There are arguments pro and con when it comes to the power to expel a/k/a dissociate an LLC member. On the one hand, expulsion can be viewed as a necessary measure to preserve the LLC as a going concern when faced with persistent misconduct or failure to perform by one of its members. On the other hand, depending how broadly or narrowly the expulsion criteria are drawn, the power to expel can be a tool of oppression and abuse by those wielding it for their self-advantage.
Expulsion can occur in one of two ways. First, the operating agreement can authorize member expulsion under specified circumstances by self-executing action of the other members or managers. This is not a feature I regularly come across in operating agreements of LLCs, especially those whose membership consists of founding owners actively involved in the business.
Second, in states that have adopted the Revised Uniform LLC Act — to date numbering 16 plus the District of Columbia; New York is not one of them — courts are authorized to expel an LLC member on application by the company or a member on three specified grounds, two of which entail fault-based standards based on intentionally wrongful conduct or material breach, and the third of which dispenses with the notion of wrongful conduct by authorizing judicial expulsion of a member who
has engaged or is engaging in conduct relating to the company’s activities and affairs which makes it not reasonably practicable to carry on the activities and affairs with the person as a member.
Not surprisingly, the open-endedness of the above provision when utilized in LLC disputes has generated litigation, with New Jersey courts taking the lead. Last week, in IE Test, LLC v Carroll, 2016 WL 4086260 [NJ Sup Ct Aug. 2, 2016], that state’s Supreme Court handed down a major decision in which it reversed the lower courts’ summary judgment order expelling an LLC member and adopted a series of factors to assist trial courts in determining whether it is not reasonably practicable to operate an LLC in light of a subject member’s conduct.
Background. You can read here my full report on last year’s intermediate appellate court ruling that was reversed last week. Briefly, the case involves a three-member LLC that rose from the ashes of a prior venture that went bankrupt, leaving one of the three — Carroll — with a $2.5 million loss. After forming the new LLC, Carroll demanded that any operating agreement provide compensation for his loss. The others refused, consequently the LLC never adopted an operating agreement which, according to the other two members who held a combined 67% membership interest, led to irreconcilable discord with Carroll and made it impossible to obtain outside financing for their growing business.
The two others successfully brought suit to expel Carroll under the no-fault provision of New Jersey’s LLC Act, winning a summary judgment upheld by the intermediate appellate court including a $227,000 court-ordered buy-out of Carroll’s membership interest. In essence, the court held that the LLC’s continued operation with Carroll as a member was “not reasonably practicable” based on his intransigent insistence on being compensated for the prior venture’s debt to him, which he admitted was not legally enforceable, as a condition of entering into any operating agreement.
The Arguments on Appeal. In his appeal to the New Jersey Supreme Court, Carroll argued that there was no evidence that he interfered with the LLC’s business; that the other members sought his expulsion because it was financially advantageous for them to do so; that they used the impasse over an operating agreement as pretext; that he was willing to assist in financing the business should the lack of an operating agreement preclude bank financing; and that the LLC Act’s default rules resolve any concerns about disruption in the company’s management by providing for majority rule in management decisions in the absence of an operating agreement.
The other members countered that judicial expulsion under the “not reasonably practicable” standard requires the court to anticipate future conflicts that may make it impossible to conduct business with a dissenting LLC member; that the parties’ impasse already had created a significant impediment by rendering the LLC unable to secure a line of credit or financing from a bank; that under the LLC Act certain decisions such as admission of new members or dissolution require unanimous consent; and that it was “inevitable” that Carroll’s dispute with the other members would undermine the LLC’s operations.
The Decision. The Supreme Court agreed with Carroll, holding that:
a disagreement among LLC members over the terms of an operating agreement does not necessarily compel the expulsion of a dissenting LLC member. If an LLC’s members can manage the LLC without an operating agreement, invoking as necessary the default majority-rule provision of the [LLC Act], then a conflict among LLC members may not warrant a member’s expulsion under the [LLC Act].
