Chicago Business Litigation Lawyer Blog
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.