Articles Posted in Shareholder Squeeze Out

In the business world of closely held companies in Illinois, minority shareholders often find themselves vulnerable to what is known as a “freeze out” or “squeeze out.” This blog post delves into this phenomenon, exploring what it means, how it happens, and the legal backdrop in Illinois that governs such situations.

What is a Freeze Out/Squeeze Out?

A freeze out or squeeze out occurs when majority shareholders in a closely held company engage in practices aimed at marginalizing, reducing, or eliminating the minority shareholders’ stake in the company. This can be done in various ways, such as refusing to declare dividends, terminating employment, or other tactics that essentially force minority shareholders to sell their shares at a reduced value.

Common Tactics Used

  1. Withholding Dividends: Majority shareholders may decide not to declare dividends, thereby cutting off a key financial benefit of holding shares.
  2. Employment Termination: Minority shareholders who are employed by the company might be terminated or demoted.
  3. Denying Access to Information: Minority shareholders might be denied access to important company information, impacting their ability to make informed decisions.
  4. Dilution of Shares: The company might issue more shares, diluting the minority’s ownership percentage.

Legal Framework in Illinois

In Illinois, the rights of minority shareholders in closely held corporations are protected under various statutes and case law. The Illinois Business Corporation Act provides certain protections and remedies for minority shareholders, including the right to a fair valuation of their shares.

  1. Fiduciary Duties: Majority shareholders have fiduciary duties to the minority. Breach of these duties can form the basis for legal action.
  2. Oppression Remedies: The law provides remedies for “oppressive” actions by majority shareholders. This can include actions that are burdensome, harsh, or wrongful.

In Illinois, there are several significant cases that provide guidance on the treatment of minority shareholder or LLC member freeze-outs or squeeze-outs.

In “Vanco v. Mancini”, the court acknowledged the vulnerability of minority shareholders to freeze-outs or squeeze-outs where the majority, for personal rather than legitimate business reasons, deprives the minority shareholder of their office, employment, and salary. The court highlighted the availability of judicial remedies, including the dissolution of the corporation, in such instances.

The case of “Rexford Rand Corp. v. Ancel” further expanded on this issue. The court suggested the necessity of a fiduciary duty on shareholders in a close corporation as a protective measure against oppressive conduct by the majority. It also indicated that a minority shareholder who has been frozen out should rely on an oppressed shareholder lawsuit against the corporation seeking damages or dissolution. Interestingly, the court discussed whether a freeze-out terminates a shareholder’s fiduciary duty to a close corporation and concluded that a minority shareholder who has been frozen out no longer exercises influence over corporate affairs that gives rise to a fiduciary duty.

“Small v. Sussman” held that the injuries alleged by a minority shareholder were injuries to the corporation, thus only a shareholder derivative action was available. It also found that a freeze-out merger that, through a reverse stock split, eliminated a minority shareholder’s fractional share, did not support a constructive fraud claim. The court ruled that a minority shareholder cannot recover on a conversion claim against the majority shareholder and corporation in connection with a freeze-out merger that eliminated his fractional share.

Further to this, “Jaffe Commercial Finance Co. v. Harris” held that a majority, by merely voting its strength to effectively oust minority from participation in the business of a corporation, did not act oppressively within the meaning of the statute authorizing liquidation. Similarly, in “Jahn v. Kinderman”, it was held that frozen-out minority shareholders in closely held corporations may seek dissolution of the entity, and majority shareholders may avoid this result via a buyout of the minority at a “fair value” to be determined by the circuit court if the parties are unable to reach an agreement.

Lastly, “Bone v. Coyle Mechanical Supply, Inc.” found that majority shareholders’ conduct in failing to hold annual meetings, failing to observe corporate formalities in increasing bonuses and compensation, and effectively “freezing-out” minority shareholders could be considered as outrageous, due to evil motive or reckless indifference to the rights of others.

Please note that these cases provide a general outline of the law in Illinois on minority shareholder or LLC member freeze-outs or squeeze-outs, and the specific holdings may vary depending on the facts of each case.

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In Illinois, the situation regarding LLC minority members bringing a derivative lawsuit for member oppression is quite specific. The Illinois Limited Liability Company Act allows LLC members to file a derivative action to protect the interests of the LLC. This is particularly relevant when the LLC itself has a cause of action, but the managers or members have failed to pursue it. Such a derivative action enables members to enforce the rights of the LLC and recover damages on its behalf.

