Member Expulsion Provisions in LLC Agreements

At the New York Business Divorce Blog, Peter Mahler reports on Harker v Guyther, 2014 NY Slip Op 07403 (N.Y.A.D. 3d Dept Oct. 30, 2014).  In Harker, the New York Appellate Division construed a member expulsion provision in the operating agreement of a Delaware limited liability company.

A member expulsion provision is any provision that allows the members of an LLC to expel one or more other members upon the occurrence of certain events (such as the commission of specified kinds of wrongdoing). These expulsion provisions are particularly tricky in LLCs having only two members, because the incentive to exercise the expulsion option is inversely related to the quality of relations between the members.  Thus when business or personal relations sour (as they can for any number of reasons), each member has an increasing incentive to characterize the other's behavior (even behavior with which they had no problem when relations were good) as triggering the expulsion provision.  This appears to have been the case, at least in part, in Harker.

As Mahler notes:

The incentive is even more powerful when linked to a mandatory redemption or buy-out at an unfavorable price and/or on unfavorable terms for the terminated owner. The same dynamics also can exist, without the impediment of co-equal control, when a majority owner or faction targets a minority owner for termination.

On a somewhat more hopeful note, Mahler offers the following guidance:

I’m not suggesting that expulsion provisions are inherently bad. Company controllers justifiably may need to be able to terminate the employment of owner-employees for certain types of serious misconduct, and to expel owners who are no longer employees. What I am suggesting is that the expulsion provisions in the shareholders’ or operating agreement should very carefully and very precisely define, using objective standards, the misconduct triggering termination. I also would recommend some form of expedited, alternative dispute resolution to deal with termination (as well as other) controversies.

Given the status of most types of alternative entities as "creatures of contract," it stands to reason that these sorts of provisions could be incorporated (with the same pitfalls and perverse incentives) into the governing instruments of limited partnerships, statutory trusts, and other types of businesses.