LLC Member Expulsion: What Hath Shapiro Wrought?

February 26, 2018

Unlike the LLC statutes in many other states, New York’s LLC Law does not authorize the LLC or any of its members to seek judicial expulsion of another member, no matter how egregious the member’s behavior. As the Appellate Division ruled in Chiu v Chiu, the only way to expel (a/k/a dissociate) a member of a New York LLC is if the operating agreement so provides.

A carefully tailored expulsion provision in an operating agreement, paired with a reasonably fair buyout, can provide a salutary mechanism for protecting the LLC against a member who engages in wrongful or illegal conduct, jeopardizes the LLC’s licensing or legal status, or consistently fails to perform his or her delegated responsibilities. On the other hand, an expulsion provision that uses subjective or overly broad criteria to define expulsion trigger events can encourage opportunistic behavior by the control faction against the minority, especially if expulsion is accompanied by a forced buyout of the expelled member on unfair financial terms. LLC guru Tom Rutledge wrote a very informative article on the topic, about which I interviewed him for my podcast, in which he gives a roadmap of the various considerations involved in designing and implementing an effective expulsion provision in an LLC agreement.

It’s one thing when all of the LLC’s members consent to an operating agreement authorizing member expulsion. However well or poorly drawn, however fair or unfair its terms, that’s called freedom of contract. You made your bed, now lie in it. But what about an operating agreement adopted by a control faction, without the consent of the minority, authorizing member expulsion at the control faction’s behest? Or how about an operating agreement with expulsion and lopsided buyout provisions adopted without minority consent, after the breakout of hostilities with the minority?

Which points back to Shapiro v Ettenson, a case I’ve written about several times before (here, here, and here). For those unfamiliar with the case, in Shapiro the lower and appellate courts construed LLC Law § 402 (c) (3) (“Voting Rights of Members”) as permitting holders of a majority interest in the LLC to adopt an initial, binding operating agreement long after the LLC was formed and commenced business, without the consent of the minority member. The operating agreement adopted in that case, among other things, converted the LLC from member-managed to manager-managed, authorized additional capital calls, the dilution of the membership interest of a non-contributing member, and member expulsion for cause.

The Post-Decision Expulsion in Shapiro

The minority member in Shapiro brought suit in 2014, after the majority terminated his salary and issued a capital call, both of which actions were based on the operating agreement adopted without the minority member’s consent. In January 2017, exactly one week after the Appellate Division affirmed the lower court’s decision validating the operating agreement, the majority members voted to expel the minority member under Article 13 which authorizes expulsion of a member who:

• “has materially breached this Agreement” or “failed or refused to perform his duties and responsibilities as a Manager or Member,” and where such breach or failure is not cured within 30 days of written notice;
• “breaches his fiduciary duties to the Company or the other Members or engages in unlawful conduct in his capacity as a Manager or Member”; or
• “engages in unauthorized or other bad faith conduct which has a material adverse impact on the business or affairs of the Company.”

The notice of expulsion (read here) cited as grounds the minority member’s alleged failure to perform his duties and “unauthorized and other bad faith conduct.” The latter conduct was cited as justification for not giving the minority member a 30-day notice to cure. As best as one can tell from the notice, which does not specify dates, the minority member’s cited conduct took place both before and after the adoption of the contested operating agreement.

The notice also offered to redeem his “former membership interest” for $76,900 in accordance with Section 13.03 of the operating agreement which further provided for mandatory arbitration of the redemption payment in the event the parties failed to reach agreement on price within 30 days after the expulsion. The arbitration provision expressly constrains the parties from submitting anything to the arbitrator other than their “final proposed Expulsion Redemption Terms” and limits the arbitrator to “awarding only one or the other of the two positions submitted but no other position.” Whether the provision precludes the parties from submitting professional appraisals in support of their positions or other evidence bearing on the LLC’s value is open to interpretation, I suppose.

Not surprisingly, the minority member’s response to the notice denied the existence of valid grounds for his expulsion and asserted his continued membership interest. In July 2017, shortly after the minority member exhausted all further appellate remedies in his original lawsuit, he filed a new lawsuit claiming that the majority had expelled him on “pretextual” grounds and seeking an accounting and other remedies.

