Thursday, August 4, 2016

New Jersey Supreme Court Analyzes Widely Used Provision for Judicial Expulsion of Member from LLC

New Jersey Supreme Court Analyzes Widely Used Provision for Judicial Expulsion of Member from LLC


Earlier this week, the New Jersey Supreme Court reversed both the trial court and the appellate decision division, finding, on the facts of this particular case, that the standard for judicial expulsion of a member from an LLC had not been satisfied. This decision has ramifications in all states that have adopted either the uniform limited liability company act or the revised uniform limited liability Company act, both containing these same standards for judicial expulsion.  IE Test, LLC v. Carroll, A-63 Sept. Term 2014, 2016 WL 4086260 (N.J. Aug. 2, 2016).

Before going any further, let me note that Kentucky does not have in its LLC act a provision for judicial exclusion of a member.  Likely one could be added in an operating agreement.

This case involves a three member LLC.  All three, two different degrees, had been involved in a predecessor organization in the same line of business;  they entity went into bankruptcy, causing one of the members, the defendant Carroll, to lose in excess of $2.5 million.  With respect to the new LLC, the three members did state their intention to enter into a full operating agreement for the LLC, IE Test, LLC, acknowledging in the meantime that “the Members of the Company and their LLC Percentage Interest have been and are: Kenneth Carroll (33%), Pat Cupo (34%) [and] Byron James (33%).”   It was with coming to agreement on that full operating agreement that the relationship between the members broke down.

Cooper and James were actively involved in the management of IE Test.  Carroll, in contrast, was not involved in day-to-day management had minimal involvement with the company beyond a single sales call.  Cooper and James drew “salary” and “benefits” from the LLC while Carroll was not similarly compensated. That said, Carroll was still feeling the sting from the $2.5 million loss he had suffered with respect to the predecessor entity. While there was agreement that IE Test LLC was not responsible on that loss, Carroll proposed an operating agreement pursuant to which he would receive certain payments intended to at least in part make him whole on the loss. Cooper and James, however, were unwilling to agree to those terms. Believing that the relationship with Carroll would be irrevocably broken consequent to their refusal to agree to those terms, they sought to judicially expel Carroll from the LLC.

Alleging all of breach of fiduciary duty of loyalty, breach of the fiduciary duty of care, breach of contract in breach of the implied covenant of good faith and fair dealing, the LLC filed an action against Carroll seeking his judicial expulsion.  To provision of the New Jersey Limited Liability Company Act at issue is N.J. Code § 42:2 B-24 (b)(3), which provides:

On application by the limited liability company or another member, the member’s expulsion by judicial determination because:

(a) the member engaged in wrongful conduct that adversely and materially affected  the limited liability company's business;

(b) the member willfully or persistently committed a material breach of the operating agreement; or

(c) the member engaged in conduct relating to the limited liability company business which makes it not reasonably practicable to carry on the business with the member as a member of the limited liability company.

On motions for summary judgment, the trial court rejected the effort to expel Carol based upon subsection (a) of the statute, finding that Carroll's insistent upon compensation did not constitute “willful misconduct” within the meaning of the statute.  Well those demands may have been unreasonable, they were not of themselves unlawful and they inflicted no harm on the LLC. Slip op. at 8.  The trial court did, however, find that Carroll could be expelled under subsection (c) on the basis that was no longer “reasonably practicable” for the three members to coexist in the LLC and that further controversy and litigation is likely to result. Slip op. at 9.  The determination would be affirmed by the Appellate Division. See 2014 WL 8132907.  This case, through the decision of the Appellate Division, has been reviewed by Peter Mahler in his blog New York Business Divorce in a posting titled Involuntary Member Dissociation Under RULLCA (September 28, 2015); HERE IS A LINK to that posting.

Looking first to the “not reasonably practicable” language of (c) in the statute quoted above, the Court began by noting that “not reasonably practicable” is not defined in the LLC Act.  Still, as the conduct at issue must be “relating to the limited liability company business,” the Court held that the “Legislature clearly did not intend that disagreements and disputes among LLC members that bear no nexus to the LLCs business will justify a member's expulsion under subsection 3(c).” Slip op. at 18.  Expanding on this theme, the Court wrote:

Significantly, the Legislature did not authorize a court to premise expulsion under subsection 3(c) 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 statue 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 for prospective harm: the LLC member’s conduct must be so disruptive that it is “not reasonably practicable” to continue the business unless the member is expelled.” Slip op. at 19.

In applying this test, “the court [is] 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.” Slip op. at 21. Detailing the factors to be considered in that analysis, the Court wrote:

In that inquiry, a trial court should consider the following factors, 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. Id. (footnote omitted).

            In this instance, as the New Jersey LLC Act has a default rule of majority rule, and as the respective ownership percentages of the members had been determined, but for narrow actions that by default require the unanimous approval of the members, the Court found that IE Test, LLC could operate.  Carroll’s conduct did not affect the LLC vis-à-vis third-parties, and it continued to financially flourish.    For those reasons, the trial court’s grant of summary judgment to IE Test LLC was reversed.

      Peter Mahler's review of this decision is available on his blog.  HERE IS A LINK to that posting.

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