The fiduciary duty of officers and directors to the corporations they serve is well settled. Illinois courts have found that in certain situations shareholders of closely held corporations owe this fiduciary duty as well. Important cases in this area include Hagshenas v. Gaylord 199 Ill. App. 3d 60, 557 N.E. 2d 316, 145 Ill. Dec. 546 (2nd Dist. 1990) and Dowell v. Bitner 273 Ill. App. 3d 681, 652 N.E. 2d 1372, 210 Ill. Dec. 396 (4th Dist. 1995). This article discusses the Hagshenas and Dowell cases, and then describes amendments to the Illinois Business Corporation Act of 1983 (BCA) in 2005 that are relevant to such disputes, including new Section 7.90 which allows a shareholder in certain circumstances to file a waiver with the corporation in order to avoid future fiduciary duty claims.
Hagshenas
The Hagshenas case arose out of the relationships among the shareholders of Imperial Travel, Ltd., an Illinois corporation that operated a travel agency in Rockford, Illinois. The shares of Imperial were owned 50 percent by Bruce Hagshenas and 50 percent by Robert Gaylord, Jr., who subsequently conveyed half of his shares to his wife, Virginia Gaylord. All three shareholders, together with Mr. Hagshenas’ wife, Barbara, were officers and directors of the corporation and were active at times in the daily operations of the business of the corporation. Although the travel agency operated by the corporation was apparently quite profitable, the relationships among the Hagshenases and Gaylords were not good. Disputes among the parties included claims that Bruce Hagshenas: changed the combination on the corporation’s post office box without the knowledge of Virginia Gaylord, who was responsible for mail coming to the company; called the police to remove the Gaylords for trespassing when they came to the office to review some records; changed the locks on the office twice without the Gaylords’ knowledge or approval; and, over the objections of the Gaylords, purchased a new vehicle for the business, moved the company into a new line of business, and took actions on raises, advertising and expense reimbursement.
Hagshenas filed suit to dissolve the company in April of 1982. The Gaylords counterclaimed alleging breach of fiduciary duty and seeking damages. On October 2, 1982, the Hagshenases resigned as officers and directors of Imperial. The following day they purchased a new agency and began competing with Imperial. In the weeks that followed, the Hagshenases hired away most of the staff of Imperial to work for their competing travel agency, then known as Superior Travel, Inc.
On the basis of the testimony and stipulations, the trial court found that Hagshenas had breached his fiduciary duty to Imperial. At trial each side had presented expert testimony as to the value of Imperial with regard to damages, however the trial court determined that damages were too inexact for a money judgment to be rendered, and instead ordered the equitable remedy that all of Hagshenas’ Imperial stock be transfered to Imperial, to be held in constructive trust and to be voted by the Gaylords. The trial court also denied the claim for dissolution brought by Hagshenas.
Hagshenas appealed the trial court’s denial of his dissolution claim, the trial court’s finding that he owed a fiduciary duty to Imperial after he resigned as a director and officer, and its finding that he was liable for breach of that fiduciary duty. The Gaylords appealed the determination by the trial court that money damages could not be determined.
The appellate court for the Second District affirmed the ruling of the trial court that dissolution was not available. The appellate court also rejected Hagshenas’ appeal of the finding that he breached a fiduciary duty as an officer and director of Imperial prior to his resignation, and dismissed Hagshenas’ claim that the doctrine of clean hands should be applied against the Gaylords to bar his liability to them. Finally, the appellate court also rejected Hagshenas’ appeal of the trial court’s finding that he owed a fiduciary duty after resigning as a director and officer of Imperial.
In addressing the question of Hagshenas’ liability for breach of fiduciary duty after he resigned, the appellate court considered the following:
With this background, the appellate court noted that Hagshenases and the Gaylords were not only equal shareholders, they were also all directors and officers of the company and oversaw the day-to-day operations of the company. The court held that Hagshenas, as a 50 percent shareholder in a closely held corporation, owed a fiduciary duty to Imperial and its shareholders similar to that of a partner, and that he violated this fiduciary duty when he opened a competing business and hired away Imperial’s employees.
