Articles Posted in Shareholder Squeeze Out

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Super Lawyers named Chicago and Oak Brook business trial attorneys Peter Lubin and Vincent DiTommaso Super Lawyers in the Categories of Class Action, Business Litigation and Consumer Rights Litigation. DiTommaso Lubin Austermuehle’s Oak Brook and Chicago business trial lawyers have over a quarter of century of experience in litigating complex class action, consumer rights and business and commercial litigation disputes. We handle emergency business law suits involving injunctions, and TROS, covenant not to compete, franchise, distributor and dealer wrongful termination and trade secret lawsuits and many different kinds of business disputes involving shareholders, partnerships, closely held businesses and employee breaches of fiduciary duty. We also assist businesses and business owners who are victims of fraud.

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Members of the board of directors of a corporation have the responsibility to orchestrate the business in such a way that is advantageous to the shareholders and the continued growth and prosperity of the company. However, there are times when those directors may act in a way that serves their own interests, and the only way to protect the business is for shareholders to file a derivative suit on behalf of the company. DiTommaso Lubin Austermuehle is always researching new developments in this field of law, and our Chicago shareholder derivative action attorneys recently came across one such case filed here in the Northern District of Illinois, Eastern District federal court.

Reiniche v. Martin is a double derivative suit brought by individual plaintiffs who are shareholders of a corporation, Health Alliance Holdings (HAH), that itself is a primary shareholder of HA Holdings (Holdings), another corporation. Plaintiffs allege that Defendants sought to freeze them and other HAH shareholders out through a series of illegal and wasteful acts that resulted in an insider transaction to sell Holdings for $10 and debt relief to another company in which Defendants had an interest. That transaction was approved by Holdings’ board of directors in spite of the fact that there was no quorum present to do so, and HAH was denied its right to sit on the board. In doing so, Plaintiffs alleged that the Defendant directors and other shareholders of Holdings breached their fiduciary duties to the company. Defendants then moved to dismiss the suit under Federal Rule of Civil Procedure 12(b)(6), claiming that Plaintiffs lacked standing, their claim was untimely, and the claims are insufficient under the law and barred by the business judgment rule.

The Court held that Plaintiffs did not have double derivative standing because such standing is only granted in the context of a parent/subsidiary relationship, and HAH was only a shareholder in Holdings – it was not a parent or holding company of Holdings. The Court went on to say that because the individual Defendant shareholders were each minority owners, none of them had a controlling interest in Holdings, and therefore did not owe a fiduciary duty to the Plaintiffs. As such, the Court found no policy reason for invoking a double derivative action and granted Defendants’ motions to dismiss.

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Our Oak Brook, Ill. shareholder dispute attorneys and Chicago business law lawyers took note of a recent appeals court decision in a heavily disputed case involving a family business. In Santella v. Kolton and Food Groupie Inc., Nos. 1-08-1329, 08-1357 & 08-1847 consolidated (Ill. 1st July 31, 2009), Rick Santella accused his sister, Mary Kolton, and her husband William of undermining the family’s business to enrich themselves once they became majority shareholders. The business is Food Groupie, Inc., which markets and sells use of anthropomorphic food characters and educational products that promote healthy eating. According to Santella, the intellectual property is the collective work of the family.

When Food Groupie was originally formed in 1987, Santella held a 35% interest; Mary and William Kolton held 25% each; and a non-party, their brother Ron Santella, held 15%. All four were named directors. In 1988, the plaintiff bought Ron Santella’s interest, giving him a 50% interest in the corporation to match the Koltons’ combined 50%. Shortly afterward, plaintiff transferred 1% of his interest to Mary Kolton, with the understanding that William Kolton would transfer his 25% to Mary, giving her a majority 51% interest with the idea that Food Groupie would be more successful if it was known as a woman-owned company. In exchange for this transfer, Santella claims, the parties executed an agreement that company decisions would be made only by a unanimous vote.