However, it’s important to understand that a derivative action is distinct from a member oppression claim. While derivative actions are filed on behalf of the LLC for wrongs against the LLC, certain types of member oppression claims are brought by individual members against the controlling members for actions that unfairly prejudice the minority members’ rights or interests and case-specific injury to the minority member but not the LLC as a whole.

For a derivative action to be initiated, certain conditions must be met. The member initiating the action should not be a manager of the LLC, and they must have made a written demand on the managers or members of the LLC to take action to enforce the right. If the managers or members fail to take action within 90 days, the member can then file a lawsuit on behalf of the LLC. It is crucial to note that derivative actions are complex and can be costly, so seeking advice from an experienced business attorney is recommended.

For member oppression, minority LLC members in Illinois have legal options to protect their interests and seek remedies, such as judicial dissolution, breach of fiduciary duty claims, specific performance or injunctive relief, and buyout or monetary damages. Again, legal counsel is crucial in navigating these options and understanding the rights and legal remedies available under the Illinois Limited Liability Company Act.

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When a shareholder or LLC (Limited Liability Company) member faces a “freeze-out” or “squeeze-out,” they are typically being pushed out of the company’s decision-making process or their economic interests are being diminished. This can be a challenging and complex situation, requiring a careful and strategic approach. Here are some general steps that might be considered:
  1. Understand Your Legal Rights and Documents: Review the company’s governing documents, such as the bylaws, shareholder agreement, or operating agreement. These documents often outline the rights and obligations of shareholders or members and may contain provisions relevant to your situation.
  2. Gather Evidence: Document any actions that contribute to the freeze-out or squeeze-out. This could include meeting minutes, emails, financial statements, or any other relevant communications.
  3. Seek Legal Advice: Consult with an attorney who specializes in corporate law, particularly someone experienced in shareholder/member rights in LLCs or corporations. They can provide advice specific to your situation, including the interpretation of any legal documents and the identification of any breaches of fiduciary duties or violations of state laws.
  4. Explore Negotiation and Mediation: Before taking any legal action, consider whether the situation can be resolved through negotiation or mediation. These alternative dispute resolution methods can often be less costly and time-consuming than litigation.
  5. Consider Your Goals: Identify what you want to achieve. Do you want to regain your position in the company, receive compensation for your lost interests, or simply exit the company in a fair manner? Your goals will guide your strategy moving forward.
  6. Possible Litigation: If negotiations fail and your legal rights are being significantly infringed upon, litigation may be necessary. Your attorney can advise on the likelihood of success and the costs involved.
  7. Financial Implications: Consider the financial impact of your chosen course of action, including legal fees, potential loss of income, and any tax implications.
  8. Communication with Other Shareholders/Members: If other shareholders or members are also being affected, it might be beneficial to communicate with them. There could be strength in numbers, either in negotiations or in legal action.
  9. Understand the Impact on Relationships: Consider the long-term business relationships and how they will be affected by your actions. Sometimes the best legal strategy might not align with your long-term business or personal relationships.
  10. Plan for the Future: Regardless of the outcome, think about your future with or without the company. This might involve considering other business opportunities or roles.

Every situation is unique, and the best course of action will depend on the specific circumstances, the governing laws of the state where the LLC or corporation is registered, and the details of the company’s governing documents. It’s crucial to balance legal considerations with practical business and personal considerations.

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Excessive management fees charged by a majority owner can potentially be the basis for a derivative lawsuit in certain circumstances. In corporate law, a derivative lawsuit is a legal action brought by shareholders on behalf of a corporation against third parties, often including insiders such as officers, directors, or controlling shareholders. The key issues in such a lawsuit typically involve allegations of breach of fiduciary duty, abuse of control, fraud, or mismanagement.

