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Question: What does a group need to consider when involuntarily disaffiliating itself from a member?

The relationship between a group and its members is similar in some respects to that of a company and its employees.  Both employees and members need to be carefully vetted before they are onboarded.  Also, there can be exposure if qualified employees or members are not brought on board for the wrong reasons.  Similarly, there can be legal issues if an employee is involuntarily terminated or a member is involuntarily disaffiliated with a buying group for the wrong reasons.  A group seeking to involuntarily terminate one of its members is a high risk situation—one that is more likely to result in litigation than most of other issues that the group will encounter.  Therefore, the group must be well prepared in advance and very thoughtful in the way it proceeds with the disaffiliation of a member.

Consider the following scenarios where a group desires to terminate the membership of a member:

  1. The member had grown to the point that it was branching out into the territories of other members and such competition was unwelcome by the other members.
  2. The member was considered as ruining the market by selling its goods at too low a price margin and the other members no longer wanted the deep discounter in the group.
  3. The member changed the way it was going to market so that it sold most of its goods online instead of through brick and mortar stores, so that the member was no longer a good fit with the rest of the group.
  4. The member who was no longer credit worthy? Suppose being cut off from the group and losing the ability to obtain the best prices, was the push that drove that member into bankruptcy.

Frankly, it is much easier to ask these questions than to answer them. But understanding the intricacies and risks involved in involuntarily disaffiliating a member is the first step towards making an intelligent and well-reasoned decision.

Before tackling these questions, we need to set the table by discussing what tools should already have in place before reaching the point of terminating the membership of a member. If members are equity owners in the group, the starting point is in the articles of incorporation, if a corporation, or the operating agreement, if the group is an LLC. We advise our clients to consider including a provision in it that makes the stock or membership callable upon a vote of the remaining shareholders or members. Typically, we require a supermajority vote of 2/3’s of the shareholders as a precautionary measure to ensure this extraordinary remedy is not taken lightly. State law should be checked to make sure that it permits all classes of equity to be subject to call provisions. Most states do not have a restriction that prohibits such call provisions, although in years past this was commonly found in state law. The call provision should be used as a last resort. It is designed to be used as catch all for when there is a legitimate reason to involuntarily separate a member, but is not covered in the membership agreement.

The next step is to include a carefully considered list of circumstances which give rise to the right of the group to involuntarily disaffiliate the member from it. The list will vary from group to group, depending upon its industry and other circumstances. Below is a sample list of events that would activate such rights in a group:

  1. Failure of the Member to continue to meet any of the membership criteria established by GROUP from time to time.
  2. If an individual, the death of Member, or if Member shall be declared by a court of competent jurisdiction to be incompetent to manage his or her business affairs.
  3. If Member is a business entity, the taking of any action for the purpose of liquidation, dissolution or termination thereof.
  4. If Member becomes insolvent, unable to pay its debts as they become due, or makes any assignment of assets or business for the benefit of creditors, or if a trustee or receiver is appointed to administer or conduct its business or affairs, or if a voluntary or involuntary petition is filed by or against Member in any court of bankruptcy.
  5. If Member is a business entity, and if Member should sell or transfer at any one time and from time to time fifty-one percent (51%) of the total outstanding voting interest or equity interest of Member for consideration to any person other than an existing owner or owners of Member.
  6. If Member is a business entity, and if there should be a sale or transfer for consideration to a third party or distribution to Member’s owners of substantially all of the assets of Member.
  7. If Member is a business entity, and if there should be a merger or consolidation of Member into another business entity, or the merger or consolidation of another business entity into and with Member.
  8. If Member is a business entity, and if there should be a transfer, sale or other disposition by the owners of Member of their equity interests in Member to another member of GROUP or to the owners of another member of GROUP, it being the intent that a member and all of its affiliates own and hold or control, directly or indirectly, only one (1) share of common stock of the GROUP.
  9. If Member should cease to own stock in GROUP.
  10. Failure to satisfy ANY financial obligation to GROUP, its suppliers, or other GROUP Members, including slow payments.
  11. Any action which could discredit GROUP or other GROUP Members.
  12. Failure to provide timely financial statements from time to time, as may be requested by GROUP.
  13. Failure to provide a personal guarantee of obligations if requested by GROUP.
  14. Cancellation, or failure to accept shipment, or a firm purchase commitment to GROUP or its suppliers, except with respect to a good faith dispute as to the shipment.
  15. Breach of any of the representations or covenants of the Membership Agreement or any other agreement or policy applicable to the relationship between the Member and GROUP.
  16. Unauthorized disclosure of any proprietary or confidential information of GROUP, whether done directly or indirectly, relative to the programs of GROUP which shall include, but not be limited to, trade secrets, financial statements, pricing, cost and expense data, sales figures, marketing data, administrative procedures, business policies and procedures, contracts and other similar information. Any such unauthorized disclosure by any director, officer, employee, agent or contractor of a Member to whom Member disclosed such information, shall be deemed a breach by such Member.

