Navigating the Complexities of Member or Shareholder Expulsion

One of the critical issues to consider when drafting or reviewing an Operating Agreement or Shareholders’ Agreement involves the terms governing expulsion of members or shareholders. Expulsion generally refers to the act of formally removing a member or shareholder from their position within the company and stripping the rights and benefits associated with membership. Below are a few expulsion issues to consider when drafting or reviewing the expulsion provisions for your company.

Issue #1: What is the expulsion procedure?

The expulsion provision should include clear steps outlining the procedure required to expel a member or shareholder from the company. The expulsion procedure should identify any required notices, applicable timelines, cure periods, and other measures that must be taken prior to expulsion. Having clearly defined expulsion procedures will ensure that everyone is on the same page.

Issue #2: What events trigger expulsion?

The expulsion provision should clearly identify the specific events or circumstances that trigger expulsion. Typical events triggering expulsion might include breaches of the Operating Agreement or Shareholders’ Agreement, breaches of a fiduciary duty owed to the company, illegal activities, detrimental or reckless behavior harmful to the company, bankruptcy, or any other acts identified by the members. The events triggering expulsion should be clear  and unambiguous. When drafting expulsion provisions, avoid ambiguous terms like “material” or “damages”. Instead, use precise definitions that clearly specify what constitutes “material” conduct and the exact amount or conditions that qualify as “damages”.

Issue #3: Who decides when a member or shareholder gets expelled?

The expulsion provision should identify the decision-makers who decide if an expulsion event has occurred. These decision-makers could be the manager, board of directors, a certain percentage of other members or shareholders, or another third party such as a formal arbitrator or neutral business associate. Having clearly defined expulsion events will greatly assist the decision-makers when determining whether an expulsion event has occurred. It is also important to consider whether the member or shareholder subject to expulsion should have the right to vote on their own expulsion.

Issue #4: How much money should an expelled member or shareholder receive for their equity?

The expulsion provision should identify the repurchase price for the equity owned by the expelled member or shareholder. Valuation methods for repurchased equity could be a predetermined amount agreed upon by the members or shareholders, an amount determined by an independent appraiser, or formulas that determine value based upon certain financial or accounting information of the company. You should also consider whether any discount should be applied to the purchase price given the expulsion circumstances. Valuation methods can be as simple or complex as you make them.

Issue #5: How should the expelled member or shareholder get paid?

The expulsion provision should provide the payment terms for the repurchased equity. Payments to expelled members or shareholders can be structured as a lump-sum payment, installment payment (with a rate of interest), or any other type of payment structure that allows the company to avoid having to come up with a large sum of cash immediately. Factors such as the financials and liquidity of the company should be considered when determining payment terms.

Issue #6: Should the company be able to withhold payments from the expelled member or shareholder?

Withholding money from an expelled member or shareholder is a sensitive topic that needs careful consideration. Therefore, the expulsion provision should identify the circumstances under which the company can withhold payments from an expelled member or shareholder, such as for example, if the expelled member or shareholder caused “harm” to the company (see Issue #2 for the importance of using definitions) or has outstanding debts or liabilities owed to the company.  Payment withholding provisions should balance the company’s financial interests with the rights of the expelled member or shareholder.

Conclusion

In conclusion, navigating the complexities of member or shareholder expulsion requires a thorough understanding of the expulsion process and careful crafting of expulsion provisions included in your Operating Agreement or Shareholders’ Agreement. Ensuring clarity and fairness in expulsion terms is crucial to protect the rights of everyone involved and maintain the harmony and productivity of your business. Remember, taking the time to address expulsion issues before they arise can save considerable time, costs, effort, and avoid legal disputes in the future.