When a majority owner charges excessive management fees, it may be construed as a breach of fiduciary duty or misuse of their position to the detriment of the corporation and its minority shareholders. In such cases, the following elements are often considered:

  1. Breach of Fiduciary Duty: Majority owners owe a fiduciary duty to the corporation and its shareholders. Charging excessive fees could be seen as a breach of this duty, especially if it harms the corporation’s financial health or is not in the best interest of all shareholders.
  2. Fairness and Reasonableness: The fees must be fair and reasonable. If the fees are exorbitant compared to industry standards or the services rendered, it could be a ground for legal action.
  3. Impact on Minority Shareholders: If the excessive fees adversely affect the minority shareholders or the value of their shares, it can be a strong basis for a derivative suit.
  4. Corporate Governance and Approval Processes: The procedures followed in approving the fees are also important. If the majority owner bypassed normal governance processes or used their influence to approve the fees without proper oversight, it could strengthen the case for a lawsuit.
  5. Jurisdiction and Specific Laws: Laws regarding fiduciary duties and shareholders’ rights vary by jurisdiction. The specific legal standards and precedents in the jurisdiction where the corporation is incorporated will play a critical role.

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The duty of oversight, often referred to within the context of corporate governance, is a critical aspect of the responsibilities of a corporation’s board of directors. This duty is essentially the requirement that board members are attentive to and oversee the business and affairs of the corporation, including its compliance with the law and its risk management processes. The duty of oversight is a component of the fiduciary duties that directors owe to the corporation and its shareholders.

The case In re McDonald’s Corp. S’holder Deriv. Litig., 2023 WL 387292, C.A. No. 2021-0324-JTL, at *1, *9 (Del. Ch. Jan. 26, 2023) is centered around allegations that the McDonald’s directors overlooked signs of a corporate culture permitting sexual harassment and misconduct from 2015 to 2020. The plaintiffs, who are shareholders, contend that this resulted in harm to the company due to subsequent employee lawsuits, loss of employee trust, and a damaged reputation. Nine directors who served during this period were named as defendants.

David Fairhurst, who served as Executive Vice President and Global Chief People Officer of McDonald’s from 2015 until his termination in 2019, was among the defendants. The plaintiffs argued that Fairhurst, as a fiduciary, was aware of potential issues with sexual harassment and misconduct in the company. They claimed that under his leadership, a culture of sexual misconduct and harassment was allowed to develop, leading to coordinated Equal Employment Opportunity Commission (EEOC) complaints, a 30-city walkout, and a second round of coordinated EEOC complaints, followed by a second one-day strike in 10 cities.

To fully grasp how this case has impacted Delaware Law concerning the duty of oversight, it is essential to understand the concept of a Caremark claim. This type of “failure of oversight” theory is observed to be one of the most challenging theories in corporation law upon which a plaintiff might hope to win a judgment. Under Delaware law, plaintiffs must plead with particularity that there were so-called ‘red flags’ that put the directors on notice of problems with their systems, but which were consciously disregarded. Continue reading ›

Limited Liability Companies (LLCs) are a popular business structure known for providing liability protection to its members. However, conflicts and wrongdoing within an LLC can occur, leading to disputes among members. When an LLC suffers harm due to actions taken by its management or majority members, a derivative suit can be an effective legal recourse for members seeking to address these issues in Illinois.

Understanding LLC Derivative Suits: An LLC derivative suit is a legal action brought by one or more members on behalf of the LLC against a third party, typically the management or majority members, alleging wrongdoing or harm done to the company. In essence, it allows individual members to sue on behalf of the LLC when the company itself fails to take action against internal misconduct.

In Illinois, the procedures and rules governing derivative suits for LLCs are outlined under the Illinois Limited Liability Company Act (805 ILCS 180) and relevant case law.

Requirements for LLC Derivative Suits in Illinois: For a member to file a derivative suit on behalf of an LLC in Illinois, several key requirements must be met:

  1. Ownership Status: The member initiating the derivative suit must be a current member at the time of filing the lawsuit and must have been a member at the time the alleged wrongdoing occurred.
  2. Exhaustion of Remedies: Generally, the member bringing the suit must show that they made a demand on the LLC’s management to take action against the alleged wrongdoing but that the demand was either rejected or ignored, or waiting for a response would be futile.
  3. Injury to the LLC: The alleged misconduct must have caused harm or damage to the LLC, affecting its financial interests or causing other significant negative effects.
  4. Representation of LLC’s Interests: The member bringing the derivative suit must adequately represent the interests of the LLC and not have conflicting interests.

