Court Enforces LLC Agreement’s “Naked” Expulsion Clause
October 26, 2020
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Unlike states that have enacted the Uniform Revised LLC Act with its provisions for judicial expulsion of an LLC member, New York’s LLC Law contains no such provision. Instead, in New York, only non-judicial expulsion is recognized and only if authorized by the operating agreement.
Until now, New York judicial precedents addressing the expulsion of an LLC member generally fall into one of two categories. First, there are those in which the operating agreement is completely silent on member expulsion, in which event the courts disallow attempts to expel a member. Chiu v Chiu is the leading appellate case for that proposition. Here’s another.
Second, there are cases in which the operating agreement expressly authorizes member expulsion for defined causes involving breach of duty and other misconduct, in which event the disputes center on whether the expelled member’s conduct falls within the defined causes. Harker v Guyther is one of the better examples in this category. Here’s another.
Thanks to a ruling this month by the Brooklyn-based Appellate Division, Second Department, in Garcia v Garcia, we can now welcome a third category of expulsion case, which we’ll dub cases involving a “naked” expulsion clause. Why naked? The LLC agreement includes the single word “expulsion” as an event of member dissociation but contains no provisions expressly addressing the grounds or procedure for expulsion.
In Garcia, the appellate panel affirmed the lower court’s ruling enforcing the majority members’ vote to expel a minority member accused of diverting company funds. The court also affirmed the lower court’s determination of the value of the expelled member’s interest in two LLCs.
A Fractured Family-Owned Business
Garcia involves a litigation saga that began in late 2010 when Joaquin Garcia and his son Michael Garcia sued Joaquin’s brother Peter Garcia for money damages, alleging that he misappropriated $2 million from two realty-holding LLCs co-owned by the three of them. Peter quickly followed with his own lawsuit against Joaquin and Michael seeking dissolution of their companies and the appointment of a receiver to liquidate the remaining realty assets.
In 2011, with the litigations in full swing, Joaquin and Michael as majority members voted to expel Peter as a member and manager of the LLCs based on his allegedly unauthorized withdrawal and use of company funds. The vote to expel Peter was based on identical provisions in the article of the two companies’ operating agreements entitled “Dissociation,” providing that “A Person shall cease to be a Member upon the happening of any of the following events: (a) the withdrawal, retirement, or expulsion of a Member.”
It is the only reference to expulsion in the agreements. The operating agreements do not specify grounds for expulsion or set forth any mechanism or procedure specifically addressing member expulsion. The agreements do provide that a dissociated member is entitled to be paid his proportionate share of the value of the LLCs as of the date of dissociation.
The Lower Court’s Rulings
Peter contested his brother’s and nephew’s allegations of financial wrongdoing and that there were grounds for expelling him. More fundamentally, Peter argued that the naked expulsion clause gave them no authority to expel him even assuming he had engaged in the alleged wrongdoing. Other remedies such as money damages, he contended, were available for breach of the LLC agreements or common-law duties.
In late 2011, the lower court issued a lengthy decision and order denying Peter’s application to enjoin Joaquin and Michael from taking any steps to expel him pending the litigation. The ruling also cut off company payments to Peter that had been previously ordered by the court.
The court reached its conclusion regarding expulsion on two bases. First, it reasoned that the operating agreement’s omission of a mechanism for expulsion did not defeat Joaquin’s and Michael’s authority to expel Peter “since a procedure for expulsion can be reasonably implied from the terms of the Operating Agreement.” The court found such implication in the agreements’ voting provisions generally authorizing member action by vote of a majority of the membership interests except for specified decisions — not including expulsion — requiring the members’ unanimous consent.
Second, citing a number of New York and out-of-state case precedents not necessarily involving LLC member expulsion, the court reasoned that “the fact that expulsion may be accomplished by a majority vote does not leave minority members unduly exposed to the risk of expulsion since an implied condition of any such expulsion is that it would be for cause.”
In 2015, after a lengthy delay due to Peter’s interim bankruptcy filing, a Special Referee held a framed-issue hearing on the validity of Peter’s expulsion, ultimately agreeing with the reasoning of the court’s 2011 decision in determining that the expulsion “was proper in that it was voted on by a majority of the membership interest in each company, and was for cause.”
In late 2016, Brooklyn Commercial Division Justice Lawrence Knipel held a hearing to determine the value of Peter’s 45% interest in one of the LLCs and his one-third interest in the other, net of monies found due from Peter to the companies. The hearing featured testimony and reports by each side’s realty appraisers. The combined top-line value of the two LLCs’ portfolios, according to Peter’s expert, was approximately $28 million versus approximately $22 million as concluded by Joaquin’s and Michael’s expert.
Justice Knipel determined the value of the two LLCs by adding to Peter’s expert’s valuation 25% of the differential between the two expert valuations, also applying a 5% discount. In March 2017, the court entered judgment awarding Peter approximately $2.4 million for his interests in the two LLCs, net of certain loans, other offsets, and about $1.8 million disproportionate distributions that he did not dispute taking.
Peter’s Unsuccessful Appeal
Peter’s appeal from the judgment sought reversal of the lower court’s judgment and orders (a) enforcing his expulsion and (b) determining the net value of his membership interests. I’ll only address the former issue, especially since the portion of the appellate decision addressing valuation said nothing of substance beyond noting that the lower court “providently exercised its discretion” and finding “no basis to disturb the court’s determination.”
