Stuck In an LLC – And Then Forced Out

Limited liability companies have become a popular business form, and I have helped form some LLCs in my practice. Although they have many advantages, a recent case from the Oregon Court of Appeals highlights a major disadvantage: it is not as easy to sell an interest in an LLC as it is to sell corporate stock.

LLCs were invented to combine the managerial flexibility and tax benefits of a partnership with limits on liability to outsiders, as in a corporation. In order to ensure that most LLCs can be flexibly managed and to protect the investments of the members, Oregon’s LLC law restricts the ability of members to sell their interests unless all of the members have agreed to allow sales. In addition, to ensure that proper records are kept, the law includes a requirement that transfers of interests are not valid until the LLC  is notified and that proof of the transfer is provided. Effectively, this requires the selling member to provide documentation of the sale.

In the case in question, the members had agreed that any one of them who wanted to transfer any interest in the LLC (called SPBC) had to offer the other members a buyout opportunity first. The only exception was that a member could transfer his or her interest to a company he or she controlled. One of the members tried to take advantage of this clause by creating a second LLC (called BT), transferring his interest in SPBC to BT, and then selling BT. Although his lawyer sent an e-mail to the SPBC that the member’s interest had been transferred, the required documentation was never delivered. That would have been important – if the other members of the SPBC had received the documentation before the sale of BT, they could have argued that the sale of the second LLC was effectively a sale of the member’s interest, and they had the right to demand a buyout offer.

SPBC sued to have the sale unwound and to have the member expelled both for the improper sale and several other violations of the members’ agreement, including a previous misappropriation of funds and failing to provide an annual report on his own finances. (SPBC had been unable to refinance its long-term debt as a result.)

The court ruled that because the member had never provided documentation of the transfer of his interest to BT, that transfer never went into effect and the SPBC could disregard it. This ruling enabled the court to avoid ruling on the more difficult question of whether the sale of BT would have been enough to get the member out from under the requirement to offer a buyout. At that point, the member remained a member and would have to pay back his buyer to undo the sale of BT.

He didn’t stay a member for long. In the next paragraph of its ruling, the court approved his expulsion and ordered the other members to buy him out, with the purchase price reduced by court costs and attorney fees.

The member had acted improperly in managing the LLC and trying to avoid a buyout requirement he had previously agreed to, and strict application of the law effectively punished him.

The extent to which members can or cannot get out of an LLC will be affected by the agreement they reach when the form the LLC. For that reason, if a member wants the LLC to be easy or hard to leave, he or she may want to get advice from a lawyer about the terms, and, to avoid creating a conflict of interest, that lawyer should not be the one preparing the LLC documents. If the member wants out and isn’t sure whether he or she can get out, bringing the agreement to a lawyer for an opinion is a good idea. Finally, members should remember that they don’t want to give the other members a reason to get rid of them.