Business Marriage and Divorce: How Quickly Can a Member of a Limited Liability Company Be Left Out in the Cold?

Like every love story, a business “marriage” between the members of a limited liability company usually begins with seemingly aligned interests, a willingness to cooperate, clearly divided roles, a shared vision and expectations of success.

As in romantic relationships, however, an important question is often overlooked during the initial “honeymoon” phase: What happens if the members’ interests diverge over time, their cooperation ceases to function or serious disagreements arise?

One of the issues that often remains in the background is the exclusion of a member. Members are frequently insufficiently aware of its consequences and its effect on the balance of power when disputes are being resolved. In practice, it is often only after a serious conflict arises that it becomes apparent how significantly the possibility of excluding a member can affect the course and outcome of negotiations between the members.

Distinguishing between contractual and judicial exclusion of a member

A member may be excluded from a limited liability company in two principal ways:

• by contractual exclusion, which is possible only if it is expressly and adequately regulated by the company’s articles of association (Article 501(1) of ZGD-1); or

  
  

• by judicial exclusion, which is sought by filing an action before the court (Article 501(3) of ZGD-1).

  
  

Contractual exclusion is permissible only if it has been clearly and sufficiently precisely regulated in advance in the articles of association. At a minimum, the articles must identify the person entitled to initiate the exclusion, the justified grounds for exclusion, the applicable procedure, the decision-making body and the method by which the decision is to be adopted.The member concerned must be informed of the grounds for the proposed exclusion and given an opportunity to respond before the vote takes place.

By contrast, every member has a statutory right to seek the judicial exclusion of another member, irrespective of whether the articles of association provide for contractual exclusion. A member may bring an action seeking the exclusion of another member if justified grounds exist.

The two forms of exclusion differ in terms of the applicable procedure and the speed of exclusion, the position of the members pending the final decision and, consequently, their bargaining power when resolving disputes.

What does this distinction mean in practice?

Members A, B and C establish a limited liability company in which each holds a one-third interest. A and B are also directors of the company.

After several years of business, disagreements arise among the members concerning the company’s future development. C disagrees with certain strategic and business decisions requiring a three-quarters majority. Consequently, A and B are unable to adopt the relevant resolutions.Relations deteriorate further when C begins to exercise his supervisory and information rights extensively, initiates several court proceedings against the company and against A and B, and files reports with various supervisory and inspection authorities. Some of the proceedings and reports are unsuccessful, while others remain pending. C is also accused of unjustifiably disclosing and misusing the company’s trade secrets.

A and B believe that this conduct is causing damage to the company and its members and preventing the company from carrying on its business normally. C disagrees and refuses to leave the company by selling his interest at the price offered to him. He believes that he is merely exercising his rights and that the other members wish to exclude him because he opposes the way in which they manage the company.

Option 1: The articles of association contain no provisions on exclusion

A and B may file an action seeking C’s exclusion from the company. The success of the action will depend on whether they can prove the existence of justified grounds for exclusion. If the action succeeds, C’s membership ceases when the judgment becomes final. The excluded member is entitled to payment of the assessed value of his interest as at the date of exclusion. The company must pay this amount, together with the prescribed interest, no later than six years after the exclusion (Article 502(6) of ZGD-1).

Until the proceedings have been finally and conclusively resolved, C retains all of his membership rights. The possibility of restricting those rights by means of an interim regulatory injunction is extremely limited. This gives C a relatively strong bargaining position, particularly in view of the duration of court proceedings and the uncertainty of their outcome.

Option 2: The articles merely provide that the general meeting decides on exclusion by a simple majority

A and B adopt a resolution to exclude C from the company by a simple majority and, on that basis, apply for the exclusion to be entered in the court register.

According to the case law, the court must examine in the registration proceedings whether the articles adequately regulate the procedure for excluding a member and define its essential elements, as well as whether the resolution was adopted in accordance with the rules set out in the articles.

Because the articles do not define the essential elements of the exclusion procedure, the exclusion resolution is void or otherwise has no legal effect. The court therefore refuses to enter the exclusion in the court register. In such a case, the only available course of action is to bring a claim for C’s judicial exclusion. This means that, at least until the court’s decision becomes final, C retains all of his membership rights in relation to the other members, third parties and the company. This gives him considerable bargaining power.

Option 3: The articles adequately regulate the exclusion procedure and define its essential elements

A and B adopt a resolution to exclude C from the company by the simple majority provided for in the articles and, on that basis, apply for the exclusion to be entered in the court register. Because the conditions for exclusion are adequately set out in the articles, C was informed of the grounds before the resolution was adopted and was given an opportunity to respond, the court allows the exclusion to be entered in the court register. C consequently loses his status as a member in relation to the company, the other members and third parties.

As a rule, the substantive existence of the grounds for exclusion is not examined in the registration proceedings. C may generally challenge the lawfulness of the resolution on the basis that no grounds for exclusion existed only by bringing an action to set aside the general meeting’s resolution, provided that he duly announced his intention to challenge it and filed the action within the prescribed time limit. Since such an action does not constitute grounds for staying the registration proceedings, it does not prevent C from losing his membership status or being removed from the court register.

Because C remains excluded from the company unless and until a different decision is issued in the proceedings challenging the resolution, A and B have a substantially stronger bargaining position when negotiating the settlement of their mutual relations and any payment for C’s interest. C’s ability to obtain temporary relief in his favour by means of an interim regulatory injunction is severely limited.

Conclusion

The regulation of member exclusion in the articles of association has much broader consequences than may appear at first sight. A properly and carefully structured contractual exclusion mechanism can provide a relatively swift and effective means of removing a member, who will generally have no remedy other than an action seeking to set aside the exclusion resolution. This places the excluded member in a significantly weaker position, as the member loses that status even before the proceedings challenging the resolution have been finally determined.

For precisely this reason, the issue of member exclusion should receive particular attention when the articles of association are being drafted. It is essential to consider not only whether contractual exclusion should be provided for at all, but also how it should be regulated. The grounds for exclusion, the decision-making procedure and the majority required to adopt an exclusion resolution are particularly important, as these elements determine the balance of power between the members in the event of a subsequent dispute.

What often appears to be merely a technical issue in the articles at the time a company is incorporated may ultimately determine who holds the stronger bargaining position in a dispute and who risks having to leave on terms largely dictated by the others.