Peter’s challenge to his expulsion, as set forth in his opening and reply briefs (read here and here), primarily argued that the operating agreement’s one-word reference to expulsion as a dissociation trigger event “is not a grant of any ‘power’ or the designation of any ‘process’ that is necessarily presently exercisable,” and thus “the naked mention of the word, ‘expulsion’ cannot fairly be read as a present grant of authority to expel.” Instead, he continued, “the words, as written, assume a pre-existing, or external grant of such power and thus indicate a contingent possibility.” Therefore, he concluded, neither by express language nor by any permissible inference do the agreements grant a “present power to expel [Peter] — for cause or otherwise.”
Peter offered several additional arguments challenging the lower’s court’s construction of the expulsion clause. One was that, under common-law principles, “courts are, and should be loath to, extinguish an owner’s right to property by implication” or “by implication [to] supply, or add to, a contract unless the parties have invited such assistance.” Another was that the use of the term “expulsion” in the operating agreements “was likely intended solely for tax purposes” having to do with the need to avoid certain corporate characteristics (i.e., to fail the test for continuity of life) prior to the IRS’s adoption of check-the-box.
Joaquin’s and Michael’s appellate brief (read here) countered:
- The term “expulsion” takes its ordinary dictionary meaning of an involuntary removal. It is not ambiguous.
- Adopting Peter’s position would render the operating agreements’ use of the term “expulsion” meaningless, contravening a basic rule of contract construction.
- The operating agreements’ provision for member voting states the procedure for expelling a member.
- The operating agreements’ provision setting forth the members’ “standard of care” (mimicking the language found in LLC Law § 409 mandating manager duties) establishes the standard for expulsion of a member.
After reciting the case background and procedural history, the appellate panel’s decision found “without merit” Peter’s contention that the Special Referee erred in concluding he had been properly expelled. Observing that the LLC Law “reflects legislative deference to the parties’ contractual agreement,” the court continued:
Here, contrary to Peter’s contention, the operating agreements for both [LLCs] did state that dissociation of a member would occur upon the expulsion of said member and, thus, the inclusion of that language in the operating agreement clearly and unambiguously established the parties’ intent to allow for the removal of a member. Although the operating agreements did not contain a detailed mechanism for expulsion, and the Limited Liability Company Law does not contain a default provision that could gap-fill, expulsion could nevertheless be accomplished under the procedures contained in the operating agreements. The operating agreements each provided that any action taken on behalf of the LLC was to be taken by a majority vote of the members. It is undisputed that Michael and Joaquin each voted to expel Peter at duly noticed meetings of the LLCs, which Peter attended. As such, we agree with the Special Referee’s conclusion that Peter’s expulsion was proper under the terms and provisions of the operating agreements. [Citations omitted.]
One can only wish the court had expanded on its analysis, particularly in regard to Peter’s contention that the agreements’ omission of grounds for expulsion renders the clause unenforceable. The decision makes no reference to the lower court’s incorporation of a for-cause requirement as an “implied condition” of expulsion. For that matter, the decision’s legal discussion makes no reference to grounds for expulsion, period.
Will We See More Naked-Expulsion-Clause Cases?
The naked expulsion clause in Garcia is not one I’ve previously encountered in my own practice or in the reported New York cases involving expulsion of LLC members. That’s not to say there aren’t plenty of agreements out there with similar clauses; I would have no way of knowing about the ones that don’t result in publicly-filed lawsuits.
The LLC agreements in Garcia, which I haven’t laid eyes on, apparently date from the late 1990’s, that is, during the infancy of New York LLCs which weren’t legislatively enabled until 1994. The dates of the agreements also roughly coincide with amendments to the LLC Law, adopted in the wake of the IRS’s check-the-box rule made effective in 1997, that flipped the default rule under Section 701 (non-judicial dissolution) to provide for perpetual existence of LLCs generally as well as specifically following the “death, retirement, resignation, expulsion, bankruptcy, or dissolution” of a member.
It should be noted that Section 701’s reference to “expulsion” in the context of non-judicial dissolution is the only place the term appears in the LLC Law. Section 606 addresses member withdrawal, not expulsion. The counterpart provision in Section 62 (1) (d) of the Partnership Law dictates non-judicial dissolution “by the expulsion of any partner from the business bona fide in accordance with such a power conferred by the agreement between the partners.”
My best guess (which could be completely wrong) is that the LLC agreements in Garcia either were first-generation, pre-amendment, “boilerplate” forms purchased from one of the several purveyors of legal forms, or were prepared by a lawyer who re-used and adapted a pre-amendment form. If I’m right, there may well be a kernel of truth to Peter’s contention that the inclusion of the word “expulsion” in the agreements’ dissociation article, like the presence of that word in pre-amendment Section 701, derives from the uncertainty surrounding partnership tax treatment of LLCs that preceded the IRS’s adoption of check-the-box.
To be clear, I’m only theorizing how the language in the form might have originated. I’m not suggesting that a tax concern either by itself or with other concerns does or does not shed light on the parties’ intent in including the naked expulsion clause, or that such concerns would be relevant unless the expulsion clause was found to be ambiguous.
In any event, I’m not predicting a flood of Garcia-like cases in the aftermath of the court’s recent ruling. We’re now 26 years post the LLC Law’s enactment during which LLCs have supplanted closely held corporations as the entity of choice for most new business ventures in New York and across the country. With time, experience, and the benefit of the growing body of LLC case law providing guidance, it’s my view that, overall, the caliber of LLC agreement drafting has improved markedly. I also think this is especially true in regard to the provisions of LLC agreements that deal with the transferability and termination of membership interests, as that area has been especially fertile ground for litigation and thus judicial precedents.
While there may be some additional naked-expulsion-clause cases down the pike, I think we’re more likely to see expulsion cases of the Harker v Guyther variety involving LLC agreements that expressly define the grounds and procedure for expulsion.