What Does The Operating Agreement Say?
An operating agreement (OA) is a contract (whether verbal or written) by and between the members of a Limited Liability Company (LLC). This agreement defines member relationships, member responsibilities and the economic benefits and liabilities of each member. While New Jersey does not require that an LLC have a written operating agreement, believe me when I tell you an oral/verbal “operating agreement” will likely lead to costly conflicts, disputes and lengthy litigation if a disagreement develops and cannot be amicably resolved. A well-written operating agreement is an essential organizational document to minimize, avoid and resolve conflicts among members. In the absence of a written operating agreement, in many circumstances the members of the LLC are bound by what are known as the default rules of the New Jersey Limited Liability Company Act. The New Jersey Limited Liability Company Act is the state wide law that controls the legal aspect of every N.J. based LLC.
Disagreements Among Members in an LLC
Understanding Member Rights Under an LLC Operating Agreement
NJ LLC law allows the members of an LLC to govern their business relationship. The law also gives members the right (subject to reasonable limitations specified in the operating agreement) to obtain information about the LLC “for any purpose reasonably related to the member’s interest” in the company including information concerning the: (1) financial affairs (including income, expenses, profits) of the LLC; (2) the membership list of the LLC; (3) the organizational documents of the LLC; (4) proof of contribution of funds by each member to the LLC; and (5) any other information about the LLC which is “reasonable”.
Managers of the LLC and those who operate the daily affairs of the LLC are given enhanced rights over other members to effectively perform their responsibilities. In that light, a manager can access the records and confidential information of the LLC, and under limited circumstances keep confidential information from other members which includes trade secrets or “other propriety information the disclosure of which the manager (in good faith) believes not to be in the “best interests of the company” because to disclose this information could damage the economic interests of the LLC.” This right to exercise discretion over the release of information can, of course, be the subject of abuse, especially in the context of a dispute or struggle for the control of the LLC by its members. If a dispute develops then a court will apply the traditional business standard of “good faith” and fair dealing among members. In the absence of an objective and bonafide reason for a manager’s decision to refuse disclosure of information about the LLC, such as a legal opinion of counsel, financial opinion of an investment banker/advisor, etc., a Court will be suspicious of any non-disclosure and will likely overturn the refusal when challenged.
Common Reasons For Member Disputes and Lawsuits
Most closely-held NJ LLC’s begin with a friendly and professional relationship between a few members. Unfortunately, these relationships don’t always remain friendly. Once business gets underway, circumstances can change. Expectations of the members may evolve or change as the business expands. One or more members may not honor their promises or carry their weight through neglect or a purposeful refusal to honor their pre-formation promises. Attitudes and opinions toward other members may not be the same as they once were. Like I previously stated, as the business evolves, so do the views of the members. Often, members disagree on the direction the company is headed, with some favoring a re-direction while and others are happy with the way things are.
A Fiduciary Duty is Owed to All Members of an NJ LLC
All members of an LLC owe what is known as a fiduciary duty to one another. This fiduciary duty stems from their business relationship as LLC members. The legal relationship between members is analogous to that of partners in a Partnership. It is a relationship built upon trust, confidence, and good faith. Every member owes this duty to all of his/her fellow members, just as all partners owe a fiduciary duty to one another in a partnership.
New Jersey law allows for legal action to be taken by a member against other members, the officers, and directors of a company who violate(s) their fiduciary duty by operating the business in a manner that is detrimental to the general welfare of the LLC and it’s members. For example, a member is prohibited from making a decision on behalf of the business for the sole purpose of personal financial gain, regardless of whether the decision is in line with the company’s normal business operations.
In corporate transactions where members, directors, and/or officers stand to realize a sizeable personal benefit, it is of the utmost importance that they respect their fiduciary duty to all members. If they do not uphold this duty and an unhappy member brings a claim alleging a breach of fiduciary duty, the burden is on the majority member to prove that the transaction was fair and equitable to all members. One must also keep in mind that the legal fiduciary duty of good faith and fair dealing requires truthfulness and transparency on behalf of all majority members, directors, and officers. Any information that is purposefully or recklessly misleading, inaccurate, or simply false is considered a breach of this duty and the minority member will have a rightful cause of action under NJ law.
