Let us consider this not-too-unusual hypothetical situation: Three friends decide to start a business together, forming a limited liability company through which to conduct its affairs. They decide that the LLC will be member-managed rather than manager-managed, with each member having an equal voice in its affairs. After a year the honeymoon is apparently over, and two of the three members engage a lawyer to represent them in ousting the third member from the company (the company is currently represented by separate counsel). They tell their lawyer that the thirdmember has been lying to the company’s customers, missing deadlines, and ignoring various company policies and procedures. They have discussed these issues with him repeatedly, but rather than improving his conduct, their attempt at rapprochement has only caused him to become defensive and disagreeable.
Their lawyer reviews the company’s operating agreement and notes that it contains no provisions for dealing with the involuntary removal or buyout of a member nor any provisions dealing with how a deadlock among the members may be resolved. Indeed, all major decisions require unanimous member approval. The two disgruntled members know that such provisions were considered at the company’s inception but that they were ultimately rejected because each member was concerned that he might be “the odd man out.”
The lawyer tells his new clients, “I have good news and bad news for you.” The good news is that the third member can likely be removed under Section 35-45 of the Illinois Limited Liability Company Act (the “Act”). The bad news is that it will require litigation to do so. (And although this provision is not perfect, it is significantly better in this respect than the Delaware Limited Liability Company Act, which has no provision dealing with member expulsion.) Section 35-45 of the Act sets forth the bases for a member’s dissociation from an Illinois limited liability company, and although certain acts or types of conduct do not require judicial intervention, Subsection 6, the only provision relevant to the situation at hand, does require court action to expel a member from a member-managed LLC under the following circumstances:
“(6) On application by the company or another member, the member’s expulsion [may be effected] by judicial determination because the member:
(A) engaged in wrongful conduct that adversely and materially affected the company’s business; (B) willfully or persistently committed a material breach of the operating agreement or of a fiduciary duty owed to the company or the other members; or (C) engaged in conduct relating to the company’s business that makes it not reasonably practicable to carry on the business with the member.”
As noted above, expulsion of a member under Subsection 6 requires court approval. This means that the two members seeking removal of the third will have to initiate a lawsuit, with the expense and delay that entails. In addition to the costs and delays involved, the members instituting a lawsuit will likely be required to testify and to provide documentary evidence of the third member’s wrongdoing.
To prevail in an expulsion proceeding, the plaintiffs do not have to prove criminal acts such as theft or fraud, but only must prove acts pertaining to the continuing operation of the LLC or its business, which may or may not be criminal. There are no reported Illinois cases holding that a deadlock among the members is sufficient to remove the party now in the minority (indeed, there are no reported cases on expulsion at all). If there is a deadlock, members may have to seek dissolution of the LLC, which may also require litigation and which may have unwanted income tax and business consequences.
It should be noted that the expelled member will not be deprived of his economic interest in the company without compensation. The Act provides that the company shall be required to purchase the expelled member’s interest at its “fair value” and grants a court broad discretion for making a determination of fair value, permitting it to consider all “relevant evidence,” including going concern value, a recommendation by an independent appraiser and any formulas set forth in the operating agreement. In addition, the Act provides that if the purchase of the interest is not completed in accordance with its terms, the expelled member may petition to have the company dissolved.
One additional item of caution is the company’s continuing liability for acts of an expelled member. Under the Act, the expelled member may still be able to bind the company or subject it to liability for two years after his expulsion, where (i) a third person reasonably believed that the expelled member was still a member and (ii) did not have notice of that member’s expulsion. Therefore, if expulsion of this third member is successful, the remaining members should promptly notify the company’s suppliers, customers and other persons doing business with the LLC of this change in the company’s membership structure and of who has the power, and who doesn’t, to bind the LLC.
In sum, expulsion is an imperfect but sometimes necessary mechanism for an Illinois limited liability to rid itself of a rogue member. And the very existence of this mechanism may enhance the company’s leverage in negotiating a buyout of this member’s interest. The not-so-veiled threat is that the rogue member’s conduct will become a matter of public record in any expulsion proceeding and that the member will also incur what could become substantial expenses. But the aggrieved members had better have a solid case satisfying the statutory requirements against the other member or they may still be stuck with him, and if a court finds their suit to be in bad faith, they could be subject to paying the third member’s attorneys fees.
The alternative to attempting to expel the rogue member might be to dissolve the company or to settle with the rogue member on what may seem like unfavorable terms, simply to get rid of him. In a complex world, such decisions are often quite difficult. A good lawyer can be a great help. May we suggest a firm?