The Business Divorce Law Report
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The removal of a member from a limited liability company, known as involuntary dissociation, is permitted by statute in most states and may also be permitted in an operating agreement.
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Removal is permitted when a member has engaged in wrongful conduct that has or will materially affect the company or when the member has repeatedly breached the operating agreement.
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Removal may also be permitted when a member files for bankruptcy or if it is not reasonably practicable for the LLC to continue with them as a member.
There are plenty of choices that we make in our lives that we would like to undo. Some we can and some we can’t. Breaking up with a business partner is the topic of this discussion. More particularly, how a member of a limited liability company can be expelled from the business. We’ll cover the circumstances in which members can be expelled, when it’s easy and when it’s not.
And we’ll review some of the consequences of expelling a member — a process known as involuntary dissociation. If you are in a business and if you think you might be put into a position of having to sever an important business relationship, then this is a pretty good introductory video. But we drill down on some of the other specific topics related to expulsion in
In the law of limited liability companies, which are in fact the most important form of new business organization by far, those members who quit or are expelled from the LLC are known as dissociated members. When you quit, you voluntarily disassociate yourself. When you’re thrown out of the business., t’s an involuntary dissociation.
I use the term expelled here instead of involuntary dissociation because they’re synonymous and expulsion is a little easier to say. We should start our discussion with the basic definition of membership in a limited liability company and what it means to be a member. The members of a limited liability company are the owners of the company, of course, but their membership interest has two components as well.
The first is the management interest. That’s the right to exercise management rights belonging to members in a member-managed limited liability company. That means the right to participate in the management of the company and make decisions about day-to-day operations. In manager-managed limited liability companies, much of the day-to-day is handled by the managers, but there are still decisions, important decisions, that only the members can vote on.
The other aspect of ownership is the financial interest of a limited liability company member. Limited liability companies distribute profits and cash flow to the members. The member interest, the financial interest, is the right to receive those payments, either on an ongoing basis or when the company makes a final distribution. So, for example, if three people are the members of an LLC and the company makes distributions of net cash flow on a quarterly basis, the member’s financial interest is the right to receive that distribution as and when it’s me.
Part and parcel of being a member of a limited liability company is also the ability to get information about the company and to participate in the major decisions about the company’s actions and directions. And for most of us, it means a job and an income. And in fact, most of the people that I represent work in the business, and it’s their livelihood.
Expelling a member does not mean that the member forfeits his or her investment in the limited liability company. You may be able to block a member from management, and some of my clients have found themselves locked out of the management of a company, but that does not mean that the ousted member forfeits their investment unless a court orders a sale.
The ousted member essentially becomes a silent partner with no management rights. So let’s start with the easy cases. These are the cases that generally involve some kind of change of status that is not compatible with staying in the business as an owner. The LLC statutes in most states require expulsion. If a member of a member-managed limited liability company files for bankruptcy, or has a receiver appointed over their assets or takes other kinds of steps that are common when someone becomes a judgment debtor and is unable to make payments on their debt.
Other kinds of entities like corporations or trusts can also be members of a limited liability company. If that business organization ceases to exist, or if it itself becomes insolvent. The limited liability company statutes in many states provide for dissociation of those entities. There are also cases in which it becomes unlawful for someone to remain as a member. For example, if a professional loses his or her license or is convicted of a crime, the LLC may expel that person.
There are also cases in which the kind of business that the limited liability company is in doesn’t permit these individuals to remain on as members. That can also lead to their expulsion. The owners of a limited liability company can also write provisions into the operating agreement that permit expulsion. In fact, the operating agreement of a limited liability company can include virtually any provision that the owners want to include for the removal or expulsion of members.
The fact is, is that this is rarely the case and most operating agreements are silent on the topic. The list of circumstances in which a member can be expelled because of a change of status is relatively long, but generally non-controversial. Kind of like the weather, circumstances change and so does the ability of an individual or trust or corporation to remain a member of the LLC.