The business ran without incident until 2002. During that time, Santella claims Food Groupie made a profit each year between 1992 and 2001 and the three shareholders always unanimously approved compensation. But in 2002, Santella alleges that the Koltons called a shareholders’ meeting without him or Ron Santella, and gave themselves salary increases, bonuses and 401(k) contributions. This cost Food Groupie a total of 45% of gross company sales, despite a profit that year of only $15,000. The alleged ruse was repeated in 2003 and 2004. As a result, Santella claims, he was paid only one dividend of $1,470 during that time, rather than the $28,808 he believes he was entitled to as a 49% shareholder.

When he confronted his sister about this in 2003, he says she froze him out of the business decisions, changed the locks on the office and was interested only in buying him out. He further claims she usurped Food Groupie’s intellectual property by trademarking characters in her own name, and inappropriately licensed the company’s intellectual property without his consent. Finally, he claims the Koltons held a secret shareholder meeting in 2004 at which they voted to replace him with William’s brother, Anthony Kolton. He sued the Koltons, individually and as a shareholder derivative claim, for breach of the shareholder agreement, breach of fiduciary duty, usurpation of corporate opportunities and violations of the Illinois Business Corporations Act.

In 2005, that lawsuit resulted in the court’s appointment of John Ashendon as custodian of Food Groupie. In 2008, Santella filed an emergency motion to stop what he claimed was his sister’s plan to liquidate the company and move its misappropriated intellectual property to a similar business called Healthypalooza. He also alleged that the couple had continued to pay themselves inappropriately high salaries and commissions, and use the company’s profits for their personal legal defense. He sought to remove the Koltons as officers and enjoin them from using the company’s assets or competing with it, among other things. The court eventually found for Santella on some issues, removing the Koltons and ordering them to return the $144,019 in commissions they had been paid in 2005, 2005 and 2007. It said the court would appoint new officers and directors. It did not say any of these remedies were interlocutory or time limited.

The Koltons filed an interlocutory appeal in 2008, but failed to move to stay the repayment order or actually repay the $144,019. The trial court found them in contempt and ordered them to pay a fine for every day they were late. They eventually paid back the $144,019, but not the roughly $20,000 or so in fines.

On appeal, the Koltons argued that the relief granted to Santella was not supported by sufficient evidence or proof. Specifically, they argued that the Business Corporations Act requires a plaintiff like Santella to prove his claims of improper conduct before the court may order return of the allegedly improper bonuses or their removal as corporate officers. For that reason, they said, the court orders must be reversed. Santella made several arguments against the appeal, most notably that the appeals court lacked subject matter jurisdiction over the non-financial claims. The defendants filed their appeal pursuant to Rule 307(a)(1), which applies to appeals concerning injunctions, and Santella argued that the trial court’s orders removing and replacing directors and officers were not injunctions.

The First agreed with this, saying it lacked subject matter jurisdiction over those orders because they were not direct orders to the Koltons “to do a particular thing, or to refrain from doing a particular thing.” In fact, it took the analysis a step further and examined whether it had jurisdiction over the repayment order. That order was an injunction, the First wrote, but it also must be interlocutory to fall under Rule 307(a)(1). If it was a permanent order, it was outside the scope of the rule. The appeals court found that it was a permanent order, because it did not preserve the status quo. In fact, the court noted, the trial judge had specifically said so when she made her contempt ruling. The trial court had also made conclusions about the rights of the parties and had not time-limited the order. For those reasons, the First found that it also lacked subject matter jurisdiction over the repayment order, and dismissed the appeal entirely. The opinion noted that appellants may still seek a finding from the trial court under Rule 304(a).

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As Illinois shareholder dispute and shareholder squeeze out and freeze out litigation attorneys, we were interested in a state appellate decision affirming that corporate bylaws may be abrogated by years of contrary practices. Kern v. Arlington Ridge Pathology, S.C., No. 1-07-2615 (Ill. 1st. Dist. Aug. 7, 2008) arose from corporate governance problems at medical corporation Arlington Ridge Pathology. Dr. Susan Kern was an original shareholder of Arlington when it was incorporated in 1994. Arlington had six shareholders originally, but that number dropped to three in 1999 and stayed there through most of the time until this suit was filed in 2005. The other shareholders and directors were Dr. Richard Regan, elected president of the board in 2005, and Dr. Kishen Manglani. Arlington had an exclusive agreement with Northwest Community Hospital, and its shareholders had offices and practiced there.

