When establishing a multi-member limited liability company, it is important to plan for the worst. It may seem cynical to think about the end before the beginning, but every company has a half-life. And while relationships at the outset of any venture are typically strong, it often becomes necessary to remove or dissociate a member who is negatively impacting those relationships—or even the business. If no protection is built into the organizational documents, the members’ recourse is limited to circumstances provided under applicable state law.
Governing law in Maryland, Virginia, and the District of Columbia provide limited circumstances where a member of a limited liability company can be unwillingly removed by the other members.
Under Maryland law, for example, a member can be removed by the other members if that member (i) makes an assignment for the benefit of creditors; (ii) files a voluntary petition in bankruptcy; (iii) is adjusted bankrupt or insolvent; (iv) files a petition for reorganization, arrangement, composition, readjustment, or liquidation (if the member is an entity); (v) seeks or consents to the appointment of a trustee, receiver, or liquidation of all or any substantial part of the member’s properties; or (vi) files an answer or other pleading admitting to or failing to contest material allegations of a petition for any of the proceedings described above.
Virginia and the District of Columbia utilize the concept of dissociation, which is not exactly equivalent to removal, as dissociation does not affect the membership interest held by a dissociated member. Instead, disassociation causes a member to lose their status as a member while retaining membership interest and being granted new status as an assignee. Virginia and the District of Columbia allow for the dissociation of a member by unanimous consent of the other members if (i) it is unlawful to carry on the company’s activities and affairs with the person as a member or (ii) there has been a transfer of all of the person’s transferable interest in the company (other than for security purposes or a court order charging the member’s interest).
Alternatively, a member may be removed or disassociated through judicial order by an application of the company or its members. Generally, state courts have the authority to grant a judicial order when a member (i) is found to be engaged, or is engaging, in wrongful conduct that has adversely and materially affected the company’s activities and affairs; (ii) materially breaches the operating agreement; or (iii) is engaged in conduct relating to the company’s activities that makes it reasonably impracticable to carry on the activities with the person as a member. This option is costly, time consuming, and unpredictable.
The aforementioned circumstances for the removal or dissociation of a member create a problem for limited liability companies dealing with members who are negatively impacting the business or the relationships therein. Fortunately, state laws grant broad authority to companies and their respective corporate governance documents for the removal of members.
The articles of organization and / or operating agreement are the operative documents here. For example, a common provision that can be incorporated into an operating agreement is a buy-sell (buyout) provision. A buy-sell provision grants the company, its members, or a combination of the company and its members the right to buy out the membership interest of another member. This is typically achieved through the votes of the members holding a majority interest in the company; however, buy-sell provisions can function and operate in a variety of ways.
Thinking about potential negative situations in your limited liability company at the outset of formation or before an internal dispute has arisen can not only save time and money, but can also provide additional protection to members.
If you have questions about drafting an operating agreement or establishing a limited liability company, please contact Michael Thurmond, the author of this blog, or a member of PilieroMazza’s Corporate and Organizational Governance or Business & Transactions practice groups.