Delaware and (I suspect) most other states have no similar provision which was also included in the original Uniform LLC Act promulgated in 1996.

Under the old and new New Jersey LLC Act, a court may dissociate a member who engages in “wrongful conduct” that “adversely and materially” affects the LLC’s business or “willfully or persistently committed a material breach of the operating agreement.” Both versions also authorize dissociation by a court when the member engages in conduct “which makes it not reasonably practicable to carry on the business with the member as a member of the limited liability company.”

All Saints University

Recently, in All Saints University of Medicine Aruba v. Chilana, 2012 WL 6652510 (N.J. Super. Ct. App. Div. Dec. 24, 2012), an appellate court held that the latter ground for dissociation does not require a showing that the member engaged in wrongful conduct. In reaching this conclusion the court contrasted the two, distinct bases for dissociation, one of which has a “normative component, requiring that the member’s behavior be ‘wrongful,’” and the other, “less stringent” ground that ”lacks such a wrongfulness element, merely requiring ‘conduct’ by the member that makes it ‘not reasonably practicable to carry on the business’ with the member’s participation” (emphasis in original).

All Saints involved a fight between paired-off members of a four-member, member-managed New Jersey LLC that operated a start-up medical school in Aruba. One pair held a combined 53% membership interest and the other 47%. The LLC agreement required unanimous approval of all management decisions. Each side accused the other of wrongful conduct in breach of fiduciary duty. Each side asked the court to dissociate the other under both prongs of the dissociation statute. The trial court ruled in favor of the 47% faction and dissociated the 53% faction under both prongs of the statute.

The appellate court’s ruling allowed it to sidestep the most contentious issues raised in the appeal of the dissociated members, who vigorously contested the trial court’s findings that they had engaged in a series of wrongful acts almost causing the shutdown of the medical school. Instead, the court upheld the trial court’s dissociation ruling under the statute’s less stringent provision based primarily on the 53% members’ refusal to contribute critically needed funds to pay school expenses, which would have resulted in the school’s collapse but for the other members’ emergency loans. As the court explained:

The trial judge had sound reasons for imposing the remedy of dissociation here, given the turmoil that led to the LLC and the medical school being pushed to the brink of failure. The judge reasonably declined to continue the status quo, given the precarious financial condition of All Saints, the fractured relationship of the LLC’s members, Yusuf’s denial of the school’s financial problems, and his unwillingness to infuse more funds into the business. In addition, Chilana, who had already provided emergency funds to save the school, understandably would not inject more capital if plaintiffs were allowed to manage the venture going forward.

The appellate court also upheld the trial court’s rejection of the 53% members’ request to dissociate the 47% members, commenting that, although the 47% members had overstepped certain restrictions in the LLC agreement, their actions were “essentially benign and in the ultimate interests of the continued viability of All Saints and the LLC,” and that their actions were “not injurious to the venture and did not occur for personal gain.”

The trial court also heard testimony as to the fair value of the dissociated members’ interests and determined that the shares had no value based on an unrefuted valuation by the 47% members’ expert appraiser. The appellate court added its own twist, finding that neither the dissociation statute nor the LLC agreement authorized a forced sale of the 53% members’ interests. “Hence,” the court concluded,

no valuation of the plaintiffs’ shares in the LLC was necessary unless plaintiffs, once dissociated, elected to have their shares valued and to tender them to defendants. Alternatively, plaintiffs could have retained their economic interests in the LLC as passive assignees [citations omitted].

After noting that the record was unclear whether the parties had stipulated to a buy-out of the dissociated members, ”for sake of completeness” the court proceeded to analyze and uphold the trial court’s acceptance of the unrebutted, zero valuation offered by the 47% members’ expert. The court resolved the conundrum by permitting the dissociated member

to file a motion with the trial court within thirty days of this opinion if he, in fact, wishes to have the court consider whether he can withdraw from the previous stipulation and, in light of the statutory clarification we have now provided in this opinion, continue to retain the economic benefit of his shares as assignee under N.J.S.A. 42:2B-44 while being dissociated from the entity’s management and operations.

In other words, either (1) stay in as a passive investor with no management rights, receive his annual profit and loss tax allocation, and pray for unlikely cash distributions and/or capital appreciation eventually leading to a liquidity event, or (2) redeem the entire membership interest now and walk away with zero. Not a happy choice.

Nor is it an entirely happy outcome for the prevailing 47% faction which, if the dissociated member chooses option #1, may be hobbled in any future efforts to raise capital or obtain debt financing for the school’s operations and growth, and whose strategic business plan may be influenced by the built-in disincentive provided by the ongoing economic interest of the dissociated member.

One final observation: Under the RULLCA-based New Jersey LLC Act that becomes effective later this month, the court is given additional authority to compel the sale of a judicially dissociated member’s interest. The provision states:

A court that expels a [dissociated] member from a company . . . may order the sale of the interests held by such person immediately before dissociation to either the company or to any other persons who are parties to the action if the court determines, in its discretion, that such an order is required by any other law, rule or regulation, or that such an order would be fair and equitable to all parties under all of the circumstances of the case.

Assuming the provision is non-waivable, in many cases (especially those involving 50/50 ownership) I would expect to see dueling dissociation claims in lawsuits between feuding LLC factions, in which each side seeks to compel a forced sale by the other, take precedence over dissolution claims (even though the latter also hold out the possibility of a forced sale). I also foresee considerable problems for litigants and judges attempting to distinguish between the wrongful conduct and non-wrongful conduct bases for dissociation. Indeed, it’s hard to read the All Saints opinion and not come away with the impression that the 47% faction came out on top precisely because the court believed that the other side’s misbehavior was relatively worse in the normative sense that the court disclaimed reliance upon.

Hat tips to Doug Batey (LLC Law Monitor) and Jay McDaniel (New Jersey Business Dissolution Journal) both of whose posts on All Saints University are worth reading.