Be Careful What You Say. It May Get You Expelled From Your LLC.
April 26, 2021
Now that I’ve got your attention, relax. At least for New York LLCs, a member can be expelled from an LLC only if expressly authorized by the operating agreement.
In my experience, expulsion provisions in LLC agreements are relatively rare, arguably for good reasons. For one, prospective, non-controlling participants in an LLC generally are loathe to subject the certainty of their investment to the discretion of a controlling member or members who have an inherent self-interest when deciding whether an expulsion trigger has occurred. For another, the financial terms of expulsion provisions tend to be punitive, returning to the expelled member substantially less than the fair value of their interest in the LLC as a going concern.
I’ve previously written about cases in which New York courts enforced expulsion provisions in LLC agreements for misappropriation of company funds, for felony conviction, and for material breach of the LLC agreement. Earlier this month I came across another case, one might say, that pushes the envelope to include a member’s statements made to third parties complaining about the LLC managers’ claimed failure to provide information in breach of the operating agreement. The statements allegedly constituted ground for expulsion under an expansive provision covering “any act or omission which, in the reasonable judgment of the Managers, is in bad faith and is detrimental to the interests of the Company, its Members or its Managers.”
Earlier this month, in Jacobowitz v Gutnick, a Brooklyn Supreme Court judge found that the challenged statements were non-actionable opinion and dismissed defamation claims brought by the plaintiff LLC and its managers against the defendant expelled member. The court nevertheless refused to dismiss the plaintiffs’ claim for a declaratory judgment enforcing the expulsion, holding that the non-defamatory nature of the statements is not determinative whether, in the “reasonable judgment of the Managers,” the defendant’s statements constituted bad-faith acts detrimental to the LLC, its managers, or members. Let’s take a closer look.
The Expulsion Provision
The defendant Mr. Gutnick and the plaintiffs Messrs. Jacobowitz and Jacobson are business partners in a number of LLCs that own commercial real estate. One of them is 1704 Ocean Avenue LLC in which Mr. Gutnick through his separate company acquired a non-managing membership interest in consideration of an initial $1,125,000 capital contribution.
Section 8.5 of the LLC’s operating agreement, entitled “Removal of Member,” states:
In the event that any Member of the Company or, for any Member which is an Entity, then in the event that any manager, officer, director, trustee, member, shareholder or beneficiary of such Member, (i) is convicted of a felony, misdemeanor or other crime (other than a minor traffic violation) (ii) engages in any act involving dishonesty or moral turpitude, or (iii) engages in or performs any act or omission which, in the reasonable judgment of the Managers, is in bad faith and is detrimental to the interests of the Company, its Members or its Managers, then the Managers, upon written notice, shall have the right to remove and expel such Member (the “Removed Member”) from the Company. With seven (7) days of notice of such removal, the Company shall pay to the Removed Member the full balance of his Capital Account less (i) any reserve which the Managers determine is reasonable and necessary and which shall be no more than any reserve withheld from other similarly situated Members; and (ii) any amount which the Managers, in their good faith judgment, believe is owed to the Company by such Removed Member, include to compensate the Company for damages sustained by reason of the conduct described in the Subsections (i) through (iii) of this Section 8.5. The Company shall also pay to such Removed Member all distributions, and shall allocate to such Removed Member income, gains, losses, deductions and credits, based on the Removed Member’s Capital Account through the date on which the payment for the Removed Member’s Capital Account is made in accordance with the immediately prior sentence of this Section. [Italics added.]
As recited in the court’s decision, Mr. Gutnick sought from Messrs. Jacobowitz and Jacobson as managers certain information about the LLC’s business affairs. Allegedly they did not comply, prompting Mr. Gutnick to seek a ruling from a rabbinical court. After Messrs. Jacobowitz and Jacobson did not appear before the rabbinical court, Mr. Gutnick sent an email and text messages to their real estate lawyer and to a number of real estate investors stating that Messrs. Jacobowitz and Jacobson were “not being transparent” and were “blatantly in breach” of the operating agreement by not providing him with requested information.
Messrs. Jacobowitz and Jacobson responded by sending Mr. Gutnick a written notice of his expulsion from the LLC. The notice tracked the language of Section 8.5 but did not specify any wrongful acts by Mr. Gutnick. Several days later, the lawyer for Messrs. Jacobowitz and Jacobson sent a letter to Mr. Gutnick in which he cited the prior expulsion notice and referred to “phone calls . . . and the many e-mails and texts which you have sent, to business associates, brokers, professionals and employees of the Company and the Managers . . . and the threats you have made against the Managers.”
The letter went on to describe reputational harm and other “damages” to the LLC as determined by the managers “in good faith”; that the managers determined that the LLC’s damages “exceed the balance” in Mr. Gutnick’s capital account; and, in so many words, that Mr. Gutnick is entitled to no compensation or further distributions on account of his forfeited membership interest.