There is nothing in the available court records to indicate whether the parties have attempted to reach agreement on the “fair value” of the minority member’s interest (much less, to arbitrate the question), likely due to the minority member’s refusal to recognize the validity of his expulsion.

Meanwhile, the majority members filed a motion to dismiss the minority member’s second lawsuit principally based on the asserted validity of his expulsion for cause, as authorized by the operating agreement. As of this writing, the motion to dismiss remains pending.

The Expulsion in Ho v Yen

After Shapiro, I made the hardly bold prediction that controllers of other LLCs, lacking a written operating agreement and experiencing turmoil within their member ranks, would follow suit by adopting, without minority member consent, operating agreements with expulsion and mandatory buyout provisions. I also wondered to what extent controllers would push the envelop by lowering the threshold for expulsion and/or cramming down buyout terms unfavorable to the expelled member.

Since then, I’ve received a number of anecdotal reports of LLC controllers doing just that upon the advice of their counsel. It also didn’t take long for one of Shapiro‘s offspring to show up in court.

Ho v Yen, which I previously featured in my recent Winter Case Notes edition, involved an LLC formed by its three founding members in 2014, without a written operating agreement, for the purpose of acquiring and developing a property located in Flushing, New York. The property seller and the LLC entered into a $17 million contract of sale in 2014 but the closing was delayed until July 2017. In the interim, the LLC obtained the right to lease a portion of the property. The two defendant members, holding a majority interest in the LLC, accused the plaintiff member of misappropriating rents.

In March 2017 — two months after the Appellate Division’s Shapiro decision — the defendant members adopted an operating agreement (read here) with an expulsion provision not all that different from the one in Shapiro, except without a 30-day notice to cure.

It also included a mandatory buyout of the expelled member’s interest, fixing a purchase price equal to the “book value” of the member’s interest as of the end of the preceding fiscal year (excluding certain specified items such as good will and reserves for contingent liabilities) “as determined by the Company’s accountants, whose determination shall be conclusive and binding on the parties.”

Only four days after adopting the operating agreement, the defendant majority members sent the plaintiff minority member a “Notice of Member Expulsion” (read here) expelling the plaintiff based on his alleged misappropriation of rents totaling $120,000. The notice went on to explain that since the “book value” of the plaintiff’s membership interest was no more than his $60,000 capital contribution, the LLC owed him nothing for his interest and was keeping the $60,000 as an offset against damages owed by the plaintiff to the LLC.

The plaintiff minority member subsequently brought suit against the majority members, denying that he misappropriated rents, alleging that the property’s value had increased to $30 million, seeking a declaration that he holds a one-third interest in the LLC, and claiming that the majority members’ purported expulsion of him was unjustified, done in bad faith, and that the allegations of misappropriation were “concocted” for the purpose of excluding plaintiff from the company and its plans to develop the highly valuable property.

As noted in my previous write-up of the case, last November the court denied the plaintiff’s motion for a preliminary injunction “reinstating” him as a one-third member with the co-equal right to participate in the LLC’s management. Among other reasons for denying interim relief, the court found that the plaintiff failed to offer “clear and convincing” evidence that he “has a 33% membership interest in the company and that he was wrongfully expelled.”

As in Shapiro, the defendants filed a motion to dismiss the complaint which currently is pending before the court.

Closing Thoughts

Unless and until the Court of Appeals or one of the other departments of the Appellate Division rules otherwise, Shapiro is the “law of the land” in New York when it comes to permitting majority interest holders to adopt binding, post-formation LLC agreements without the consent of all members.

At the same time, I think we’re in the very early stages of post-Shapiro case law development in which courts will be asked to apply heightened scrutiny to the actions of controlling LLC factions in adopting non-consent operating agreements containing capital call, expulsion, mandatory redemption, and other provisions the design and implementation of which are susceptible to allegations of opportunism and self-interest, especially when such agreements are adopted and applied retroactively against minority members amidst open hostilities.