Addressing Hagshenas’ argument that his resignation relieved him of his fiduciary duty, the court noted that he maintained his 50 percent ownership interest in Imperial, and that after his resignation he objected to Imperial buying a new agency and continued to pursue his suit for dissolution. In supporting its decision, the appellate court stated:
We find it implicit that people who enter into a small business enterprise, as in this case, place their trust and confidence in each other. Thus, we find support for finding a fiduciary duty from Kulp, 41 Ill. 2d at 215, 242 N.E. 2d 228, which held that a fiduciary relationship exists in all cases in which a confidential relationship has been acquired…The parties being equal shareholders, were at each other’s mercy. If there were problems that could not be resolved, then the course of action would have been to negotiate a sale or buyout of the shares or file for dissolution. We are aware that Bruce made an attempt to sell his shares and file for dissolution. Until a final sale or order of dissolution, however, Bruce owed a fiduciary duty to Imperial.
Hagshenas, 199 Ill. App. 3d at 72.
Dowell
The more recent case of Dowell v. Bitner, 273 Ill. App. 3d 681, 652 N.E. 2d 1372, 210 Ill. Dec. 396 (4th Dist. 1995), involved both a partnership and a corporation. Sharon Dowell and Steven Bitner were partners in S&S Irrigation Company (S&S). Additionally, they and four other individuals were shareholders, officers and directors in P&A Irrigation, Inc. (P&A). S&S had operated under an oral partnership agreement from October, 1983 through March 15, 1989, on which date Dowell signed a partnership agreement presented to her by Bitner two days earlier. On March 17, 1989, two days after the partnership agreement was signed, Bitner gave notice of termination under the partnership agreement and also resigned as an employee of P&A. On March 20, 1989, Bitner began a new business that competed with S&S and P&A, began soliciting their customers, hired the best service employee from P&A, and then on March 24, 1989 submitted his written resignation as an officer and director of P&A.
Dowell and P&A sued Bitner for breach of the fiduciary duty Dowell alleged that Bitner owed to both Dowell and to the corporation. The complaint sought the equitable relief of voiding the partnership agreement and termination notice, dissolving the partnership, giving Dowell an accounting, and allowing Dowell to wind up the partnership affairs. The complaint also sought compensatory and punitive damages for breach of fiduciary duty. Bitner counterclaimed to enforce the termination notice or in the alternative to dissolve S&S, to take an accounting, and to dispose of its property and divide the proceeds. The trial court held that Bitner’s duty to P&A as a shareholder terminated March 18, 1989, but his duty as a director and officer ended when he submitted his resignation in writing on March 24, 1989. The trial court refused to admit evidence of breach or damages occurring after March 24, 1989, finding that Bitner did not breach his fiduciary duty and that no damages existed. The court also found that the winding up of the partnership was fair, reasonable and proper.
Dowell and P&A appealed the trial court’s determination regarding breach of fiduciary duty and Bitner appealed the determination the holding that the partnership accounting was fair and reasonable. The Fourth District Appellate Court found that Dowell’s reliance on the Hagshenas decision was misplaced, holding that something more than mere status as a shareholder in a close corporation is required to impose a fiduciary duty on Bitner. In support of its holding, the appellate court cited the case of Graham v. Mimms, 111 Ill. App. 3d 751, 67 Ill. Dec. 313, 444 N.E. 2d 549 (1st Dist. 1982), in which a majority shareholder was found to owe a fiduciary duty to a minority shareholder when the majority shareholder, after resigning his corporate positions, used his majority status to elect his sister and brother-in-law to corporate positions to retain control of the company and to fire the minority shareholders. In trying to reconcile its decision with the Hagshenas and Graham cases, the appellate court in Dowell stated, “It could be argued that Illinois courts look at a shareholder’s ability to hinder, influence, or control the corporation when determining whether the shareholder has a fiduciary duty to other shareholders.” Id. 273 Ill. App. 3d at 690. The Dowell court went on to find that Bitner did not have the ability to hinder, influence or control P&A, and therefore owed no fiduciary duty to P&A as a shareholder after he ended his employment and ceased being a member of the board of directors.
