breach of fiduciary duty – Paul Porvaznik

Lumber Exec’s Diversion of Profits to Company Owned by Son Supports Minority Shareholders’ Breach of Fiduciary Duty and Shareholder Oppression Claims – IL 2nd Dist.

Roberts v. Zimmerman, et al., 2021 IL App (2d) 191088-U provides a useful primer on the pleadings and evidence required to sustain a breach of fiduciary duty and shareholder oppression claim against a corporate officer and the contours of the business judgment rule defense to those claims.

The case involved three separate but related lumber buying companies: Outstanding, Our Wood Loft, Inc. (“OWL”), and Lake City Hardwood (“Lake City”). OWL is owned 1/3 by the two plaintiffs and 2/3 by the defendant majority shareholder. Lake City is owned by the majority shareholder’s son.

Plaintiffs’ salient claim was that OWL’s majority shareholder breached his fiduciary duties to the company and minority shareholders by buying lumber from Lake City at a higher price than he could have paid other vendors. According to the plaintiffs, the net result of the majority shareholder’s actions was a depletion in OWL profits over a multi-year span. The fact that the director was paying the increased lumber prices to his son’s company created additional bad optics and provided more ammunition for the plaintiffs’ lawsuit.

Plaintiffs’ alleged breach of fiduciary duty and shareholder oppression under Sections 12.56(a)(3)(oppressive conduct) and 12.56(a)(4)(misapplication of corporate funds and/or waste) of the BCA. Plaintiffs also joined an aiding-and – abetting claims against the majority shareholder’s son and wife. Plaintiffs alleged these latter defendants were complicit in the majority shareholder’s scheme to enrich his son’s Lake City business to the detriment of OWL.

The trial court dismissed all claims except for the breach of duty claim premised on diversion of profits. After a bench trial, the trial court found in favor of the majority shareholder on this surviving claim on the basis that Plaintiffs failed to prove compensable damages. Plaintiffs appealed.

Reversing, the appeals court first examined Illinois breach of fiduciary principles in the context of a close corporation shareholder dispute.

Breach of Fiduciary Duty

Corporate officers owe a fiduciary duty of loyalty to the corporation and are precluded from actively exploiting their positions within the corporation for their own personal benefit or impeding the corporation’s ability to conduct the business for which it was formed.

Here, the Court found the majority shareholder owed a fiduciary duty of loyalty to act in OWL’s best interest, to deal on behalf of OWL fairly and honestly, and seek to maximize OWL’s profits. This duty included ensuring that OWL got the best price for lumber it bought from third parties.

The Court held that the majority shareholder breached his fiduciary duty by paying inflated lumber prices to his son’s company – Lake City.

The Court rejected Defendant’s business judgment rule (BJR) defense. Under the BJR, courts will not interfere with business decisions of a corporate officer even if it seems that a more prudent decision could have been made. However, a corporate officer cannot use the rule as a shield for conduct that does not rise to the level of due care.

Here, the court gave the BJR a cramped construction: it found that the rule only applies to honest mistakes in judgment and activities over which a corporate officer has discretion – such as whether an officer spent too much or too little on advertising, salaries, and the like. The Rule does not apply to situations where challenged conduct subverts the rights of a corporation. A corporate officer does not have discretion to divert profits from a corporation.

According to the Court, with minimal investigation, the majority shareholder would have discovered that Lake City was profiting at the expense of OWL by selling lumber at inflated prices to OWL. [¶ 71]

Shareholder Oppression and Aiding-and-Abetting Claims

Reversing the Section 2-615 dismissal of the Plaintiffs’ shareholder oppression and aiding-and-abetting claims, the Court noted that shareholder oppression is not limited to acts that are illegal, fraudulent, or that involve mismanaged funds. Instead, shareholder oppression applies to a wide gamut of conduct including a course of heavy-handed and exclusionary conduct and self-dealing.

To state a colorable aiding-and-abetting claim in Illinois, a plaintiff must allege (1) the party whom the defendant aids performed a wrongful act that caused an injury, (2) the defendant is generally aware in his or her role as part of the overall or tortious activity at the time or she provides assistance; and (3) defendant must knowingly and substantially assist the principal violation.

Here, Plaintiffs sufficiently alleged enough facts to sustain both claims. The allegations that the majority shareholder overpaid for lumber at OWL’s expense and to his son’s/Lake City’s benefit sufficiently pled an actionable oppression claim.

The Court similarly held that the Plaintiffs adequately pled Lake City’s active participation in the underlying lumber purchasing scheme in the aiding-and-abetting Complaint count.

Afterwords:

Roberts cements the proposition that a majority shareholder’s diversion of corporate profits to another entity can support both a breach of fiduciary duty claim and a statutory shareholder oppression action.

