In most states, limited liability companies are creatures of contract, with the underlying limited liability statute providing only gap-fillers and guardrails. One issue that is often neglected at the creation of an operating agreement for a limited liability company is expulsion of a member. Many states do not provide for expulsion of a member by statute but permit it if provided for in the operating agreement.[1]
Expulsion has several components that should be considered at the drafting of the operating agreement because in most states it cannot be created later.
First, the operating agreement must expressly provide for expulsion.[2]
Second, the operating agreement must provide the grounds for expulsion. These grounds will often be interpreted against the backdrop of certain well-worn legal standards associated with corporate duties. For example, “willful misconduct” or “wrongful misconduct” is construed in Delaware to correspond with the “traditional duty of loyalty.”[3] So if the drafter intends a broader (or stricter) ground than these legal standards, the operating agreement should say that, such as “willful misconduct means any of the following…and is not limited to breach of the duty of loyalty.”
Third, the operating agreement should provide for whether the expelled member is compensated for their membership interest as part of the expulsion. This could depend on the grounds for expulsion. For example, willful failure to contribute could result in forfeiture, but willful misconduct could not. Again: this all depends on the language of the operating agreement. But if forfeiture without compensation is intended as a potential consequence then that must be expressly stated because forfeiture is generally disfavored.[4] If there are conditions for forfeiture, they should be clearly stated.[5]
Fourth, the procedure for expulsion should be clear in the operating agreement. Is a meeting required? Or just a written vote by a certain percentage of members? What percentage? Should the expulsion be required to contain express reasons? Are the expelling members limited to those reasons in a subsequent challenge? If these questions are not answered in the operating agreement, a reviewing court will answer them and different courts take different approaches. Some permit “after-acquired evidence” to justify expulsion. Others do not. Some hold the expelling members to their stated reasons. Others permit discovery to provide the reasons.[1] If the operating agreement does not answer the questions above, there is a relative lack of predictability about how a challenge to the expulsion will be reviewed. This can be avoided by simply answering the questions above in a clear way in the operating agreement.
Fifth, the operating agreement should specify who has the burden of proof in a challenge to expulsion. While it might seem that the plaintiff— the expelled member— should have the burden, some states construe expulsion differently and put the burden on those defending the expulsion because they are exercising a contractual right to effectively terminate a contract.[2]
Sixth, drafters should be wary of fee-shifting clauses for expulsion or clauses that could be construed as fee-shifting, such as indemnification. The operating agreement should plainly state whether an expulsion challenge is fee-shifting for the prevailing party so that there is predictability in not just what will be relevant in a subsequent challenge but the exposure of all involved.[3]
Ultimately, in most states, expulsion is a pure matter of contract.[4] Failing to answer the questions above in an operating agreement will render an expulsion less predictable and more prone to challenge and reversal.
[1] See Robinson v. Darbeau, 2021 Del.Ch. LEXIS 36 at *18-19 (Ch. Mar. 1, 2021) (Delaware). New Jersey provides that a court may expel a member if certain conduct is established, but that is different from the right to expel without court intervention. See e.g. N.J.S.A. 42:2C-46(b), 48. California has a similar provision. Cal Corp Code § 17706.02.
[2] Dissociation is different than expulsion; former merely provides for a member to be removed from voting or other rights in the limited liability company, not removed as a member. See N.J.S.A. 42:2C-46.
[3] See In re Cadira Grp. Holdings, LLC Litig., 2021 Del.Ch. LEXIS 151 at *26-27 (Ch. July 12, 2021); Feeley v. NHAOCG, Ltd. Liab. Co., 62 A.3d 649, 664 (Del. Ch. 2012).
[4] See e.g. Cantor Fitzgerald, Ltd. P’ship v. Ainslie, 312 A.3d 674, 692 (Del. 2024).
[5] See e.g. Thomas v. Headlands Tech Principal Holdings, Ltd. P’ship, 2020 Del.Super. LEXIS 2832 at *14-15 (Sup. Ct. Sep. 22, 2020).
[6] See e.g. 2009 CAIOLA Family Tr. v. PWA, Ltd. Liab. Co., 2015 Del.Ch. LEXIS 262 at *46 (Ch. Oct. 14, 2015); Davenport Grp. MG, L.P. v. Strategic Inv. Partners, 685 A.2d 715, 723 (Del. Ch. 1996).
[7] See State Farm Mut. Auto. Ins. Co. v. Spine Care Del., LLC, 238 A.3d 850, 860 n.55 (Del. 2020); Buck v. Viking Holding Mgmt. Co. LLC, 2024 Del.Super. LEXIS 660 *16-17 (Ch. August 16, 2024); AB Stable VIII LLC v. Maps Hotels & Resorts One LLC, 2020 Del. Ch. LEXIS 353 *134 (Ch. Oct. 28, 2020); Hexion Specialty Chems., Inc. v. Huntsman Corp., 965 A.2d 715, 739 (Del. Ch. 2008).
[8] See e.g. Deere & Co. v. Exelon Generation Acquisitions, Ltd. Liab. Co., 2016 Del.Super. LEXIS 588 at *3 (Super. Ct. 2016). [1] See e.g. Garcia v. Garcia, 187 A.D.3d 859, 862 (NY App. Div.) (expulsion by contract in New York).
[9] See e.g. Garcia v. Garcia, 187 A.D.3d 859, 862 (NY App. Div.) (expulsion by contract in New York).