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NJ Supreme Court Clarifies Standard for Member Expulsion under LLC Act

by   |   February 14, 2017

One of the features of the Revised Uniform Limited Liability Company Act (RULLCA) that has been adopted in Minnesota and many other states is that it allows for an LLC to expel a member by judicial order under certain circumstances. One of the triggers for expulsion requires a finding by the court that it is “not reasonably practicable to carry on” the LLC’s activities with the person remaining as a member.   So far, there is little judicial guidance on how to analyze and apply the “not reasonably practicable” standard, and the RULLCA commentary does not provide guidance, either. But in 2015 a New Jersey state court decision seemed to indicate that proving that standard was a relatively low bar that required the court to engage in predictive analysis and merely come up with potential drawbacks or impracticalities that might result from the member’s continuing membership.  In late 2016, the New Jersey Supreme Court reversed that decision, and in doing so established that the “not reasonably practicable” standard is a high bar, providing a set of seven factors that should be considered when evaluating whether the standard has been met. Due to the scant case law, there is a high likelihood that a court considering this question in jurisdictions outside of New Jersey will at least consider the New Jersey opinion (just as the New Jersey Supreme Court itself considered some Colorado case law in deriving its seven-factor test) in analyzing an expulsion claim.

IE Test, LLC v. Carroll, 226 N.J. 166 (2016), involved three individuals, Kenneth Carroll, Patrick Cupo, and Byron James. Carroll and Cupo had previously owned and operated Instrumentation Engineering, LLC, which had employed James.  Carroll was the majority owner, and the company ultimately failed, filing for bankruptcy with alleged outstanding liabilities owed to Carroll and his other businesses of approximately $2.5 million.  Carroll, Cupo, and James subsequently formed IE Test, LLC and purchased some of the key assets of the now-defunct Instrumentation Engineering.  The three men had nearly equal percentage interests (Cupo had 34% to the others’ 33%), and Cupo and James played active roles in the business and drew salaries of $170,000 each, with $10,000 bonuses paid from time to time.  Carroll was a passive owner and was not paid any salary or bonus.  There was no written operating agreement for IE Test.  Carroll claimed that the three had an agreement that, over time, IE Test would compensate Carroll for his unrecovered $2.5 million from the prior business.  Carroll proposed an operating agreement that included a compensation mechanism intended to allow him to recoup that prior loss over time.  The IE Test business was successful, but Cupo and James came to view Carroll and his request for compensation as a drag on the business.  Via email, they posited that the business was not profitable enough to support three owners drawing out money.  Cupo and James caused IE Test to initiate a lawsuit seeking, among other things, the expulsion of Carroll based on the claim that it was not reasonably practicable to continue the business with Carroll as a member.

The trial court agreed with IE Test, first determining that the “not reasonably practicable” standard required predictive reasoning and analysis, and then surmising that Carroll’s continued involvement in the business might, in the future, lead to the inability to secure Carroll’s approval of essential documents, or that Carroll’s continued involvement might lead to more controversy and litigation that would be a drain on the business. This was a troubling result, especially in light of the fact that it was undisputed that Carroll did not have a day-to-day role with the company and had never interfered in company business in any direct way. It appeared that a disagreement among the members as to the financial terms of the operating agreement was enough to trigger expulsion.

The New Jersey Supreme Court reversed the trial court, holding that the “not reasonably practicable” standard was a high bar that required a finding that it is “unfeasible, despite reasonable efforts” to continue the business of the company under its current circumstances.

“Significantly, the Legislature did not authorize a court to premise expulsion under subsection 3(c) on a finding that it would be more challenging or complicated for other members to run the business with the LLC member than without him. Nor does the statute permit the LLC members to expel a member to avoid sharing the LLC’s profits with that member.”

The court then laid out a seven factor test to be considered by New Jersey courts in confronting this question in the future, with no single factor or group of factors being dispositive one way or another:

  1. The nature of the member’s conduct in relation to the company’s business;
  2. Whether the entity can be managed so as to promote the purposes for which it was formed with the member remaining;
  3. Whether the dispute precludes the members from working with one another to pursue the company’s goals;
  4. Whether there is deadlock among the members;
  5. Whether, despite deadlock, members can make decisions on the management of the company pursuant to the operating agreement;
  6. Whether there is still a business to operate, in light of the company’s financial position; and
  7. Whether continuing the company with the member is financially feasible.

The seven factors outlined in the decision are probably less important than the finding that the “not reasonably practicable” standard is a high bar that requires more than a showing of inconvenience or deadlock over the terms of the operating agreement.

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