Expert Opinion (#12 December 2013)

Title Right vs. Right to Expel

Illya A. Tkachuk

Ever wondered what it felt like when you think you own something but then it turns out you don’t? It is hard enough to fend off a rather hostile business environment as it is, and it certainly is not very comforting to be in constant fear that your own partners may turn their backs on you and force you out.

So, how serious and how high is the risk of losing one’s investment in a limited liability company (LLC)?

Digging to the core

According to the laws of Ukraine1, a participant of a LLC may be expelled from an LLC in the following cases: (1) systema- tic non-performance (or improper performance) of the participant’s obligations; or (2) commitment of actions which create obstacles for the activity of the LLC.

By expulsion the law means taking away the participation interest in the share capital of the LLC irrespective of the participant’s will and in exchange for compensation.

It is important to note that the participant is stripped of his interest not due to a breach of public order or for the good of the general public, but by virtue of a decision of other participants of the LLC. Without digging into the history of this provision or the idea which was in the minds of the members of parliament back in the nineties when it was adopted, we should face the fact that today this provision may be misused by one participant to expel another participant. Needless to say that just a thought about the possibility of such abuse may frighten off potential investors.

Rights must be respected

The right of ownership is in the fundamental proprietary rights guaranteed by Article 41 of the Constitution of Ukraine.  This right allows its holder to own, use and transact with the property at his own discretion. By virtue of the law, this right should not depend on the will of other persons.

One may come to a conclusion that expulsion of a participant from an LLC may somehow contradict the inviolable right of ownership. Indeed, according to the Constitution of Ukraine, forced alienation from property rights is only possible in case of public necessity with full compensation of their value. It is hardly possible to imagine a situation where expulsion of a participant from an LLC may be considered to constitute “public necessity”.

It is interesting to note that the Presidium of the Higher Commercial Court of Ukraine2 noted, in its recommendations to lower courts with regard to expulsion of participants from LLCs, that the shareholder’s rights (compared to the rights of participants) arise from the title to the shares. Without giving further explanations the Higher Commercial Court noted a difference between the rights of shareholders based on the title to shares and the rights of participants which are based on… Indeed, what are the rights of participants based on?

We are used to selling participation interests in the share capital of LLCs although this asset is poorly formalized. In addition to that, we are used to indicating in sale agreements provisions stating the transfer of all corporate, proprietary and other rights attributed to the respective participation interest. All of this leads to the idea that a Ukrainian LLC is a quazi-partnership where, if I may say so, personal participation is of the same importance as financial contribution to share capital. But let us leave this analysis to academic minds and concentrate on the actual situation as it is.

Right to expel

According to the laws of Ukraine, the right to expel a participant falls within the exclusive competence of the general meeting of participants of an LLC and, according to the Supreme Court of Ukraine3 and the Higher Commercial Court of Ukraine4, commercial courts should not decide on the expulsion of participants from an LLC for precisely that reason.

It is interesting to note that Lichtner-Beton Lviv LLC submitted a request for clarification to the Constitutional Court of Ukraine5 with regard to the nature of Article 64 of the On Business Companies Act. The request was drafted in a way as to ask whether the provision in question is sufficiently “optional” and whether the issue of expulsion can be considered not only by the general meeting of participants but also by a court.

In February 2013, the Constitutional Court refused to give any clarifications based on the fact that the request did not correspond to the constitutional requirements. It is worth noting that the decision was accompanied by a dissenting opinion of one judge stating that putting this question to the exclusive competence of the general meeting of participants should not prevent courts from considering such issues.

In any case commercial courts still have the jurisdiction over appeals against decisions of general meetings of participants relating to inter alia expulsion of participants.

Following the guidelines of the Supreme Court of Ukraine and the Higher Commercial Court of Ukraine, when reviewing appeals against such decisions lower courts must carefully examine the grounds for the expulsion: (1) systematic (3 or more times) non-performance or improper performance of obligations; (2)violations must concern only those obligations which are listed in the laws of Ukraine and the Charter of LLC; (3) participation of the participant in the general meeting of participants and voting against certain commercial issues cannot be treated as creation of obstacles for the company’s activity; (4) occurrence of negative consequences for the LLC or a risk thereof is a must.

When expulsion is not possible

According to the On Business Companies Act of Ukraine, a decision to expel a participant requires 50% of total number of votes of participants, while the participant whose expulsion is sought cannot vote on the matter.

At the same time, the law does not provide for any specific quorum rule in this case and, therefore, the general quorum of 60% + 1 vote still applies. It is apparent that a participant who received a convocation notice with the expulsion issue in the agenda may refrain from attending this general meeting of participants, especially if his participation interest is needed for the quorum.

Therefore, in practice, it will be hardly possible to expel a participant owning 40% and more in the share capital of the LLC.

What to expect

There are two draft laws on limited liability companies (Draft 2011 and Draft 2011-1)6 registered in the Verkhovna Rada of Ukraine which may regulate this issue. However, these two draft laws were prepared by different working groups and propose to regulate the issue on expulsion of a participant in different ways.

