Supreme Court Sets Standard to Expel Member from Limited Liability Company

The rationale underlying the court’s decision in IE Test, LLC v. Kenneth Carroll, No. A-63 075482 (August 2, 2016) goes further than the dispute over the operating agreement that was at issue in the case. It equates the “not reasonably practicable” to carry on with the member to “not really possible.” It may not be enough that the members can’t stand each other or don’t want to work together; the court held that there should be some real impediment to continued operations before a court should expel one of the members.

This opinion is a pretty clear retreat from the significantly more flexible interpretation that had been applied by the Appellate Division in its two prior unreported decisions, in which the court seemed to indicate that not it was sufficient that prospective conduct would by all accounts make it unreasonable to continue the status quo. (See Expelled LLC Members: No Right to Force Purchase and Limited Liability Company Breakup: Crossing the Hudson Makes a Difference). The Court adopted and refashioned a set of seven criteria for answering the “not reasonably practicable” question and, in so doing, became the first supreme court to address the issue interpreting a provision common in both limited liability and partnership statutes.

MEMBERS CANNOT AGREE ON OPERATING AGREEMENT

The dispute among the members of IE Test, a maker of electronic testing equipment grew out of the prior bankruptcy of a Delaware LLC. One of the members, Patrick Cupo, formed the IE Test and was eventually joined by Kenneth Carroll and Byron James. At the time of bankruptcy, Carroll claimed $2.54 million in debts owed by the bankruptcy entity. Carroll bought the assets out of bankruptcy and the new entity continued the operations. The owners entered into a preliminary agreement to execute and operating agreement with Carroll and James owning 33%, and Cupo 34%.

Cupo and James managed the business and were paid salaries and bonuses. Carroll did not work in the business and received no salary or bonuses. The members could not agree on an operating agreement or how Carroll would be compensated. Carroll also demanded repayment of the $2.54 million that he had loaned to the predecessor entity. Ultimately, IE Test brought suit to expel Carroll. After discovery, IE Test moved for summary judgment.

IT Test’s claims were based on two theories: that Carroll had engaged in wrongful conduct that materially affected the business and that it was not reasonably practicable to continue the business with him as a member, both claims arising under N.J.S.A. 43:2b-24(b)(3)(a) and (c). The trial court granted summary judgment and was affirmed in an unpublished opinion of the Appellate Division. Both opinions focused on the prospective difficulties that would arise if the litigants tried to stay in business with each other – even with Carroll as a passive member – as well as the failure to agree on an operating agreement.

INTERPRETING THE UNIFORM LIMITED LIABILITY COMPANY ACT

The court’s decision hinged on its interpretation of the language of the New Jersey Limited Liability Company Act (LLCA), N.J.S.A. 42:2B-24(b), that was in effect when the litigation began. The current statute, the Revised Uniform Limited Liability Company Act (RULLCA) contains an identical provision,N.J.S.A. 42:2C-46(e).

The statutes permit a court to dissociate – for practical purposes to expel from management — a member for wrongful conduct that materially affected the enterprise.  N.J.S.A. 42:2B-24(b)(3)(a). It also permits involuntary dissociation when it is “not reasonably practicable” to continue with him or her as a member. In this case, the question faced by the court was whether the alleged wrongful misconduct by the ousted member, Kenneth Carroll, rendered the future operation of the business “not reasonably practicable.”

APPLYING THE NOT REASONABLY PRACTICABLE STANDARD

The Supreme Court’s opinion more strongly equates practicable with possibility, taking a narrower approach than the prior Appellate Division opinions. The court examined the language for its plain meaning and concluded that the member’s behavior must be so disruptive that the operations of the business could not continue with all of the members intact. That is, the expelled member’s presence would render the business inoperable, not make it merely more “challenging or complicated.” His/her presence must make it unfeasible despite reasonable efforts to continue operating the business with all the members intact.

In addition, the expelled member’s wrongful conduct must have “adversely and materially affected the business.” The court held that expulsion is inappropriate when the dispute among the LLC members is not related to the actual business of the company. The court held that the “pivotal language suggests that it must be unfeasible, despite reasonable efforts, to keep the LLC operating while the disputed member remains affiliated with it.” This is not an irreconcilable differences standard. “[T]he Legislature clearly did not intend that disagreements and disputes among LLC members that bear no nexus to the LLC’s business will justify a member’s expulsion under subsection 3(c).”

In this case, the court found that the members’ disagreement over the terms of the operating agreement was not by itself sufficient to render the business inoperable. The court reasoned that an LLC may operate under majority rule without an operating agreement. The issue thus became whether the company was going to be hindered in some way by the continued involvement of Carroll as a member.

Neither provision [subsection 3(c) and N.J.S.A. 42:2C-46(e)(3)] authorizes a court to dissociate an LLC member merely because there is a conflict. Instead, both provisions require the court to evaluate the LLC member’s conduct relating to the LLC, and assess whether the LLC can be managed notwithstanding the conduct, in accordance with the terms of an operating agreement or the default provisions of the statute.

THE NEW SEVEN FACTOR TEST

In reaching its decision, the court devised a new formula to guide trial courts’ future determinations. The court provided seven factors, which it had distilled from a Colorado appeals court decision, Gagne v. Gagne, 338 P.3d 1152, 1159-60 (Colo. App. 2014):

• The nature of the LLC member’s conduct relating to the LLC’s business;
• Whether, with the LLC member remaining a member, the entity may be managed so as to promote the purposes for which it was formed;
• Whether the dispute among the LLC members precludes them from working with one another to pursue the LLC’s goals;
• Whether there is deadlock among the members;
• 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;
• Whether, due to the LLC’s financial position, there is still a business to operate; and
• Whether continuing the LLC, with the LLC member remaining a member, is financially feasible.