In addressing the claim of P&A that it should have been allowed to present evidence of breaches of Bitner’s fiduciary duty with regard to events consummated by Bitner after resigning as an officer and director but begun by him before the resignations, the appellate court in Dowell summarized its view of Illinois law on this issue as follows:
In the absence of fraud, a contractual restrictive covenant, or the improper taking of a customer list, former employees may compete with their former employers and solicit former customers provided there was no demonstrable business activity before termination of employment. However, corporate officers owe a fiduciary duty of loyalty to their corporate employer not to (1) actively exploit their positions within the corporation for their own personal benefit, or (2) hinder the ability of a corporation to continue the business for which it was developed. The resignation of an officer will not sever liability for transactions completed after termination of the officer’s association with the corporation for transactions which (1) began during the existence of the relationship, or (2) were founded on information acquired during the relationship (citations omitted).
Dowell, 273 Ill. App. 3d at 691.
The appellate court in Dowell found that the trial court erred by not allowing P&A to present evidence that Bitner’s activities, which were commenced before his resignation but did not come to fruition until after his resignation, constituted a breach of fiduciary duty.
New BCA Section 7.90 and Amended Section 12.56(f)
It is clear that in appropriate circumstances a shareholder of a closely held Illinois corporation may be found to owe a fiduciary duty to the corporation and its other shareholders, and may also be held liable for breaching that duty. The facts giving rise to this duty and any liability for its breach have been, and will continue to be, determined by courts on a case-by-case basis. Practitioners will, however, now have some statutory guidance on the issue of a shareholder’s fiduciary duty. Senate Bill 533, which was enacted by Public Act 94 394 and became effective July 1, 2005, made important changes to the Illinois Business Corporation Act of 1983 by adding Section 7.90 and amending Section 12.56(f). New Section 7.90 provides a mechanism by which the potential future fiduciary duty of such a shareholder may be ended in certain circumstances. The amendment to Section 12.56(f) addresses what was perceived to be an inequitable requirement that shareholders petitioning for a judicial remedy under that Section of the BCA must offer their shares to be purchased by the corporation and the other shareholders as part of the process of seeking relief under Section 12.56.
New BCA Section 7.90 provides a “safe harbor” waiver mechanism by which a shareholder, under certain circumstances, may avoid a claim of future liability for fiduciary duty. Under Section 7.90(a), a shareholder who is not then a director or officer of the corporation can avoid future fiduciary duty to the corporation and its other shareholders by delivering to the corporation a written instrument that irrevocably waives the right: (i) to vote any shares held by such shareholder; (ii) to be a director or officer of the corporation; and (iii) in any other manner, directly or indirectly to control any of the corporation’s actions or the election or removal of any director or officer. This right may be denied to a shareholder if so provided in the corporation’s Articles of Incorporation. While Section 7.90 provides assurance of no future fiduciary duty after filing the waiver under these circumstances, it specifically provides such a waiver will not affect any breach of fiduciary duty that arose prior to the effective date of the waiver.
The remaining sections of new Section 7.90 address various issues related to the waiver and its effects. Section 7.90(b) requires that the corporation give prompt notice of the waiver to all remaining shareholders if the corporation does not have shares listed on a national securities exchange or that are regularly traded in a market maintained by members of a national or affiliated securities association. Subsection (c) makes it clear that none of the waiving shareholder’s other rights or obligations under the BCA are affected by the waiver. Subsection (d) specifies that shares subject to the waiver are not to be counted in determining the number of shares necessary either for a quorum or for a shareholder action under Section 7.60, and also provides that a waiver does not continue to apply to a transferee of the shares. Subsection (e) makes the waiver specifically enforceable. Finally, subsection (f) clarifies that new Section 7.90 is not intended to identify circumstances under which a fiduciary duty arises, whether or not a shareholder executes a waiver under subsection (a).
The 2005 change to BCA Section 12.56(f) is also relevant, since many shareholders who claim that a breach of fiduciary duty has occurred will also look to Section 12.56 for the remedies it provides. Section 12.56 specifies remedies available to shareholders of Illinois BCA corporations that have no shares listed on a national securities exchange or regularly traded in a market maintained by members of a national or affiliated securities association. Subsection (a) lists the circumstances in which a court may order relief for a petitioning shareholder, while subsection (b) sets out a non exclusive list of remedies available to the court. Prior to amendment in 2005, Section 12.56(f) gave the right to the non petitioning shareholders or to the corporation to purchase all of the shares owned by the petitioning shareholder for their fair value. The 2005 amendment modified subsection (f) by making this right available only in the event petitioning shareholders request the purchase of their shares as part of the relief sought. As a result, shareholders will no longer be forced to allow their shares to be purchased unless they affirmatively elect this alternative at the time of filing for relief under Section 12.56, or presumably in any subsequent amendment to the petition for relief.