Draft 2011 does not contain any provision directly regulating the right of expulsion of a participant from an LLC. In a rather broad manner, Section 3 of Article 8 allows the participants to agree on additional obligations which are not specified in the law. This provision may potentially be used for inclusion in the Charter of an expulsion mechanism.

It is worth noting that such an optional approach is used by many European countries. For example, in France, the law does not specifically allow expulsion of a participant from a limited liability company (une société à responsabilité limitée). At the same time, the law allows participants to specifically introduce into the charter the right to exclude participants from the LLC. In this case, the participants must specify the procedure and conditions for expulsion assuming that such conditions must correspond to the rules for purchase of shares7.

In its turn, Draft 2011-1 provides for a rather diversified approach for expulsion of participants. The general meeting of participants may decide to expel a participant holding not more than 50% in the share capital of the LLC only in the following cases: (1) death of a participant; (2) liquidation or termination of a participant; (3) declaration of a participant as dead or missing.

This rule seems to specifically address the problem of so-called “dead souls” which can be resolved by the LLC itself. One may argue that this right of LLCs violates the right of ownership guaranteed by the Constitution of Ukraine, which may bring us back to the question of what constitutes the basis for the right of participants — a “stake in the share capital” or “personal participation”.

At the same time, according to Draft 2011-1, an LLC will be allowed to ask a court to rule on expulsion of a participant in the following cases: (1) such participant creates obstacles for activity of the LLC; or (2) such participant disclosed conformational information which caused damage to the LLC; or (3) the participant or his affiliated person holds a stake in, or is a member of the management body of, a competing company.

In my personal opinion, this approach appears to be more practicable and reliable in Ukraine. Notwithstanding all of the existing problems in the Ukrainian judicial system, the fact that only a court may decide on the expulsion of a participant may make foreign investors feel more confident.

It is worth noting that a similar approach is practiced by the Russian Federation. According to Article 10 of the On Limited Liability Companies Act of the Russian Federation8, participants of an LLC in the aggregate holding not less than 10% in the share capital of the LLC may ask a court to rule on the expulsion of a participant who does not perform his obligations or create obstacles for the company’s activity.

In the light of Draft 2011-1 establishing a 50% threshold, it is interesting to note that court practice in the Russian Federation confirms the possibility of expulsion of a participant owning more than 50% in the share capital of the LLC9.

* * *

All in all, the right of expulsion of a participant from an LLC exists in Ukraine and I see no particular reasons for abolishing this right as such.

It is apparent that the right of expulsion should serve as a remedy for effective management of an LLC which, however, should in no way violate the right of ownership or other rights of participants of the LLC. At the same, it should never be used for the wrong reasons.

In my opinion, one of the issues that can be further improved would be the introduction of the exclusive competence of courts over expulsion of participants from LLCs. In practice, courts consider cases of expulsion of participants under the veil of validity of the respective decisions of the general meeting of participants, save for the right to decide on the merit.

Even though Ukrainian courts are often criticized, I believe that the involvement of an independent judicial body in the process of expulsion may bring more confidence to foreign investors and improve the investment climate in Ukraine in general.


 

1 Section 3 of Article 100 of the Civil Code of Ukraine No. 435-VI, of 16 January 2003, as amended and Article 64 of the On Business Companies Act of Ukraine No. 1576-XII, of 19 September 1991, as amended.

2 Recommendations of the Presidium of the Higher Commercial Court of Ukraine with regard to the practice of application of laws when considering corporate disputes No. 04-5/14 of 28 December 2007, as amended.

3 Summary of court practice with regard to corporate disputes by the Supreme Court of Ukraine of 1 August 2007 and Resolution of the Plenum of the Supreme Court of Ukraine with regard to consideration of corporate disputes No.13 of 24 October 2008.

4 Recommendations of the Presidium of the Higher Commercial Court of Ukraine with regard to the practice of application of laws when considering corporate disputes No. 04-5/14, of 28 December  2007, as amended

5 Decision of the Constitutional Court of Ukraine in response to the constitutional enquiry of Limited Liability Company Lichtner-Beton Lviv for official interpretation of Para 4 of Article 58, Para 1 of Article 64 of the On Business Companies Act of Ukraine (Case No. 1-3/2013) as of 5 February 2013 No. 1-рп/2013.

6 Draft Act On Limited Liability Companies and Additional Liability Companies No. 2011 of 14  January 2013 and Draft Act On Limited Liability and Additional Liability Companies No. 2011-1, of 25 January  2013.

7 Article 1843-4 of the Civil Code of France.

8 On Limited Liability Companies Act of the Russian Federation No. 14-ФЗ of 8 February 1998, as amended.

9 Informational Letter of the Presidium of the Supreme Arbitration Court of the Russian Federation No.151 of 24 May  2012.

 

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