The case also makes clear that shareholder oppression is not limited to acts that are illegal, fraudulent, or that involve mismanaged funds. Here, Plaintiffs allegation that the majority shareholder used an unnecessary middleman – Lake City – to which the company overpaid for lumber and lost resultant profits – was enough to make out a colorable oppression claim.

Finally, Roberts clarifies that a successful aiding-and-abetting a breach of fiduciary duty claim requires allegations of a defendant’s active participation and knowledge in/of underlying wrongful conduct. Constructive knowledge is not enough.

Presumption of Fraud Involving [Power of Attorney] Agent Trumps General Rule of Joint Account Donative Intent – IL 2nd Dist.

In Estate of Gerulis, 2020 IL App (3d) 180734, two siblings [Petitioners] sued their brother [Respondent] for allegedly looting their father’s [Decedent] estate to the tune of several hundred thousand dollars.

Underlying Facts

Shortly after moving to Illinois from Florida to live with Respondent [his eldest son], Decedent and Respondent opened multiple bank accounts and purchased certificates of deposit from an Illinois bank, [a bank where Respondent’s wife happened to work] and transferred over $60K from two of Decedent’s Florida bank accounts to the same Illinois banks. Respondent then withdrew monies from the Illinois accounts to pay for home improvement costs and other personal expenses.

In addition, shortly after Decedent’s move to Illinois, Respondent deposited over $300K from the sale of Decedent’s Florida condominium in one of the Illinois accounts.

Lower Court Result

Petitioners sued Respondent alleging he breached fiduciary duties to Decedent by initiating various transfers of money from the estate to Petitioners’ detriment. They further alleged Respondent exerted undue influence over Decedent by convincing him to change his will after he moved in with Respondent.

The parties filed cross-motions for summary judgment. The trial court entered summary judgment for Petitioners and (1) ordered Respondent to pay back the estate over $900,000 (including nearly $300,000 in prejudgment interest), and (2) voided Decedent’s changed estate planning documents [a revised will, trust, and power of attorney that favored Respondent over Petitioners].

Appellate Decision

The Second District affirmed in part the trial judge’s order.

Under Illinois law, an individual holding a power of attorney [POA] is a fiduciary as a matter of law. The person designated as a POA agent owes a fiduciary duty to the principal – the person making the designation. The fiduciary relationship between a principal and agent under POA is triggered once the POA document is signed.

Presumption of Fraud – POA Agent Benefits from Transaction

This fiduciary relationship prohibits the agent from obtaining a selfish benefit for himself, and if the agent does so, the transaction is presumed fraudulent.

Under a POA, any conveyance of a principal’s property that financially benefits the agent is presumed fraudulent. This includes transfers directly to the agent as well as those to third parties engineered by the agent.

Once this presumption attaches, the burden shifts to the agent to disprove the fraud by clear and convincing evidence To satisfy this burden, the agent must establish he acted in good faith and did not betray confidence placed in him. If the agent meets this burden, the challenged transaction is upheld. If the agent doesn’t, the transaction is set aside.

Factors a court considers when determining whether an agent has rebutted a presumption of fraud include (1) whether the fiduciary make a full disclosure to the principal of key information, (2) whether the fiduciary paid adequate consideration for the transfer, and (3) whether the principal had competent and independent advice.

The trial judge found (a) the multiple transfers from Decedent’s Florida accounts into the various Illinois accounts and (b) Decedent’s gifting $130,000 to Respondent occurred during the existence of the POA fiduciary relationship. The Court also noted that Respondent plainly benefitted from the transfers. These events activated the presumption of fraud.

The appeals court agreed with the trial judge that Respondent failed to carry his burden of showing the transfers were in good faith.

Principal’s Mental Competence Won’t Always Defeat Presumption of Fraud

The Court first held it wasn’t enough that Decedent was mentally competent when the challenged transfers occurred. This was because Respondent couldn’t prove he was acting at direction of the Decedent or that Decedent even knew Respondent transferred Decedent’s Florida bank account funds to the Illinois accounts under Respondent’s [and his wife’s] control.

The Court then cited a lack of evidence of consideration or compensation paid [from Respondent to Decedent] to support the transfers. Absence of consideration for a transfer [no quid-pro-quo] can trigger a court’s heightened scrutiny of a POA agent’s conduct.

Joint Bank Accounts

With a joint account [the FL and some of the IL accounts were joint accounts] there is a presumption of donative intent: each joint account holder gifts to the other holder the joint account funds.

So long as funds are deposited and a joint tenancy account contract is signed by the joint owners, the presumption of donative intent prevails and can only be defeated by a showing of clear and convincing evidence.

This is especially so where a joint account is opened before a fiduciary relationship is formed.

When this happens [joint accounts are opened before a POA, e.g.], the two presumptions [presumption of fraud for POA transaction v. presumption of donative intent with joint bank accounts] “cancel each other out” and the Court decides the breach of fiduciary duty objectively on a fresh factual record.