Summary
In summary, new Section 7.90 is not intended to guide shareholders, practitioners or the courts on when or whether a fiduciary duty of a shareholder may arise or exist, or what actions would result in a breach of that duty, however it does give clear guidance on the steps that a shareholder may take to prospectively avoid that duty. Additionally, the change to Section 12.56(f) allows shareholders who believe they are entitled to a judicial remedy to commence an action without being required to offer their shares for purchase in the process.
If asset protection is important for your clients’ business, series LLCs may be an entity organization option to consider. This option was never previously available in Illinois.
Illinois Secretary of State Jesse White’s Business Laws Advisory Committee has been studying the series concept for more than two years. A draft bill amending the Illinois Limited Liability Act to permit formation of series LLCs in Illinois was submitted to the 2005 session of the Illinois General Assembly. It successfully passed and took effect last August. This article will outline the important components of Public Act 094-0607. Further, it will describe how series LLCs work in businesses. Finally, it will explore how to determine whether its use is right for your clients.
Illinois Series LLC Amendment
Effective August 16, 2005, PA 94-0607 added section 37-40 (series of members, managers or limited liability company interest) to the Limited Liability Company Act (805 ILCS 180) (“Act”) and amended section 50-10 (fees) authorizing domestic series LLCs in Illinois. The Illinois Secretary of State has added new forms 5.5(S) (Articles of organization for a series LLC) and 37-40 (Certificate of Designation). The Secretary of State has ruled that existing Illinois LLCs (and foreign LLCs) may amend their articles to become series LLCs.
Under section 37-40 of the Act, an operating agreement may designate members, managers, or company interests as having separate rights in regard to property, as well as company obligations, profits, and losses in connection with certain property or responsibilities of the company. Additionally, an operating agreement may set forth different business or investment objectives for certain company members, managers, or interests.
If one or more series of company members, managers, or interests are recognized in the operating agreement of a limited liability company, then only the assets of the identified series are subject to seizure for payment of debts, liabilities and obligations incurred, contracted for or otherwise existing with respect to a particular series. Separate records must be preserved for every series, and the assets of the series must also be kept apart from the general assets of the company. Adequate notice for the creation of a separate series consists of filing such notice with the Secretary of State and describing the restriction of the series’ liability. In addition, a series will be regarded as an entity separate from the company to the degree specified by the articles of organization. Nevertheless, a series LLC will be only be considered in good standing so long as the company as a whole is in good standing.
The provisions of the Act are generally applicable in the same manner to a series within a limited liability company as they are to the company itself. A series can be terminated and its transactions brought to a close without requiring dissolution of the entire company. Further, an individual series may conduct business in a foreign jurisdiction by having itself registered as a limited liability company regardless of whether the company as a whole is registered in that foreign jurisdiction.
Section 50-10 of the Act lists the fees for limited liability companies and provides that a fee of $750 shall be collected in order to file articles of organization for a limited liability company having a series as depicted under section 37-40. A fee of $250 is owed in connection with the filing of a limited liability company’s annual report, and an additional $50 is collected for every series within a limited liability company that was properly created according to section 37-40 of the Act. To simply designate a series as separate within a limited liability company costs $50.
How Series LLCs Work
The ordinary limited liability company allows business owners to attain limited liability for debts of the business while the IRS taxes it on a relatively unrestricted pass-through basis. The LLC also provides protection to its owners for debts unrelated to the business in that LLC property and LLC interests themselves generally cannot directly be seized or attached by creditors of debtor members. 805 ILCS 180/30-20. Instead, such creditors are limited to a “charging order” issued by a court requiring the LLC to make payments to that creditor, instead of the debtor member otherwise entitled to the distribution.
