No one wants to plan for the worst, in marriage or business. However, like a prenuptial agreement, an operating agreement for an Illinois limited liability company (LLC) needs proper drafting and advance planning to prepare for unexpected departures of members. Careful drafting will permit orderly departures that implement the members’ succession plans and avoid court-supervised departures. Proper planning for worst-case scenarios in the operating agreement will save time and money in the long run.
Under the Illinois Limited Liability Company Act, the termination of a member’s interest in the LLC is called the dissociation of his or her interest. Dissociation of an interest in the LLC should not be confused with dissolution of the LLC, which means the termination and winding up of the LLC’s business.
Dissociation of a member’s interest can occur in several different ways. First, a member may voluntarily dissociate under the Act in certain circumstances. For example, a member of a member-managed company has the power to dissociate at any time, rightfully or wrongfully, under the Act. A member’s dissociation is wrongful only if it violates an express provision of the operating agreement. Accordingly, in order to avoid conflict, if members want the ability to voluntarily separate from the company, the operating agreement must specifically permit such a departure.
As contrasted with a member-managed company, a manager-managed company is actively managed by one or more managers, not the members, and the managers are not required to be members. Unless the operating agreement provides otherwise, a member of a manager-managed company does not have the power to dissociate until after the company is dissolved. Therefore, if members want the ability to voluntarily separate from the LLC before dissolution, they must include it in the operating agreement.
Dissociation can also occur pursuant to a predetermined event specified in the operating agreement. Section 45(2) of the Act provides that when a mutually agreed event occurs, such as the passage of time or the completion of a job, a member may be dissociated.
Section 45(4) of the Act provides for a member’s expulsion pursuant to the operating agreement. This event of dissociation also ousts a member upon the occurrence of an agreed event, but is much more adversarial. The parties can agree in advance, for example, that conviction of a crime will cause a member’s expulsion.
A third event of dissociation occurs when the company or a member seeks to oust another member through the courts. Section 45(6) of the Act provides that judicial dissociation occurs when another member: (1) engages in wrongful conduct that adversely and materially affects the company’s business; (2) willfully commits a material breach of the operating agreement or of a duty owed to the company or other members; or (3) engages in conduct that makes it not reasonably practicable to carry on business with the member.
If the operating agreement does not grant the right to expel a member, then the company or a member must rely on a court-ordered dissociation under Section 45(6), which can be messy and costly for all parties involved. Section 45(6) provides little guidance on what constitutes “conduct relating to the business that makes it not reasonably practicable to carry on the business with the member” or “wrongful” conduct that adversely affects the company. “Wrongful” conduct most likely does not mean a violation of the operating agreement, because Section 45(2) of the Act already provides that members may be dissociated for a violation of the operating agreement.
Although there is little case law under Section 45(6), one could assume that “wrongful” conduct arises when a member violates his or her fiduciary duties to the company or other members. However, that would apply only to members of member-managed LLCs, because members of manager-managed LLCs do not owe any fiduciary duties to the company or other members. Courts in other jurisdictions have found misappropriation of company funds and other crimes to be “wrongful conduct” or “conduct that makes it not reasonably practicable to carry on business with the dissociated member.”
If the operating agreement fails to properly define prohibited or wrongful conduct and fails to include a method for valuing an exiting member’s interest, members will be left with having a court define the terms. Even if the members seeking dissociation are successful in establishing that a member’s conduct justifies dissociation, it will be up to the court to place a value on the business.
Carefully drafted operating agreements can avoid contentious and expensive disputes between members. An operating agreement should always include a tie-breaking mechanism for deadlock situations. If need be, select an independent mediator for disputes. An operating agreement should also include a provision that allows members to leave the company. The members should agree in advance on how they wish to value the exiting member’s interest. Further, if the members are uncomfortable with having other members’ heirs succeed in ownership upon the death of a member, you can avoid the scenario with a buyout provision that is triggered upon the death of a member.
The various provisions you can include in an operating agreement are endless. However, owners should first seek the advice of counsel to customize dissociation provisions to their benefit. If an operating agreement is already in use, you should seek counsel to determine how to amend the existing operating agreement. In the end, making decisions about who you do business with and the value of your business will avoid the costly alternative of allowing a court to do so for you. IBI