A Matter of Trust: Closely-held derivative lawsuits

Derek P. Usman, The Usman Law Firm, P.A.

 

A shareholder may initiate a direct action lawsuit against a corporation to redress an injury inflicted by the corporation upon the shareholder. However, a shareholder may also assert a cause of action on behalf of the corporation. Such a suit, a derivative lawsuit, arises against officers or shareholders when the corporation has failed to commence suit for injuries to the corporation itself. The Illinois Business Corporations Act creates a statutory cause of action for such an event. Nevertheless, distinctive characteristics and needs of close corporations have resulted in these companies receiving disparate treatment upon litigation.

 

Foremost, derivative lawsuits must be distinguished for close corporations (and other closely-held firms) and widely-held and/or publicly held corporations. For the former, derivative lawsuits are categorized as “Closely-Held”. While public or widely-held corporation derivative lawsuits are designated either as “Corporate Impropriety” or “Exploitation of Control” derivative lawsuits. “Corporate Impropriety” includes derivative suits seeking to impose personal liability on the board for a discrete act of corporate wrongdoing (typically a violation of law or a regulatory requirement). Corporations in this category tend to be larger and shareholdings more widely dispersed. “Exploitation of Control” suits are limited to challenging transactions between the corporation and those who control it. The Exploitation of Control category involves corporate transactions with or on behalf of the persons who control it. For cases in this category, the corporations tend to be smaller, the plaintiffs tend to hold significant blocks of stock, and that stock tends to be thinly traded, especially compared to that of the corporations in the Corporate Impropriety category.

 

While public corporations tend to incorporate in Delaware, close corporations are incorporated in the state of their principal state of business. The unique treatment afforded close corporations is further evident in the adoption of special code sections governing close corporations. In Illinois, a corporation’s failure to elect close corporation status will not prevent the corporation to be treated as a close corporation if under common law principles it would qualify as a close corporation.

 

The most extreme statutory provision that impacts shareholders in close corporations is involuntary dissolution. The remedy of involuntary dissolution will be administered in derivative lawsuits if the defendant acts “oppressively”. While the Illinois statutes do not define oppression, the courts have supplied definitions of oppressive conduct in closely-held cases. In Illinois, there is an enhanced fiduciary duty to shareholders of a close corporation that is similar to that of partners in a partnership. The emphasis placed on fiduciary duties in closely-held cases negates a requirement of finding fraud or illegal conduct.

 

Close and public corporations differ in ways that make general corporate law ill suited to close corporations. A major distinction for close corporations is that shareholders of a close corporation often serve as the directors or officers. Corporate law gives controlling insiders considerable latitude to run the corporation as they see fit. Understandably, they will generally favor their own priorities and objectives over those of the minority. Aside from their investments, these shareholders are also actively managing the company. Unlike public corporation shareholders, most close corporation shareholders’ income derives solely from distributions from the corporations. Consequently, a minority shareholder is particularly vulnerable to the whims of the majority. A minority shareholder’s dependence on the corporation, lack of control and a lack of market for shares all create unique circumstances for the minority shareholder.

 

There are several recurring scenarios that lead to derivative litigation in the close-corporation context. For example, a “freeze-out” or exclusion of a minority shareholder from management of the corporation prompts litigation. Also, disparate treatment of different shareholders, e.g., purchase of one shareholder’s share for fair value and not the others. Another common scenario involves the frustration of “reasonable expectations” of a shareholder; often the minority shareholder is deprived of a prominent position (director, officer or employee). Still yet, a shareholder’s attempt at competing with the corporation in another business leads to litigation.

 

It should be noted that situations arise where majority shareholders are the ones with the scales tipping against them. Minority shareholders may have the capacity to overpower a controlling shareholder (especially where corporate actions require supermajority approval). Of course the share liquidity issue is just as relevant for majority shareholders. Also, it might very well be that the minority shareholder brings all the expertise to the table.