Shortly after sending Mr. Gutnick the expulsion notice and lawyer’s letter, Messrs. Jacobowitz and Jacobson in their own names and in the LLC’s name filed a complaint against Mr. Gutnick seeking $20 million in damages for defamation and for a judgment declaring that the LLC need not return Mr. Gutnick’s capital account.
Mr. Gutnick responded with a motion to dismiss the complaint for failure to state a valid claim. His motion argued that the alleged defamatory statements were non-actionable opinions and that the dismissal of the defamation claims necessarily required dismissal of the declaratory judgment claim concerning his capital account.
The plaintiffs opposed the motion, arguing that Mr. Gutnick made false statements of fact, not opinion. They also argued that whether Mr. Gutnick’s statements were defamatory under common law was an entirely different question as to whether Messrs. Jacobson and Jacobowitz used reasonable judgment in deciding that Mr. Gutnick’s actions were detrimental to the LLC and whether they used their good faith judgment in determining the amount owed to compensate for the detrimental actions.
The court rendered a split decision, dismissing the defamation claims but allowing the declaratory judgment claim to go forward.
As to the former, the court found that “the gist of defendant’s statements is that the plaintiffs breached a contract, i.e., the operating agreement” and that “such statements are either true or nonactionable opinion.”
As to the latter, the court agreed with the plaintiffs that “[t]he fact the statements were not defamatory under the law is not determinative” to the application of Section 8.5’s expulsion provision. The court explained:
One of the pivotal issues with respect to the cause of action for a declaratory judgment is whether Mr. Gutnick “engage[d] in or perform[ed] any act or omission which, in the reasonable judgment of the Managers, [was] in bad faith and . . . detrimental to the interests of the Company, its Members or its Managers.” Contrary to defendants’ contention, simply because the plaintiffs did not allege a viable cause of action for defamation is not determinative even though the plaintiffs’ claim stated in paragraph 59 that they are entitled to “a declaratory judgment that the damages sustained as a result of Gutnick’s defamation exceeds the balance of [Gutnick’s] capital account . . .”
. . . Thus, one of the critical issues in the declaratory judgment action is whether the statements made by Mr. Gutnick to the third-parties, in the reasonable judgment of the Managers, were made in bad faith and detrimental to the interests of the Company, its Members or its Managers.
It’s unclear from Mr. Gutnick’s court filings whether, going forward, he will contest his expulsion or only the amount due him from the LLC upon his expulsion, i.e., his capital account and any outstanding profit share due him. As of this writing, Mr. Gutnick hasn’t yet filed his answer to what remains of the complaint or any counterclaim.
The Yin and Yang of Expulsion Provisions
In a post I wrote ten years ago about an expulsion case, this is how I described the positive and negative of expulsion provisions in LLC agreements:
The inclusion of a for-cause expulsion provision in the LLC agreement is a delicate matter to be carefully considered on all sides when the agreement is under negotiation. Sure, it’s nice for the majority to have the power to expel, but particularly in a very small company where the members work closely together, the specter of expulsion of the minority member based on some finding of misconduct, especially if on financial terms highly unfavorable to the expelled member, can poison inter-member relations and the company’s long-term prospects for stability and success.
More recently, in a post about my podcast interview of LLC (and all-around) guru Tom Rutledge, I linked to his informative article highlighting the complex issues surrounding LLC member expulsion. Under the subheading “Where You Stand Depends on Where You Sit,” Tom wrote:
In considering expulsion provisions, attention must be paid to the particular circumstances of the client. While uncertainty as to whether a particular member will be the one expelled versus one who remains with the company may balance the competing pressures for a high-versus-low threshold for expulsion and high-versus-low payout upon expulsion, that is not the only dynamic at issue. There are as well questions involving: (a) the basis for expulsion; (b) the threshold to trigger expulsion; (c) the forum for effecting an expulsion; (d) the effect of expulsion; and (e) the question of judicial review (or arbitration) of the validity of the basis for expulsion.
I don’t think there’s much debate about the usefulness of an expulsion provision triggered by a member’s fraudulent theft of company funds or a felony conviction, like the one in the Tradesman case, where the conviction poses an existential threat to the LLC due to licensing or other regulatory requirements.
On the other end of the spectrum is an expulsion provision like the one in Jacobowitz v Gutnick, authorizing expulsion for any act deemed “detrimental” by the managing members, with the fuzzy, non-self-enforcing standard of reasonableness being the only check on their decision to expel. The provision’s further grant of broad discretion to the managing members, to withhold from payment of the expelled member’s capital account an amount for “reserves” and for “damages” determined by the managing members, heightens the conflict of interest inherent in the decision to expel.
Member expulsion is a loaded issue, but that’s not a reason to shy away from it when entering into a LLC agreement. Ideally, should co-owners decide there’s need for an expulsion provision, they should strive for one that dis-incentivizes and protects against acts and events that pose serious harm to the company while ensuring that those making the decision to expel are not abusing the expulsion power out of self-interest, which also implicates the fairness of the payout to the expelled member.