The court observed that, under the “not reasonably practicable” prong of the statute employed in IE Test, in contrast to the statute’s other, backward-looking, fault-based prongs, “the court prospectively analyzes the impact of [the subject LLC member’s] conduct on the LLC’s future.” It then explained:
Significantly, the Legislature did not authorize a court to premise expulsion under [the “not reasonably practicable” subsection] on a finding that it would be more challenging or complicated for other members to run the business with the LLC member than without him. Nor does the statute permit the LLC members to expel a member to avoid sharing the LLC’s profits with that member. Instead, the Legislature prescribed a stringent standard of prospective harm: the LLC member’s conduct must be so disruptive that it is “not reasonably practicable” to continue the business unless that member is expelled.
Underscoring the stringency of its newly adopted standard, the court added that LLC members seeking to expel a fellow member “are required to clear a high bar”; that the statute does not “authorize a court to disassociate an LLC member merely because there is a conflict”; and that the provision “require[s] the court to evaluate the LLC member’s conduct relating to the LLC, and assess whether the LLC can be managed notwithstanding that conduct, in accordance with the terms of an operating agreement or the default provisions of the statute.”
The court then laid out seven factors for trial courts to apply in evaluating the LLC member’s conduct, “among others that may be relevant to a particular case”:
(1) the nature of the LLC member’s conduct relating to the LLC’s business;
(2) whether, with the LLC member remaining a member, the entity may be managed so as to promote the purposes for which it was formed;
(3) whether the dispute among the LLC members precludes them from working with one another to pursue the LLC’s goals;
(4) whether there is a deadlock among the members;
(5) whether despite that deadlock, members can make decisions on the management of the company, pursuant to the operating agreement or in accordance with applicable statutory provisions;
(6) whether, due to the LLC’s financial position, there is still a business to operate; and
(7) whether continuing the LLC, with the LLC member remaining a member, is financially feasible.
The inquiry, which the court acknowledged is borrowed in large part from the standard for judicial dissolution of LLCs, requires a “case-specific analysis . . . with no requirement that all factors support expulsion, and no single factor determining the outcome.”
Applying the first factor to Carroll’s alleged conduct, the court concluded that, notwithstanding that he “provoked a distracting dispute among the LLC members that was never resolved” concerning his demand for compensation, there was no evidence that he “actively interfered with IE Test’s business, or that he used the impasse over the compensation issue as an excuse to undermine the business by failing to cooperate when needed.”
The court found that the remaining factors either did not support summary judgment or, at most, raised genuine issues of material fact for trial. There was conflicting evidence concerning the LLC’s ability to obtain financing and whether Carroll’s compensation demand stood in the way; there was no evidence of deadlock; and the business operated with increasing revenue despite the member discord and Carroll’s continued involvement.
The court’s decision accordingly reversed the grant of summary judgment and remanded the case to the trial court for proceedings consistent with its opinion.
Some Observations. Apart from IE Test and the All Saints University case which I wrote about here, also decided by a New Jersey court, I’m not aware of any other reported decisions addressing judicial expulsion under the “not reasonably practicable” statutory provision. None is cited in IE Test. We’ll have to wait and see whether courts in other states with the same statute follow the New Jersey Supreme Court’s first-impression interpretation setting a “high bar.”
I have a hunch that future cases involving the same statute will involve claims that blur the line between grounds for dissolution and expulsion. I can imagine, for instance, a 50% LLC member suing to expel the other 50% member primarily alleging a deadlock over important management decisions that is causing or likely will cause business paralysis. Absent wrongful conduct, one may ask, under those circumstances why should one member be forced out at the behest of the other, as opposed to dissolving the LLC and allowing the two members to bid against each other (and perhaps third parties) for the business assets?
Two final observations:
- The statute at issue is a default rule that can be eliminated in the LLC operating agreement or modified to specify different criteria for judicial (and non-judicial) member expulsion.
- IE Test is another in a seemingly endless stream of poster children for the proposition that, if you form and begin operating a multi-member LLC without first agreeing on an operating agreement, you’re asking for trouble.
My thanks to Tom Rutledge for alerting me to the IE Test decision, and whose own post on the case can be viewed on his Kentucky Business Entity Law blog. If the subject interests you, keep an eye and ear out for my forthcoming interview of Tom on the subject of judicial and non-judicial expulsion of LLC members on my Business Divorce Roundtable podcast.