When not tightly drafted, expulsion provisions in shareholder or LLC operating agreements can cause a lot more trouble than they’re worth. Case in point: Harker v Guyther, 2014 NY Slip Op 07403 [3d Dept Oct. 30, 2014], decided last month by the Appellate Division, Third Department, in which the court resorted to dictionary definitions of the term “misappropriation” in denying summary judgment to a 50% LLC member who sought to expel the other 50% member in a fight ostensibly over health insurance coverage, of all things.
The case involves a Delaware limited liability company known as 3H Corporate Services, LLC based in Saratoga Springs, New York. The company, formed in 2003, bills itself as specializing in the provision of corporate and insurance licensing services to the insurance community. 3H’s two members, each holding a 50% interest, are Gary Harker and Joan Guyther.
In 2008, Harker and Guyther agreed to have 3H pay for their health insurance as an employment benefit. They later disagreed over various business issues, including Guyther’s contention that she deserved extra compensation for the disparity between the higher cost of Harker’s family health insurance plan and her individual coverage. The lid blew off after Guyther withdrew over $3,000 from the company’s operating account to true up the discrepant insurance premiums over the prior six months, and announced to Harker her intention to continue doing so.
When Guyther rejected Harker’s demand to return the funds, he purported to terminate her employment and membership in the LLC under a provision in the operating agreement providing for termination and mandatory redemption of the membership interest in the event of “embezzlement or substantial misappropriation of the Company’s assets by Member employee in excess of $1,000.” Guyther not surprisingly disagreed, following which Harker brought suit for judgment declaring that Guyther’s employment had been properly terminated under the operating agreement and directing that her membership interest be redeemed for a stated sum based on an appraisal secured by Harker.
The trial court denied Harker’s subsequent motion for summary judgment, finding that he failed to establish as a matter of law that Guyther’s conduct constituted misappropriation within the meaning of the termination provision. Harker’s appeal to the Appellate Division in Albany culminated with its decision last month unanimously affirming the lower court’s ruling.
The operating agreement included a Delaware choice-of-law provision, prompting the court to observe that “Delaware law governs the substantive interpretation of the agreement — including the meaning of the term “misappropriation . . .” which was left undefined in the agreement.
Initially, the court rejected Harker’s contention that misappropriation was defined without more by the $1,000 monetary threshold in the termination provision (“substantial misappropriation . . . in excess of $1,000”). “This monetary baseline,” wrote the court, “may be fairly read in the agreement to define ‘substantial,’ but does not define the operative term.”
For the meaning of the operative term, misappropriation, the court turned to the dictionary, quoting from Lorillard Tobacco Co. v American Legacy Foundation, 903 A2d 728, 738 [Del 2006], for the proposition that “‘[u]nder well-settled case law, Delaware courts look to dictionaries for assistance in determining the plain meaning of terms which are not defined in a contract.'” Citing several dictionary entries in Black’s Law Dictionary and the Random House Webster’s Unabridged Dictionary, the court concluded that the term misappropriation “carries a connotation of fraudulent — or, at a minimum, wrongful — intent . . ..” Here’s what the court said specifically on that point:
Black’s Law Dictionary defines “misappropriation” as “[t]he application of another’s property or money dishonestly to one’s own use” (Black’s Law Dictionary [9th ed 2009], misappropriation [emphasis added]). That entry is cross-referenced with the definition of “embezzlement,” which is “[t]he fraudulent taking of personal property with which one has been entrusted, esp[ecially] as a fiduciary” (Black’s Law Dictionary [9th ed 2009], embezzlement [emphasis added]). Another dictionary defines “misappropriate” alternatively as “to put to a wrong use” or “to apply wrongfully or dishonestly, as funds entrusted to one’s care” (Random House Webster’s Unabridged Dictionary [3d ed 1999] [emphasis added]). Moreover, as used in Delaware law, the term “misappropriation” often implies dishonest or wrongful intent, or breach of duty (see e.g. 6 Del C § 2001 ,  [misappropriation of trade secrets]; In re Vanderslice, 55 A3d 322, 326 [Del 2012] [attorney committed theft by “misappropriating” client funds]; Lingo v Lingo, 3 A3d 241, 242, 244 [Del 2010] [attorney-in-fact committed a “breach of trust” by misappropriating funds]).
The appellate court accordingly affirmed the lower court’s denial of Harker’s summary judgment motion, holding that he did not prove as a matter of law that Guyther acted with the requisite wrongful intent in withdrawing the disputed funds and that, in any event, Guyther’s contention that she was fully authorized to make the disputed withdrawal “gives rise to triable issues of fact barring summary judgment as to whether her conduct constituted ‘substantial misappropriation’ providing grounds to terminate her employment.”
The Takeaway. It’s unusual to find an involuntary termination provision in an agreement between 50-50 owners of a business (the exceptions often involve licensed professionals who, by law, cannot remain in ownership if they lose their license). In those rare situations where the agreement enables one owner to initiate termination of the other, if the relationship sours there is built-in incentive to find any possible excuse to pull the termination trigger no matter how minor the trigger event, which is what appears to have happened in Harker where, as the decision noted, the dispute over a relatively small sum of health insurance expense was part of an unspecified, larger disagreement over “various business issues.” The incentive is even more powerful when linked to a mandatory redemption or buy-out at an unfavorable price and/or on unfavorable terms for the terminated owner. The same dynamics also can exist, without the impediment of co-equal control, when a majority owner or faction targets a minority owner for termination. I’m not suggesting that expulsion provisions are inherently bad. Company controllers justifiably may need to be able to terminate the employment of owner-employees for certain types of serious misconduct, and to expel owners who are no longer employees. What I am suggesting is that the expulsion provisions in the shareholders’ or operating agreement should very carefully and very precisely define, using objective standards, the misconduct triggering termination. I also would recommend some form of expedited, alternative dispute resolution to deal with termination (as well as other) controversies.
Update November 11, 2014: Mack Sterling (North Carolina Business Litigation Report) posted yesterday about an interesting North Carolina trial court’s decision that also rejected an expulsion effort by one of two 50% LLC members based on allegedly unauthorized switching of bank accounts. The decision also held that the one 50% member who sought to expel the other lacked authority to engage counsel on the LLC’s behalf to defend against a dissolution proceeding.