Here, the fiduciary relationship between Decedent and Respondent attached before the Florida account funds were transferred to Illinois and the opening of the various Illinois accounts. As a result, the presumption of fraud was triggered before the Illinois joint accounts were opened. The Court therefore held that the POA fraud presumption took primacy over the general rule of mutual gifts for joint accounts.

Take-aways:

The POA fiduciary relationship is triggered upon signing the POA document;

To rebut a presumption of fraud, a POA agent must do more than show his principal was mentally competent. Instead, the agent must prove the principal authorized, directed or had actual knowledge of a challenged act;

With a joint bank account, where a fiduciary relationship predates the opening of such an account and the POA agent benefits financially from the account [i.e. withdraws funds], the presumption of fraud wins out over the conflicting presumption that a gift between joint account holders was intended.

Federal Court Grapples with Illinois Account Stated and Joint Venture Theories in Broken Airline Pact

The Illinois Northern District recently examined the contours of Illinois fiduciary duty, account stated, and joint venture breach claims in Flair Airlines v. Gregor, LLC, 2018 WL 4404649 (N.D.Ill. 2018)(slip copy).

The plaintiff airline company hired the defendants to rebrand and create a technological infrastructure for the airline including a website and online reservation system. While the defendants/counter-plaintiffs prepared a written agreement that formalized the terms of the venture (which called for future multi-year profit-sharing agreements, among other things), the airline never signed the agreement. This was done, according to counter-plaintiffs, for the airline to buy time to form a competing business in Canada and to leverage the fruits of defendants’ work.

The parties’ business relationship eventually crumbled and the airline sued defendants for unfair competition and deceptive trade practices. (The thrust of the complaint was that defendants were wrongfully using plaintiff’s domain names and websites, among other allegations).

Defendants counter-sued for account stated, breach of fiduciary duty, and breach of the never-signed joint venture agreement. The airline moved to dismiss all counterclaims.

The Court first denied the plaintiff’s motion to dismiss defendants’ account stated claims.

In Illinois an account stated is a form of proving damages on a pre-existing obligation. It is an alternative legal theory to one sounding in breach of contract for a plaintiff to recover the same damages asserted in a contract action.

An account stated determines the amount owed between parties who have previously conducted monetary transactions with each other.

Where a plaintiff renders a statement of account to a defendant who retains the statement beyond a reasonable amount of time without objection, the law views this as a tacit acknowledgement of the statement’s validity.

However, an account stated “cannot be made the instrument to create an original liability; it merely determines the amount of the debt where liability previously existed.”

The Court found that the counter-plaintiffs’ allegations that they regularly sent invoices to the plaintiff who then retained them without objection, were enough to state a colorable account stated claim.

The court also sustained the counter-plaintiffs’ breach of fiduciary duty claim against the airline.

Under Illinois law, a breach of fiduciary duty plaintiff must allege (1) a fiduciary relationship, (2) a breach of the fiduciary duty, and (3) injury resulting from the breach. Fiduciary duties exist as a matter of law in a joint venture relationship.

The court found the counter-plaintiffs’ allegations that they formed a joint venture with the airline to expand its business and build the airline’s operations and reservations systems and the airline’s abandonment of the venture was enough to state a viable fiduciary duty claim under Federal notice pleading standards.

On the counter-plaintiffs’ breach of joint venture (JV) claim, the Court noted that under Illinois law, a JV exists where there is (1) an express or implied agreement to carry on an enterprise, (2) a manifestation of intent by the parties to be associated as joint venturers; (3) a joint interest as shown by the parties’ contribution of property, financial resources, effort, skill or knowledge; (4) a degree of joint ownership over the enterprise including the mutual right to exercise control over it; and (5) the joint sharing of profits and losses.

The court rejected the plaintiffs’ argument that the joint venture claim was defeated by the Statute of Frauds. In Illinois, a contract that cannot be performed within the space of one year must be in writing in order to be enforceable. The plaintiff argued that since part of the alleged JV contemplated future three-year contracts between the airline and the defendants’ company, a writing was required.

The Court disagreed. It found the unsigned JV provided evidence of the key terms of the parties’ business arrangement and that even so, a sender’s name on an email could satisfy the signature requirement of the Statute of Frauds.

The court ultimately dismissed the counter-plaintiffs’ JV claim though since the counterclaim didn’t properly identify the JV members. The Court granted the counter-plaintiffs’ 14 days leave to replead the JV count.

Take-aways:

Where a plaintiff sends a statement of account to another who retains the statement beyond a reasonable time without objection, this can establish an account stated.

A joint venture doesn’t have to be in writing and can give rise to breach of fiduciary duty claim.

On the Statute of Frauds question, this case solidifies the dual propositions that (1) the formal execution of a contract isn’t necessary if a court can piece together the key contract terms through various writings, and (2) a properly authenticated email can serve as proxy for signature requirement of Statute of Frauds.

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