Arlington’s original articles of incorporation are silent on the issue of a quorum for doing business or configuration of the board. However, its bylaws say a quorum is a majority of directors and the board should be made up of four to nine directors who are shareholder employees and doctors. Similarly, the articles of incorporation do not specify requirements for board actions, but the bylaws say the board may remove a director with a vote of 80% of shares. They also require an 80% vote to adopt new bylaws. Despite the board requirement, Arlington operated with a three-member board for most of the time since 1999. According to Kern, there were no regular meetings, no changes to bylaws and only two special board meetings. All actions of the board were unanimous.

Conflicts arose between Kern and Bruce Crowther, chief executive officer at Northwest. She alleges that their relationship was never good, but it became worse after a dispute that led to filing an incident report with Northwest on Sept. 12, 2001. Later, in June of 2005, an Arlington employee filed a report with Northwest accusing Kern of unprofessional and improper behavior. Kern alleged that this led to a “circus investigation,” but Regan met with Crowther to say Arlington would handle it internally. Nonetheless, Kern said, Crowther sent Regan a letter around the same time threatening to end the hospital’s contract with Arlington if it didn’t either fire Kern or send her to professional counseling.

Regan called a special board meeting for Oct. 21, 2005 at 1:30 p.m. — but he and Manglani met beforehand with Arlington’s attorney. They voted to change the articles of incorporation to allow an alternation or amendment of the bylaws with a two-thirds vote. When Kern arrived for the meeting and connected her attorney by speaker phone, she was given the minutes of the earlier meeting and a required five-day notice of the change. Kern and her attorney objected to the earlier meeting, but Arlington’s attorney said they weren’t needed because the directors already knew her position. When the resolution came into force, Manglani and Regan made several more bylaw changes, including one that required a two-thirds vote to remove a director and terminate an employee.

Two days later, Kern filed this action against Arlington and Regan, later amended to include damages for conspiracy and breach of fiduciary duty. At trial, the court granted summary judgment to the defendants and denied Kern’s motion to reconsider. It found that, by operating for years with only three shareholders, Arlington had abrogated its bylaws. Thus, a quorum was present at the Oct. 21 pre-meeting meeting at which Manglani and Regan made their decision, and the amendment was proper, the trial court said. Kern appealed the summary judgment ruing.

On appeal, one controlling issue emerged: whether the trial court was correct to find that the Oct. 21 meeting between Regan and Manglani had a quorum. Kern argued that it did not, according to Arlington’s articles of incorporation and bylaws as well as Illinois caselaw and the Business Corporations Act. Illinois courts have found that articles of incorporation are enforceable contracts between corporations and their shareholders, she said. Furthermore, previous decisions by Arlington’s board had been made unanimously, with all members present. Thus, the absolute minimum number of shareholders for a quorum on Oct. 21 should have been three, she argued, because the bylaws set a minimum number at four. And because the bylaws specified an 80% vote for any change of the bylaws, Kern argued, the shareholders clearly wanted a supermajority.

The appeals court disagreed. It found authority for the trial court’s decision that the Arlington board had abrogated its quorum rule in Johnson v. Sengstacke, 334 Ill. App. 620 (1948) and The First Church of Deliverance v. Holcomb, 150 Ill. App. 3d 703 (1986). In both of those cases , courts found that years of practices that did not follow the bylaws abrogated those laws by implying the board members’ consent. The same is true in this case, the court said.

This formed the basis of its decision in favor of Arlington and Regan on almost all issues. Past practices and the Business Corporation Act dictated that there was a quorum; that a two-thirds rather than 67% vote was appropriate; and that summary judgment on the conspiracy and breach of fiduciary duty claims was proper because the other directors had taken no illegal actions. It also dismissed her conflict of interests claim against Regan and Manglani, saying the relevant section of the law applies only to outside corporate actions, not internal governance matters. The First affirmed the trial court’s rulings on all counts.

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As Chicago business, shareholder rights and commercial law litigators, we frequently handle cases involving allegations of business fraud or financial mismanagement, often as part of complex business dispute, that require significant expertise in financial issues. When handling a divorce involving a family business or other closely held company, we also sometimes find we need an expert’s help properly valuing the business, so we can help our clients get the most equitable possible distribution of marital property.