Minority vs. Majority Rights
A difference of opinion does not give majority members the right to oppress minority members within their LLC. A difference of opinion also does not give minority members the right to dissolve the LLC. The New Jersey legislature protects minority ownership members by creating laws that specifically address what is known under the law as minority member oppression. These laws give minority members certain rights to action in the courts if they are unfairly treated or taken advantage of by the majority members. The most common disputes between members that arise in the New Jersey courts are:
- Breach of Fiduciary Duty;
- Breach of the Duty of Loyalty;
- Breach of Contract;
- Tortuous Interference with a Prospective Economic Advantage;
- Usurpation of a Company Opportunity;
- Breach of the Covenant of Good Faith and Fair Dealing;
- Fraud;
- Conversion;
- Violations of the revised Limited Liability Company Act
- Unlawful Expulsion
- Refusal to Disclose Information
- Freeze Out of Involvement in the Officers of the LLC
The Wrongful Expulsion of a Member From the LLC
The terms of an operating agreement may discuss if, how, and when a member can resign and/or terminate his/her interest in the LLC and receive a return of their capital contribution. You may be surprised to learn that sometimes a member cannot voluntarily leave the LLC. Yes, that’s correct. If the agreement requires the consent of all members or a stated percentage of the members before a member can resign, then without their consent a member who attempts to leave will be considered to have wrongfully disassociated himself/herself from the company per the operating agreement. The LLC statute (NJSA 42:2B-48 provides that an attempted disassociation is wrongful if it is a breach of an express provision of the operating agreement and the operating agreement makes clear that majority or unanimous consent is required to disassociate. A breach has the potential for a lawsuit against the withdrawing member and exposure to damages. It can also result in the member not receiving back his/her capital contribution and/or other economic benefits from the LLC.
New Jersey Law on the Expulsion of a Member From an LLC
The NJ Limited Liability Company Act provides for several methods by which an LLC member may be disassociated from the LLC. One such procedure is expulsion by “judicial determination” under N.J.S.A. 21:2B-24(b)(3). The statute provides that a member shall be disassociated from a limited liability company under the following circumstances:
On application by the limited liability company (LLC) or another member, a member’s expulsion by judicial determination can be ordered because:
(a) the member engaged in wrongful conduct that adversely and materially affected the limited liability company’s business;
(b) the member willfully or persistently committed a material breach of the operating agreement; or
(c) the member engaged in conduct relating to the limited liability company business which makes it not reasonably practicable to carry on the business with the member as a member of the limited liability company.
If a court makes a judicial finding that an LLC member engaged in the type of behavior/action(s) described in any one of the three subsections recited above, it may grant the remedy of expulsion. If expelled, the disassociated member’s interest in the LLC is immediately limited to the “rights of an assignee of the member’s interest in the LLC, subject to the provisions of N.J.S.A. 42:2B-39. This provision of the law also addresses the issue of a buyout of a member’s interest at fair value, (see N.J.S.A. 42:2B-24.1). Pending a buyout (if ordered by the Court) the member may no longer take part in the day to day business decisions affecting the company and may lose part or all his or her investment.
As described earlier on this page the law also authorizes the expulsion of an LLC member (by order of a Court), based on the member’s “conduct with his or her co-members relating to the [LLC] which makes it not reasonably practicable to carry on the business with the member as a member of the [LLC].” N.J.S.A. 42:2B-24(b)(3)(c).
This statute does not define the term “not reasonably practicable,” nor does it describe the type of conduct by an LLC member that will trigger the application of subsection 3(c). Its legislative history is also silent, but a recent and significant N.J. Supreme Court case discussed this section of the law at length. It’s a controversial decision in the business law community. This Supreme Court case is beyond the scope of this page so I invite you to contact me to arrange a consultation to discuss how and if this decision impacts you and your LLC.