It’s not something that most people take personally. You can compare that, however, to what I refer to as the hard cases and these are the cases in which expulsion is brought about by some type of inappropriate behavior. They’re hard cases because the facts are hard to prove, because the emotions are hard, and because very frequently they’re extremely difficult to resolve without a prolonged battle.
These are some of the types of cases that most frequently end up in litigation. Most of the cases in which a person is expelled rise from either the language of the Uniform Limited Liability Company Act or from provisions in an operating agreement or from provisions in an operating agreement. Expulsion under the Uniform Limited Liability Company Act, which is in effect in 26 states, focuses on specific provisions that permit expulsion for cause.
Under these statutes, a person can be expelled by a court because of wrongful conduct, and wrongful conduct is defined as behavior that is, first of all, wrongful, but that has also adversely and materially affected or will adversely and materially affect the company’s activities. Exactly what is wrongful conduct is going to depend on the circumstances, but some examples should include misappropriation of corporate assets, setting up a competing business involvement in criminal conduct.
It’s important to note that the statute speaks in terms of past, present and future acts. What is significant in the analysis is, first of all, whether the conduct was wrongful. And second, whether the effect was adverse in a material way to the company’s activities, either in the past or in the future. There is a third provision for expulsion, using what I would call the “reasonably practicable” test.
You see this standard ,reasonably practicable or not reasonably practicable, applied in a number of ways in the law of closely held businesses. The Uniform Limited Liability Company Acts says that a court may order dissociation of a member if that member has or is engaging in conduct relating to the company’s activities that make it — and this is the key language — not reasonably practicable to carry on the activities with that person as a member.
In terms of carrying on the activities, the Court’s going to look at the operating agreement and the certificate of formation and try to determine what the purpose of the LLC is and whether or not keeping the person as a member allows the parties to continue to operate in accordance with their operating agreement and to pursue the purpose that they’ve defined for themselves. Now there isn’t a great deal of decided case law on what it means to have someone’s participation, make it not reasonably practicable to continue with that person as a member of the company. The cases that have been decided provide an interpretation that not reasonably practicable is “not really possible.”
So, for example, if the participation of a particular member results in a deadlocked member’s vote on something that the company needs to decide in order to not materially and adversely affect its operations, then that conduct, that deadlock that’s brought on by the person, probably falls within the definition of not reasonably practicable. Other kinds of circumstances that seem to be clearcut grounds for expulsion?
Barring a member from a company that makes most of its money participating in public bidding when the owner has been convicted of a crime that makes it impossible for the company to continue soliciting public contracts while that person is a member. Some of the cases that have interpreted the reasonably practicable standard have made it clear that personality conflicts, disagreements over routine matters,
even the inability to agree on the terms of an operating agreement, are just not sufficient to meet the threshold for expulsion. The position of the majority of the courts is that if there is a clear majority and the majority is able to continue managing the company, then conflict among the members or the managers is not grounds for expulsion.
One issue that comes up is whether expulsion is warranted when a member exercises their minority veto to block a corporate action, and that action is material to the company’s continued operations. In that circumstance, it may not be reasonably practicable to continue with the person as a member. A minority veto comes into play in those limited cases in which a member of a limited liability company has the ability to block some type of action because it requires a unanimous vote.
The unanimous vote can be required either by the operating agreement or by the applicable LLC statute. So for example, you see the minority veto coming into play in such things as admission of a new member, adoption of a critical amendment to the operating agreement, loans are mortgages that are necessary for operations and that require unanimous consent, mergers and acquisitions.
In all of these cases. It is much more likely that the court would find that it really is not reasonably practicable to continue with a particular individual as a member when that person is using their minority veto to block the forward progress of the company in a material way. So involuntary dissociation is not the end of the road for these types of member disputes.
Most owners of an LLC do not want the dissociated members who no longer work or contribute to the business to continue getting their share of the profits. And in fact, it’s pretty rare that the expulsion of a member is not part of a larger action in which the member’s interests will be repurchased. How that works, how the process and how the transaction is completed we will leave for another day.