The charging order is not an attractive remedy for a creditor, however. It does not provide the creditor with voting rights, such as the right to vote for a distribution. Thus, if the company does not make distributions to the debtor member, the distribution will not go to the creditor.
Segregating high-risk assets and businesses in separate entities, away from each other, can prove beneficial for investors and promoters. This is particularly valuable in cases when the business owns both low and high risk assets alike. An example could be when a business has both a rental home component and operates a gas station. In order to spread this particular risk around, such a client might be advised to have two separate LLCs, one for each business. Another example is a client with a dozen rental properties could be advised to open separate LLCs, one for each property.
Under the new Act, only one LLC may be required. The Act allows an LLC agreement to designate a series of members, managers, or LLC interests that have separate rights and duties with respect to specific LLC property or obligations. Consequently, each series can be tied to specific assets and can also have different members and managers. If the various series within an LLC have different members or different membership percentages or rights, each series may be treated as a separate LLC for income tax purposes.
Most importantly, the Act provides that debts, liabilities and obligations incurred, contracted for or otherwise existing with respect to a particular series are enforceable against that series only, and not against the assets of the LLC generally or any other series of the LLC.
Series LLCs May Be Right For Clients
Limited liability companies appeal to business people in an assortment of circumstances because they permit the business owners to limit their personal liability for the debts and actions of the company to what they have invested in it, while at the same time receiving some of the benefits of a partnership. Such rewards include management flexibility and pass-through taxation.
Series LLCs can help some clients continue to limit personal liability while still enjoying certain advantages of partnership. But it contains additional flexibility. It now permits a company’s operating agreement to establish a designated series of members, managers, or limited liability company interests having separate rights, powers, or duties with respect to specified property or obligations of the limited liability company or profits and losses associated with specified property or obligations. Each such series may have a separate business purpose or investment objective.
Further, as long as the operating agreement so describes, and the statute’s requirements concerning notice in the articles of organization and the keeping of separate and distinct records and books are met, the statute specifies that the debts and other liabilities of one series shall be enforceable against the assets of that series only, and not against the assets of any other series or of the limited liability company generally. Additionally, none of the general liabilities of the limited liability company shall be enforceable against the assets of an individual series. An exception would include a provision in the operating agreement for cross-over liability between the series.
When an LLC holds diverse sorts of assets or different businesses, or assets in different states, certain issues can arise. As an illustration, a company may hold both a business and cash investments, and it may see substantial liability accumulating as a result of its business placing its cash assets at risk. Such a company may want to find a way to segregate its assets in the event liability results from the operation of the business and its cash would otherwise have to be used to satisfy this liability. Alternatively, the company may segregate its assets so that an investment in one state would not be placed at risk for liability resulting from the business activities of another asset in a different state that may impose different standards for liability.
The series LLC may also prove to be an estate planning tool. An affluent client with substantial and diversified assets will now be able to control management and ownership interests through the creation of just one document. That document will be able to assign different assets to different series with different ownership interests within the same LLC. While that client could have achieved the same goals before the enactment of the series LLC statute, the series structure should make doing so easier and less expensive.
There is also some less favorable news respecting series LLCs, as fees for these new entities are high. To create a series LLC in Illinois or qualify a foreign one here, the fee is $750 plus $50 per separate series when you so designate. To expedite the filing, it will cost another $100. Filing the annual report will cost $250, plus $50 for each designated series. So, if a new LLC has 10 different series, the filing fee is $750 plus $500 for the 10 different series. An additional fee of $100 will also be due if you expedite the filing, bringing the total cost to $1,350, plus attorney fees. Also, annually this LLC will pay a $750 reporting fee. However, these costs may be mitigated by the savings from having a single tax filing.
To conclude, businesses requiring particular attention to high risk assets should consider using series LLCs. Generally speaking, series LLCs will limit debt, liabilities and other obligations incurred with respect to a particular series against the series itself, while avoiding risking other assets of the LLC. Requirements include specifying the assets subject to seizure with in the individual series, separating records for each separate series, and providing adequate notice for the creation of a separate series. However, one set back to consider with respect to series LLCs is the high initial filing fees and annual fees for maintenance, which should be considered against the accounting and tax filing savings.