The above list, although extensive, is not all inclusive, nor should it be considered a one-size-fits-all type of list. Some of the items will not apply to a group and it is quite likely that some items will need to be added, given the individual circumstances of the group. The list is offered to provide some idea of the types of provisions that could be included as triggering events in the Membership Agreement. If the reason for disaffiliating a member from the group is covered in the Membership Agreement, the likelihood of a dispute from the departing member will be greatly reduced.The above list, although extensive, is not all inclusive, nor should it be considered a one-size-fits-all type of list. Some of the items will not apply to a group and it is quite likely that some items will need to be added, given the individual circumstances of the group. The list is offered to provide some idea of the types of provisions that could be included as triggering events in the Membership Agreement. If the reason for disaffiliating a member from the group is covered in the Membership Agreement, the likelihood of a dispute from the departing member will be greatly reduced.

Reverting to the questions posed above, let us consider first the question of the member whose operations have expanded into the areas of the other members. The underlying antitrust concern is that it is illegal for competitors to divide up a market among themselves by territory. A standard provision included in antitrust guides we prepare for buying groups is that a member’s area of operation cannot be a factor in excluding a member from the group. On the other hand, there is nothing wrong with pursuing a member because it nicely fills a gap in the group’s coverage. Nor is it wrong not to take the initiative of recruiting a prospective member because of its location. In this situation, if a legitimate reason or reasons can be found for disaffiliating the member from the group, then they should be relied upon as the grounds for taking the action. A member should not be disaffiliated because of where it operates.

Suppose however, the group provides a marketing program to its members and licenses them to use its service mark as a trade name for the stores they operate. A safer approach than disaffiliating the expanding member (but not necessarily without risk) would be for the group to restrict where its service mark may be displayed by territory, without restricting where its members may operate without using the licensed service mark as a trade name. Legal counsel should be consulted before attempting such an arrangement as a full understanding of the attendant circumstances would need to be considered before competent advice could be given.

The desire to terminate the deeply discounting member poses an even more serious antitrust concern. For the members to attempt to regulate the prices that other members charge through the group would doubtlessly be viewed as horizontal price fixing, which is per se illegal and punishable as a criminal offense. Such price policing activities are best left to the manufacturers who sell to the group. Ther is much less risk for a vendor to cut off a customer, than for group to attempt to do so, under those circumstances. Whether or not the members can request the manufacturer to take such action is a complicated and risky action. It goes beyond the scope of this discussion. Suffice it to say that legal counsel should be sought before making any such request.

In each of the two above examples, it should be noted that the danger of antitrust violation is greater when the group is owned and operated by its members. If no members are involved in the ownership or operation of the group, the restrictions imposed by the group are arguably more vertical, then horizontal. Note: for an explanation of the terms “horizontal” and “vertical”, please [click here].

The third scenario posed above pertained to a member who had changed its business from primarily a brick and mortar business to an online business. If the group had an established criterion that a large percentage of a member’s business must be conducted through a physical store facility and a member chose to no longer follow that requirement, the group would be within its rights to disaffiliate that member. If no such criteria existed at that time, then, the group would need to find another grounds for termination. We sometimes see a more general membership criteria that the member’s operation must be compatible with the objectives and policies of the group. Relying upon such a criterial alone is not ideal, but would at least provide the group with a colorable position for termination. If no criteria or grounds existed for termination under these circumstances, then if the group had the call provision discussed above, by a vote of the owners it could cause the ownership interest of the member in question to be redeemed. If lack of stock ownership was a grounds for termination (as included in the above list), then the membership agreement could be terminated as a result of the exercise of the call provision.

The last scenario posited above was the member who was no longer credit worthy and was on shaky ground financially.

Again, it would be important to check the Membership Agreement to see if credit worthiness was a membership criterion. Typically, it is. If it is not, then the call provision could be exercised, as noted above. Before proceeding with the disaffiliation action, however, counsel should check the state laws of where the group is incorporated, if different, the laws that are specified as governing the membership agreement and the state laws of where the member is incorporated. The laws of some states could be interpreted as requiring an extended notice of termination be given, such as 90 days, to permit the member some time to make other arrangements before the termination takes effect. Without providing such notice, the group could be held liable for the damages incurred by the terminated member. Even if there were no state laws which specifically required notice, consideration should be given to allowing a longer transition period than required in the membership agreement to soften the blow to the faltering member. Any such accommodation would likely require some tighter credit limits and payment terms as to what could be purchased through the group programs.

Any decision to terminate a member should be made at the board of directors level, especially if it entails purchasing back the ownership interest of the member in the group. Fortunately for buying groups, there is a 1985 US Supreme Court holding that a buying group is not required to provide a due process type hearing to the member by the group’s board of directors or one of its committees before taking action to disaffiliate the member voluntarily [See Northwest Wholesale Stationers, Inc. v. Pacific Stationery & Printing Co., 472 U.S. 284 (1985) at https://supreme.justia.com/cases/federal/us/472/284/.] However, it should be kept in mind that the laws of some states may require that there be good cause for exercising a call provision selectively.

As one can see, the disaffiliation of a member is a complex process and can be fraught with risk if strongly resisted by the target member. Ray Law Firm, PLLC is well acquainted with the nuances involved in this process and can help. Please call on us if you have any questions not answered in this discussion.