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A Case Study In Business Divorce: Member Expulsion And Its Associated Hazards

By Daniel Glasser and James Kin

The forced termination of any business relationship is painful. But the expulsion of a member from a limited liability company (an “LLC”) can raise additional challenges—especially where the rules of engagement are either poorly defined or undeveloped. For example, a recent decision by the Delaware Court of Chancery may leave members personally liable for the value of an expelled member’s interests in the LLC if the operating agreement is silent or ambiguous on the matter. Careful review of an LLC’s operating agreement by an experienced litigator should help alleviate the anxiety of members and practitioners who recognize that recent court decisions have the potential to essentially rewrite key elements of existing operating agreements and leave members on the hook for unplanned liability.

On August 13, 2018, the Court of Chancery, in Domain Assocs., L.L.C. v. Shah, 2018 Del. Ch. LEXIS 276 (May 15, 2018) resolved breach of contract claims stemming from a Delaware LLC’s forced expulsion of a member. Each of the other members were ultimately ordered to pay the expelled member the fair value of his interest. The member involved, Nimesh S. Shah (“Shah”), held a membership interest in Domain and had paid a modest capital contribution in exchange for that interest. Although Shah was once a rising star within the company, his area of expertise—medical devices—had not proved profitable for Domain and the other members eventually voted to expel him as a member of the LLC. Shah demanded payment for his membership interest based on his ownership share of the company multiplied by Domain’s cash on hand. Domain, however, refused to pay that sum and argued that Shah was only entitled to receive the value of his capital account.

Domain filed suit first, seeking a declaratory judgment affirming its reading of the operating agreement was correct, i.e., that Shah was only entitled to receive his capital account balance. Shah counterclaimed for breach of contract.  Shah argued that Domain’s operating agreement failed to specify how much Shah was supposed to be paid so the court should resolve the matter based on provisions contained in the Delaware Limited Liability Company Act (the “Act”).

The court ultimately found that the operating agreement was silent on the question of Shah’s right to payment upon forced withdrawal. Thus, the court turned to the Act in search of guidance regarding the calculation of his buyout. According to the Domain court, Section 18-604 of the Act only applies to voluntary withdrawals. See footnote 140. The court cited instead to Section 18-1104 of the Act for the premise that, in a case like this, “the rules of law and equity . . . shall govern.” See footnote 146. Then, relying on the rule of “law and equity,” the court looked to partnership law to decide how an involuntarily terminated member should be paid for his interest. In the partnership context, the law calls for payment equal to the fair market value of a partner’s stake. The Domain court, therefore, awarded Shah the fair market value of his interest in Domain. And because this matter arose from a contract among all members (i.e., the operating agreement), each of the members were jointly and severally liable to Shah for this sum.

The Domain decision is noteworthy for at least four reasons: First, Domain underscores how important it is for members of an LLC to clearly spell out the consequences of member withdrawal—whether forced or voluntary. Operating agreements are contracts and they should be explicit about how and on what terms members may exit the business. Second, even if the members (and their counsel) think an operating agreement is clear, expelled members will almost certainly interpret the language differently and the court may construe any ambiguity against the drafter. When such a dispute finally works its way through the courts, it is difficult to predict which interpretation will prevail. Third, an absence of statutory law and ambiguity in an operating agreement may open the door for courts to import duties and obligations from other business structures, including corporations and partnerships. Finally, Domain illustrates the very real personal risks members face if they violate the terms of a contract among all members (i.e., the operating agreement).

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