The LLC statute also requires a very close reading to understand when the law allows a judicial expulsion of a member. The language of subsection 3(c) differs from the language of subsection 3(a). Subsection 3(a) involves any “wrongful conduct” by an LLC member that has “adversely and materially affected [the LLC’s] business. Under subsection 3(c), a court considers only the conduct by the LLC member “relating to the business of the limited liability company. It is less concerned about the relationship(s) between members.” Disagreements and disputes among LLC members are routine but if it bears no nexus to the LLC’s business, such conflicts will not justify a member’s expulsion under subsection 3(c).
The distinction between subsections 3(a) and 3(c) seems confusing. But not really. Here’s why; subsection 3(c) uses different language to describe the impact a LLC member’s “conduct” must have on the LLC in order to warrant a member’s expulsion. To expel (disassociate) an LLC member under subsections 3(a), a court must find that the member’s wrongful conduct has “adversely and materially affected” the company’s business, and the member’s “wrongful conduct” must have damaged the LLC’s business in the past. In contrast, subsection 3(c) does not mandate a finding that the LLC member’s conduct has materially and adversely affected the business in the past. Under subsection 3(c), the court looks to the future to analyze the probable impact of a likely member’s conduct upon the LLC, its members and its future operations. Because of this focus upon the future, a court will not expel a member merely because of past difficulties presented by a member(s) or because it would be less challenging or complicated for the other members to presently run the business without the “disruptive” LLC member remaining. The LLC member’s conduct must be so disruptive that it is “not reasonably” practicable” to continue the business in the future unless that member is expelled. (N.J.S.A. 42:2B-24(b)(3)(c)). Because the LLC laws in NJ authorize majority rule in the day-to-day management, and affairs of an LLC, if the LLC members fail to reach unanimous agreement on the conduct of the business then majority vote controls. Thus, the courts believe disputes among LLC members on most issues relating to their business can be resolved by majority vote. Therefore, despite an impasse among LLC members regarding the company’s management, an LLC can be effectively operated pursuant to majority rule and if still not adequate then according to the default provisions of the LLCA.
In short, LLC members seeking to expel a member under RULLCA, (N.J.S.A. 42:2C-46(e)(3)), are required to demonstrate significant negative consequences to the LLC going forward. None of the provisions of the law(s) I just discussed with you authorizes a court to disassociate an LLC member merely because there are member conflict(s). Instead, both sections of the statute require the court to evaluate the LLC member’s conduct relating to the LLC and assess whether the LLC can be managed notwithstanding that conduct, in accordance with the terms of an operating agreement or the default provisions of the statute.
In that end, a trial court will consider the following factors, among others that may be relevant to a particular case: (1) the nature of the LLC member’s conduct relating to the LLC’s business; (2) whether, with the LLC member remaining as a member, the entity may be managed by majority vote or otherwise so as to promote the purposes for which it was formed; (3) whether the dispute among the LLC members precludes them from working with one another to pursue the LLC’s goals; (4) whether there is a deadlock among the members; (5) whether, despite that deadlock, members can make decisions on the management of the company, pursuant to the operating agreement or in accordance with applicable statutory provisions; (6) whether, due to the LLC’s financial position, there is still a business to operate; and (7) whether continuing the LLC, with the LLC member remaining a member, is financially feasible.
A trial court considering an application to expel a member under RULLCA, N.J.S.A. 42:2C-46(e)(3), will conduct a case-specific factual analysis with no requirement that all factors support expulsion, and no single factor alone will determine the outcome.
Fredrick P. Niemann Esq.
Have questions about your LLC operating agreement and a potential lawsuit by a member? Contact me personally today to meet and discuss your New Jersey LLC matter. I am easy to talk to, very experienced in New Jersey business and you will find me to be highly approachable. Allow me to offer you practical, legal ways to handle all your LLC concerns. You can reach me toll-free at (855) 376-5291 or e-mail me at fniemann@hnlawfirm.com.
Written by Fredrick P. Niemann, Esq. of Hanlon Niemann & Wright, a New Jersey LLC Law Attorney