Business relationships can be like some marriages – they’re great . . . until they aren’t. In an ideal world, both sides in a relationship would recognize that something isn’t working and agree to call it quits. When business partners separate on good terms, it is usually because an LLC member simply retires or decides to change careers. More commonly, however, the need to remove another member arises where he or she commits a breach of conduct, damages the company’s goodwill, or has a dispute with other LLC members.
When members decide that somebody within their ranks must leave the company, an LLC has two main options: (1) negotiate a buyout of the offending member’s interest in the LLC; or (2) attempt to remove the member involuntarily, either pursuant to the LLC’s governing documents or applicable state law.
Negotiating a Buyout
The best-case scenario when an LLC member has done something wrong is for that member to withdraw voluntarily from the company. Unfortunately, like trying to convince your slacker roommate to move out, it is also the least likely. The LLC could instead negotiate a buyout deal on a voluntary basis. While this would keep the matter out of court, saving time, money, and headaches, the disadvantage is that the offending member may have little incentive to cooperate or negotiate in good faith.
Expelling a Member
(a) Pursuant to the Operating Agreement
If the member is not willing to withdraw voluntarily, the next best scenario is having an operating agreement that provides a procedure to expel that member. While you may have picked the wrong business partner, pat yourself on the back for hiring an attorney who explained the need to include an expulsion clause in your operating agreement. The usual method of involuntary removal is a vote by the other members followed by a buyout based on the departing member’s interest or share in the company. Member buyouts can be addressed in a buy-sell agreement or another internal governing document. And where there are only two members of an LLC, the importance of a deadlock provision cannot be overstated. For other critical operating agreement provisions, see “Do You Really Need An Operating Agreement And Why The Answer Is Yes.”
(b) Pursuant to State Law
If the LLC lacks an operating agreement that specifies a method for involuntarily removing a member, and if a voluntary departure cannot be negotiated, the removal will need to be resolved judicially in accordance with state law.
Kentucky follows the expulsion standard in the Revised Uniform Limited Liability Company Act (“RULLCA”), which provides three situations in which a court may order the expulsion of a member:
- The member engages in “wrongful conduct” that “adversely and materially” affects the company’s activities.
- The member has “willfully or persistently” committed a “material breach of the operating agreement” or materially breached their duties to the company.
- The member engages in conduct that “makes it not reasonably practicable to carry on the activities and affairs with the person a member.”
Importantly, in cases where the court acts to expel a member from an LLC (referred to as “disassociation”), the member does not necessarily lose all of their rights and interests. Although they lose the right to participate in the LLC’s activities and no longer have fiduciary obligations, they are still entitled to receive distributions.
Dissolving the LLC
If the LLC in question does not have a carefully crafted operating agreement, with deadlock provisions and/or a buy-sell agreement, the only remaining option may be to seek judicial dissolution of the LLC. Upon request, a court will oversee the dissolution of the LLC, ensuring that its creditors get paid and its remaining assets are distributed among members. It should come as no surprise that having a judge determine how your company shuts down is far from ideal.
Final Steps
Once an LLC member has left the company, whether voluntarily or involuntarily, the company’s records should be updated to reflect the change. This may involve filing documents with the state where the company operates, as well as notifying financial institutions, insurance companies, investors, the Internal Revenue Service, and other stakeholders.
We Can Help
Let’s make sure that your operating agreement protects you and your LLC. Call English & English today for help drafting your new operating agreement or fixing the one you already have.