What circumstances suffice to show that a member’s conduct has made it “not reasonably practicable to carry on the business” of the LLC as long as he or she remains a member? The New Jersey Supreme Court confronted that issue in IE Test, LLC v. Carroll, 226 N.J. 166, 140 A.3d 1268 (2016). The court unanimously ruled that absent an operating agreement addressing the issue, conflict among the members was not enough to show either “wrongful conduct . . . that adversely and materially affected the business” or that it was “not reasonably practicable” to carry on the [company’s] business with the person as a member” as required by the Limited Liability Company Act (LLCA). While dissension among members could make managing the company more difficult, the court reserved the drastic remedy of expulsion only for situations in which it was “unfeasible, despite reasonable efforts, to keep the LLC operating while the disputed member remains affiliated with it.” The decision gives a minority member increased leverage in LLC membership disputes that are not governed by an operating agreement, and thus provides a compelling reason why LLC members should have an operating agreement that addresses the grounds for dissociation.
The IE Test case arose out of a conflict among the three LLC members. The majority members, Cupo and James, were both engaged in the company’s operations, while the third member, Carroll, held a 33 percent interest and was more akin to the proverbial “silent partner.” The three men entered into a preliminary agreement setting forth their ownership percentages but an operating agreement was never finalized. Although the company’s revenues continued to increase, Carroll kept pressing the other members for compensation that would allow him to recoup some of his lost investment in a prior venture among the three men. Even though Carroll conceded that the company had no legal obligation to pay him, Carroll’s continued insistence on compensation led to dissension among the members. Ultimately, the two majority members filed an action in the company’s name seeking Carroll’s expulsion.
In the absence of an operating agreement, the default standards for member dissociation are governed by the LLC Act, N.J.S.A. 42:2B-24(b)(3) (which has been replaced by the identical provision in the Revised Uniform Limited Liability Company Act (RULLCA), N.J.S.A. 42:2C-46(e)(3)). The majority members asserted two statutory bases: subsection 3(a), which required “wrongful conduct” by a member that “adversely and materially affected the LLC’s business,” and subsection 3(c), which required conduct by a member that made it “not reasonably practicable to carry on the business of the LLC” as long as he remained a member. After discovery, the majority members sought partial summary judgment on those grounds. The trial court and the appeals court both agreed that the record did not show that Carroll had engaged in any actions that could amount to “wrongful conduct” or that his actions adversely impacted the business. Indeed, the revenues of IE Test grew despite the friction among the owners, and there was no showing that Carroll had interfered in the company’s business, disparaged the company or its management, or that the membership dispute prevented the company from taking any necessary corporate actions. However, both lower courts held that the company had met the “not reasonably practicable” standard under subsection 3(c), finding that the ongoing conflict might make it impossible for the majority members to obtain Carroll’s consent on essential documents and that Carroll’s continued involvement would generate further controversy and litigation. The New Jersey Supreme Court disagreed.
Writing for the court, Justice Anne M. Patterson reasoned that the Legislature intended to protect minority investors, especially in circumstances where the members could not agree on the terms of an operating agreement, by including default provisions for rule by the “majority of the interests” in the absence of such an agreement. While the Supreme Court agreed with the lower courts’ rulings that Carroll’s conduct did not rise to the level of “wrongful conduct” that had a material and adverse effect on the company under subsection 3(a), and that subsection 3(c) provided a more expansive standard, it did not believe the majority had met the “high bar” for judicial expulsion under 3(c).
The court believed that the “Legislature clearly did not intend that disagreements and disputes among LLC members that bear no nexus to the LLC’s business” would satisfy subsection 3(c). 226 N.J. at 181. That provision required that a court “prospectively analyze[ ] the impact of [the member’s] conduct on the LLC’s future” to determine whether the member’s conduct was “so disruptive, that it is ‘not reasonably practicable’ to continue the business unless the member is expelled.” Id. at 181-82. The court strictly construed the statutory language to prevent the majority from removing a minority member for pretextual reasons or simply because it would be “more challenging or complicated for other members to run the business with the LLC member than without him.” Id. at 182. Indeed, the court reasoned that because most disputes could be resolved by majority rule, the company could be effectively operated “despite an impasse among LLC members regarding the company’s management.” The court set forth seven factors to be considered in evaluating whether, in fact, the LLC could be run despite the conflict:
- 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 a 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.
Id. at 183. The court emphasized that this analysis called for “a case-specific analysis of the record, using those factors and any other considerations raised by the record, with no requirement that all factors support expulsion, and no single factor determining the outcome.” Id. at 184.
Given the facts before the Court in IE Test, the standard for expulsion under subsection 3(c) was not met. There was no showing that Carroll had interfered with the business or undermined its employees, vendors or clients. And, Carroll’s limited involvement in operations made it unlikely he could do so in a way that would threaten the viability of the business. Indeed, the business was able to operate despite the dissension among owners, and in fact was able to grow. Although the majority owners contended that the lack of an operating agreement impaired the company’s efforts to secure credit or bank financing, the court noted that the proofs did not substantiate these claims.
IE Test shows the court will closely scrutinize any attempt by the majority to expel a minority member under subsection 3(c) or its counterpart under RULLCA, N.J.S.A. 42:2C-46(e)(3). It remains to be seen, however, whether the court would impose the same high bar under slightly different facts. Suppose the minority member refused to execute loan documents needed for an expansion or plant modernization or new product line? What if the ownership discord led higher collateral requirements from a bank or more onerous financing terms? Could a disgruntled minority member essentially condemn the majority to operate on a “mom and pop” basis and forgo growth opportunities? What if the impact of the ownership conflict affected employee morale and productivity? Under IE Test, a court might still view these impacts, individually or collectively, as insufficient to make the continued operation of the LLC “infeasible, despite reasonable efforts.” Yet, denying dissociation would seem to condemn the majority members to bend to the whims of a disruptive minority, a result inconsistent with the majority rule provisions of the Act.
The risks and uncertainties of relying on the statutory judicial dissociation provisions as protection against a disgruntled member can be avoided (or at least significantly reduced) if members had a comprehensive operating agreement in place at the outset of any proposed LLC venture. An operating agreement could, and commonly does, eliminate the ability of any member to disrupt the company’s business by providing an express delegation of authority to a specified manager or managing members for all operations except for a narrow category of structural changes like merger, dissolution and so forth. An operating agreement could also set forth standards on member conduct, the breach of which would constitute grounds for termination of membership and trigger the buy-out of the member’s interest.
(A copy of this article previously appeared in the December 19, 2016, issue of the New Jersey Law Journal at page 51.)