Our Chicago, Oak Brook, Wheaton and Naperville business trial attorneys have handled many complex business and commecial law litigation matters which have involved presenting or cross-examining accounting witnesses.

While we’re confident in our legal skills, these situations call for specialized financial skills. To give our clients the best possible representation in business, shareholder and other commercial disputes, we sometimes retain a forensic accountant or fraud examiner. Both of these jobs are twofold: They help attorneys and their clients understand the complex financial aspects of their cases, and they may also be called to testify as expert witnesses. A forensic accountant’s job is to examine a person or corporation’s accounts “cold,” from the outside; the subject isn’t generally expected to cooperate. Similarly, a fraud examiner delves deep into a company’s finances, looking for the source of anything that seems inconsistent or suspicious. Both can serve as expert witnesses who help establish the value of a business or testify to the existence of fraud.

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Only managers in manager-operated limited liability corporations have a fiduciary duty to the company or to other members, the First District Court of Appeal ruled in a usurpation of corporate opportunity lawsuit involving a closely held LLC. Katris v. Carroll, No. 1-04-3639 (Dec. 23, 2005).

Peter Katris was one of four members/officers and two managers of an Illinois limited liability corporation, Viper Execution Systems LLC. Viper LLC was formed to market a type of options-related software, also called Viper, written by LLC member Stephen Doherty for member Lester Szlendak. Its articles of organization specified that management was vested in Katris and the other manager, William Hamburg.

Defendant Patrick Carroll employed Doherty before and during the organization, and defendant Ernst & Company later hired Doherty to work with Carroll. Their work included the writing of another software program, WWOW, which Katris believed was functionally similar to Viper. Five years after the organization, Katris sued Carroll and Ernst for collusion and usurpation of corporate opportunity because of WWOW’s similarity to Viper. (He also sued Doherty for collusion and breach of fiduciary duty, claims they later settled.)

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Experienced Illinois business litigators probably recognize Professor Charles W. Murdock of the Loyola University Chicago School of Law as a former Illinois Deputy Attorney General, former Loyola Dean and expert on Illinois business law. Given his status, it was with great interest that we read some of his scholarship on the concept of fairness in conflicts between shareholders or other parties interested in a business, especially in situations where the majority is using its greater power against a minority. These papers are a few years old, but they directly address some of the issues that are important to our firm and our clients in corporate freeze-out or squeeze-out litigation, breach of fiduciary duty and other internal business disputes in closely held companies.

In Fairness and Good Faith as a Precept in the Law of Corporations and Other Business Organizations, 36 Loy.U.Chi. L.J. 551 (2005), Murdock addresses the fiduciary duty of good faith and fairness that controlling interests of a business owe to minority interests. Noting that this internal duty is a fairly recent legal phenomenon, he surveys caselaw on the subject from around the country that applies to closely held corporations, public corporations and LLCs. Noting that the Uniform Limited Liability Company Act (ULLCA), a model law adopted by several states, doesn’t include language that gives members of an LLC fiduciary duties to one another, he praises Illinois for modifying that language to protect members in the updated Limited Liability Company Act.

Another of Murdock’s articles that directly addresses issues important to us is 2004’s Squeeze-outs, Freeze-outs and Discounts: Why Is Illinois in the Minority in Protecting Shareholder Interests?, 35 Loyola Chicago L.J.737 (2004). As you might expect from the title, Murdock argues in the article that Illinois business law, despite its “pro-shareholder” reputation, fails to protect minority shareholders in “fair value” proceedings. (Fair value proceedings are intended to resolve conflicts when majority shareholders want to do something that would harm the minority shareholders.) Until recently, those proceedings often led to marketability and liquidity discounts imposed on minorities, and the courts usually allowed it — giving rise to Murdock’s criticism. However, amendments to the Illinois Business Corporation Act in 2007 prohibited these discounts “absent extraordinary circumstances.” While the article is now out of date, fortunately for minority shareholders in Illinois, it still provides good arguments for the change and a survey of common circumstances under which fair value proceedings might arise.