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