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Shareholder and LLC member disputes can be complex and contentious, especially when one party attempts a “freeze-out.” A freeze-out refers to excluding a shareholder or member from the decision-making process or the benefits of ownership. In Illinois, recent court decisions have shed light on the legal principles surrounding these disputes. In this blog post, we will explore some of these notable cases and the lessons they offer for those facing or involved in freeze-out situations.v

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It’s commonly said that you have to spend money to make money, but taken too far, that philosophy can easily bankrupt a company. When that company has investors and shareholders whose money you’re spending so you can try to make money, you have to justify your expenses to those shareholders. You have a responsibility to spend their money wisely so they can expect a good return on their investment.

According to a series of lawsuits filed against Madison Square Garden Entertainment Corp., the company allegedly made a series of moves the shareholders considered to be in violation of the company’s fiduciary duty.

One such move was the decision made by MSG Network’s board of directors and controlling stockholders to merge with MSG Entertainment. The reason given for the move was to save costs, but the minority shareholders allege the move was not made with their best interests in mind. Continue reading ›

In a recent 11th Circuit Court of Appeals decision, Warrington v. Rocky Patel Premium Cigars, Inc., No. 22-12575, 2023 WL 1818920 (11th Cir. Feb. 8, 2023), the court provided valuable lessons for partners, shareholders, and small business owners who may find themselves in disputes. This case serves as a cautionary tale, highlighting the importance of careful strategy and legal counsel when pursuing litigation or arbitration.

The dispute centered on Brad Warrington, a minority shareholder in Rocky Patel Premium Cigars, who wanted to divest from his holdings in the company. The buy-sell agreement between Warrington and Rakesh Patel, the majority shareholder, included an arbitration provision for any disputes arising out of the agreement. However, the case demonstrates how mistakes made during litigation can result in a waiver of the right to arbitration.

After years of disagreement over the value of Warrington’s shares and alleged improprieties by Patel, Warrington found a private buyer and notified Patel of his intention to sell. Patel refused to acknowledge the notice and subsequently sued Warrington in Florida state court, seeking a declaratory judgment and alleging breach of contract, among other claims.

While the state action was pending, Warrington sued Patel in federal court, bringing several counts, including breach of contract and breach of fiduciary duty. Patel moved to dismiss, remand, or stay the federal action, but the district court denied his motion. It wasn’t until June 2022 that Patel moved to stay and compel arbitration under the agreement. However, the district court denied this motion, finding that Patel had waived his right to arbitrate by initially filing in state court and moving to dismiss or remand Warrington’s federal action. Continue reading ›

When starting a business, co-owners envision the best—working together productively and profitably. But it is all too common for business partners to encounter a serious impasse over how to operate the business. When partners are unable to work through a dispute, it may be time for one partner to exit the company via a buyout of their interest. It is not uncommon for this scenario to arise in conjunction with claims that the majority shareholder or shareholders are oppressing the minority shareholder or shareholders.

For Illinois corporations, the Illinois Business Corporation Act of 1983 (BCA) permits shareholders to pursue legal action against each other based on allegations of fraud, illegal activity, corporate waste or other disruptive conduct. The BCA provides for 12 categories of relief that a court may order as an alternative to dissolving the business. Minority shareholders frequently opt to pursue the remedy of a buyout, in which the exiting shareholder’s interest is purchased by the remaining shareholders for “fair value.” Similarly for Illinois LLCs, the Illinois Limited Liability Company Act provides that a court may order the entity or the remaining members to purchase the interest of the outgoing member.

The BCA defines “fair value” as the value of the shares “taking into account any impact on the value of the shares resulting from the actions giving rise to a petition under this Section.” The statute goes on the explain that “‘fair value,’ with respect to a petitioning shareholder’s shares, means the proportionate interest of the shareholder in the corporation, without any discount for minority status or, absent extraordinary circumstances, lack of marketability.” For many companies, this provides a much more favorable valuation to a minority shareholder than selling shares for fair market value or any other metric of value normally employed when selling an interest in a small business. This is particularly true for closed (or closely held) corporations where a market for the minority’s shares might not otherwise exist since the statutory valuation does not generally speaking allow for a discount for the lack of marketability of the minority’s shares. Continue reading ›

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