The Perils of For-Cause Expulsion Provisions in LLC Agreements
A number of valuable lessons can be learned from a recent decision by Manhattan Commercial Division Justice Melvin L. Schweitzer (pictured) in Jain v. Rasteh, Decision and Order, Index No. 109920-09 (Sup Ct NY County Feb. 1, 2010), where the court summarily dismissed a complaint by a minority member of a limited liability company who was expelled from the LLC for breach of its operating agreement.
The last time I wrote on the subject (read here) I noted that, unlike some other states, New York's LLC Law has no express provision authorizing or prohibiting member expulsion, although LLCL Section 701(b) mentions member expulsion in the context of various events (death, retirement, bankruptcy, etc.) not requiring the LLC's dissolution. Jain involved an LLC formed under Delaware's LLC Act, which, unlike New York's law, expressly authorizes the LLC agreement to provide for the elimination or forfeiture of a member's interest for failure to comply with the LLC agreement, or under any other circumstances specified in the LLC agreement (see Delaware LLC Act Section 18-306 and Section 18-502(c)).
The subject of Jain is a New York based, two-member company called White Eagle Partners, LLC formed in Delaware in 2008 to provide investment management and advisory services for a hedge fund. Majority member James Rasteh contributed most of the firm's capital and held an 83% profit interest. Minority member Niket Jain held the balance. Section 5 of the LLC agreement designated Rasteh and Jain as co-managers, however it also gave Rasteh the final say in case of disagreement on any issue with specified exceptions such as dissolution and admission of new members.
Section 12 of the LLC agreement, entitled "Withdrawal of a Managing Member," included a subsection (a)(ii) governing involuntary withdrawal by Jain, authorizing Rasteh to "require" Jain to withdraw at any time for "Cause" as defined. The definition included conviction for felony or violation of securities laws, fraud, or "a material breach of this Agreement." Section 13 of the LLC agreement entitled Jain to be paid specified percentages of the firm's net profit over the three years following any such involuntary withdrawal, depending on the number of years of service. For termination after less than two years -- which is what happened -- Jain's share of net profit goes from 4.25% in the first year down to about 1.4% in the third year. Under Section 17 of the LLC agreement, following his termination for any reason Jain is prohibited for six months from competing with the company or soliciting any of its clients or employees.
According to Jain's amended complaint (which includes a copy of the LLC agreement), in February 2009, Rasteh barred Jain from the company's business office, threatened to have him "escorted out" if he tried to gain entry, and refused him access to the company's books and records. According to Rasteh's submissions in support of his motion to dismiss the complaint, between February and the end of June 2009, Jain agreed to, and did, work from home with remote access to the necessary databases and company information, and he also received a tax distribution as provided in the LLC agreement.
On June 30, 2009, Jain's attorneys received a letter from company counsel informing them that Jain was terminated for cause under Section 12(a)(ii) of the LLC agreement. The letter gave as the basis for termination two material breaches of the LLC agreement. First, the letter cited Jain's refusal to comply timely with company requests for his personal trading information for an SEC compliance audit. Second, the letter accused Jain of disobeying Rasteh's directive not to communicate with the company's largest client concerning their internal dispute after Jain suggested seeking its assistance with their settlement discussions. In both instances, the letter characterized Jain's conduct as a breach of Section 5 of the LLC agreement giving Rasteh the final say in the event of any disagreement between them concerning the LLC's business affairs.
Shortly thereafter Jain filed his initial complaint against Rasteh and the company for breach of the LLC agreement. He also applied for a preliminary injunction requiring the defendants to give him access to the company's office and books and records. By order dated August 13, 2009, Justice Schweitzer denied preliminary relief and granted the defendants' cross motion to dismiss the complaint for pleading defects with leave to replead, following which Jain filed his amended complaint.
Rasteh and the company again opted to move for dismissal rather than answer the amended complaint, this time on the basis of documentary evidence establishing their defenses as a matter of law, as permitted by Section 3211(a)(1) of the Civil Practice Law and Rules. As Justice Schweitzer's subsequent decision notes, the standard under Section 3211(a)(1) is "high" and requires evidence that "utterly refutes" the plaintiff's allegations which must be deemed true.
Defendants agued that they met the standard, and that their expulsion of Jain complied with the LLC agreement as a matter of law. Primarily they relied on a series of email exchanges between the parties and their legal counsel evidencing Jain's failure to disclose his personal trading information, and Jain's disclosure of their internal dispute to a company client over Rasteh's objection. Jain countered that his complaint must be "liberally construed" and that the documentary evidence was contradictory, however, Justice Schweitzer agreed with the defendants, writing:
It is clear from the record currently before the court . . . that Mr. Jain's personal trading account information was requested for an annual compliance audit, and that Mr. Jain failed to provide it in a timely fashion. Although Mr. Jain correctly notes that dismissal of an action is not appropriate unless no significant dispute between the parties remains, he has failed to provide credible evidence to contradict defendants' documentary evidence.
So what are the lessons to be learned from Jain? I can think of four:
- The inclusion of a for-cause expulsion provision in the LLC agreement is a delicate matter to be carefully considered on all sides when the agreement is under negotiation. Sure, it's nice for the majority to have the power to expel, but particularly in a very small company where the members work closely together, the spectre of expulsion of the minority member based on some finding of misconduct, especially if on financial terms highly unfavorable to the expelled member, can poison inter-member relations and the company's long-term prospects for stability and success.
- If you're a minority member of an LLC whose operating agreement includes a provision authorizing your expulsion at the behest of the majority, depending how broadly or narrowly the clause is drafted, do not take too much comfort from the fact that the grounds for expulsion are limited to defined circumstances constituting "cause" for removal. I've seen a number of LLC agreements such as the one in Jain with for-cause expulsion provisions predicated on a catch-all material breach of the LLC agreement. At a minimum you may be buying yourself an expensive lawsuit over the existence or not of the requisite breach, and you may be doing so after being locked out of the company with no salary.
- Once it becomes apparent that the members' relationship is in jeopardy, the minority member must walk on eggshells, so to speak, to avoid giving the majority member any excuse for triggering the for-cause expulsion. It's interesting to note that, in Jain, although the complaint alleged that Jain effectively was thrown out of the company in February 2009, the grounds for his formal expulsion concerned only his subsequent actions in the following months.
- Jain also teaches lawyers a practice pointer, namely, never underestimate the power of a well-supported pre-answer motion to dismiss the case based on documentary evidence. Over many years of following court decisions I've seen relatively few successful Section 3211(a)(1) motions, and those that do succeed usually rely on some dispositive provision in the parties' contract without need for extraneous evidence of the parties' conduct. In that sense Jain is an unusual case because the court had to look outside the LLC agreement for evidence of the claimed breach. In defending against such a motion, the better practice is to treat the motion as if it were one for summary judgment and put in the record, whether by way of affidavit or documentary exhibits, any and all available evidence raising a factual dispute.