 

Generally, cases in the Exploitation of Control and Closely-Held categories involve applications of the duty owed to minority shareholders by the majority. Derivative litigation performs the task of translating the abstract concepts of fiduciary obligation, good faith and fairness into the specific limits on the insiders’ ability to favor themselves. To this end, Illinois courts have embraced the “enhanced fiduciary duty” as a solution. The expansion of the duties makes more sense since closely-held shareholders often neglect to have a shareholders’ agreement in place. Thus, the old adage, “an ounce of prevention is worth a pound of cure”, is quite relevant in the avoidance of derivative litigation. The presence of a shareholders’ agreement significantly reduces the likelihood of a corporate breakdown. Additionally, under a longstanding history of allowing the freedom to contract, courts traditionally uphold shareholder agreements. The trick is to balance the interests of the majority and the minority. A shareholders’ agreement requiring unanimous approval for corporate actions might curb arbitrary actions by the majority. Nevertheless, such a provision providing the minority with carte blanche veto power might result in the minority shareholders holding the majority shareholders hostage. Similarly, the emergence of venture capitalists as minority shareholders further necessitates the need for a well-drafted shareholders’ agreement to avoid litigation scenarios.

 

Shareholders would be wise to employ a competent legal draftsman to produce an explicit agreement that reflects acceptable conduct by close corporation shareholders. Practitioners must communicate to their clients that the presence of a shareholders’ agreement would reduce the risk of litigation. While courts navigate around the contours of fiduciary duties, a shareholders’ agreement goes a long way towards preventing inequitable treatment.

COMING THIS SUMMER: THE NEW ILLINOIS POWER OF ATTORNEY ACT

Effective July 1, 2011, changes in the Act create new statutory Power of Attorney (POA) forms for property and healthcare.  A Power of Attorney is a legal document that gives another person (your agent) the authority to make financial and other legal decisions on your behalf.

The revised act provides more guidance to the agent in the performance of his duties.  For example, the agent will now receive a notice describing his responsibilities.  As before, you, the principal, must decide whether the agent is granted the power immediately or at a later time.

The property and healthcare POA forms are essential estate planning tools for adults.  The forms allow your wishes for medical and financial decisions to be carried out by someone trustworthy if you were to become incapacitated.

THE CONTRACT – HAVE IT IN WRITING

A written document to memorialize terms of an agreement between two or more persons minimizes confusion and possibility of litigation. Even though an oral agreement is usually sufficient to form a legal binding contract, a written contract provides proof of the intentions of the parties.

To demonstrate a breach of contract, the aggrieved party must first show that a contract exists.  An offer and acceptance is the starting point for a contract to exist.   Since a written contract explicitly spells out the obligations of all the parties to the contract, a breach by one of the parties is easier to establish.  Then under the terms of the contract, the aggrieved party must have performed its obligations while the other party did not.  Finally, there must be damages resulting from the breach.  A written contract also allows the parties to stipulate specific damages upon the occurrence of a breach of the contract.

A START-UP BUSINESS MIGHT BE WISE TO CHOOSE THE LLC AS ITS ENTITY FORM

Since tax considerations are of utmost importance in choosing an entity form, entrepreneurs should determine the advantages of beginning their business as a LLC. In particular, the applicability of the LLC structure must be examined when the entity plans to go public or merge with a public corporation.

While enjoying the benefits of a LLC prior to “going public”, the conversion of a LLC to a corporation is quite seamless.

An incorporation of an LLC can follow three forms:
1. the LLC can transfer its assets to the corporation in exchange for stock;
2. the LLC can distribute its assets to its members who then contribute those assets to the corporation in exchange for stock and;
3. the members can contribute their interests to the corporation in exchange for stock.

Of course, the incorporation of the LLC can also take place as part of the initial public offering under Section 351.

Also, the LLC’s conversion to a corporation should not prevent a subsequent tax-free reorganization under Section 368 when the corporation is acquired by a public company.

AMENDING PLEADINGS IN ILLINOIS COURTS

Section 2-616 of the Illinois Civil Practice Law provides for amendments to pleadings on just and reasonable terms before final judgment.

Loyola Academy v. S & S Roof Maintenance, 146 Ill.2d 263 provides the standard for amending pleadings in Illinois. The Loyola Academy court looked to four factors in determining the appropriateness of allowing leave to file an amended pleading:

The four factors are the following:

  1. Whether the proposed amendment would cure the defective pleading;
  2. Whether other parties would sustain prejudice or surprise by virtue of the proposed amendment;
  3. Whether the proposed amendment is timely; and
  4. Whether previous opportunities to amend the pleadings could be identified.