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NOVEMBER 2004

CONTROLLING PERSONS' QUALIFIED PRIVILEGE
TO INFLUENCE CORPORATE ACTIONS

By: R. Stephen Scott, Esq. and Mark D. Thielen, Esq.

I.   Introduction

         In its recently published opinion in IOS Capital, Inc. v. Phoenix Printing, Inc., d/b/a Colortech Printing, et al.,1 ("IOS" hereafter), the Fourth District Appellate Court of Illinois reaffirmed Illinois' common law rule allowing a controlling shareholder/director the qualified privilege to influence corporate actions. In IOS, the controlling shareholder of a non-publicly held corporation was determined on appeal not to be liable for his corporation's tort of conversion. Following institution of a lawsuit by the lessor plaintiff against the corporate lessee of certain commercial copiers for recovery for past rent, breach of contract and replevin, the controlling shareholder, following his attorneys' advice, directed the corporate president not to return the copiers. Even though the parties disputed their contractual obligations and the condition of the copiers, the Court found the plaintiff proved the necessary elements of conversion (a right in the property, a right to possession, demand for possession and wrongful control by the defendant). However, the Court found the controlling shareholder had not participated in the actions which "initially gave rise to the corporation's liability" for conversion. The controlling shareholder had originally ordered the copiers to be returned, but the order was not followed. Only after suit was instituted did he direct the copiers not be returned, for evidentiary reasons, among others. Such action was privileged.

         The IOS case is significant because it confirmed the general non-liability of shareholders, directors and officers for actions of their corporations, and clarified the qualified privilege of such controlling persons who direct the actions of a corporate entity. The basis and application of these necessary corporate operating rules are discussed hereafter.

II.   The Business Judgment Rule

         Historically, neither the United States Constitution nor the Constitution of the State of Illinois, nor any of the 50 states for that matter, require the economy of the United States or State of Illinois to be a free market economy. The boon and genesis of the free market economy and small business, the backbone of America, are all traceable or in some way attributable to the concept of a corporate entity, whereby the shareholders, officers and directors benefit from no personal liability for obligations or undertakings of the corporation, except to the extent of their capital contribution. As the laws regarding limited liability entities progressed, the business judgment rule grew as a privilege and defense of officers and directors against suits by shareholders for mismanagement or waste. The business judgment rule provides that as long as an officer or director is acting with full knowledge and with a good faith belief that his actions are in the best interest of the corporation, there is no imposition of personal liability for acts or omissions done on behalf of the corporation. In Re Abbott Lab Holders Litigation.2

III.   The Qualified Privilege

         In IOS, the Appellate Court acknowledged the interest which corporate officers and directors are serving, i.e., an undivided and unselfish loyalty to the corporation to act in its best interest and that of its shareholders. Because of that fiduciary obligation, their good faith actions should not be hindered by fear of liability. The Appellate Court analogized cases where the privilege of corporate officers and directors (and even contract managers) to use their business judgment and discretion without liability was upheld even though the resulting corporate action caused a breach of contract. Citing Turner v. Fletcher3 and HPI Health Care Services, Inc. v. Mt. Vernon Hospital, Inc.,4 the Fourth District Appellate Court summarized the law of director/officer qualified privilege: "that if the conduct was the defendant acting to protect an interest the law deems of equal or greater value than the Plaintiff's contractual rights, there will be privilege available to that defendant officer or director."5

         For the director/officer privilege to apply, the actions taken must be without malice or unlawful purposes. In H.F. Philipsborn & Co. v. Suson,6 the Illinois Supreme Court upheld the privilege of a controlling shareholder/director and officer to seek and obtain a loan for his corporation which was for more money and at a lower interest rate than the corporation had already contracted with the Plaintiff. Such action was found not to be motivated by malice or unlawful purpose, but only the best interests of the corporation, even though it breached its existing contract.

         In a dissimilar situation Swager v. Couri,7 the Illinois Supreme Court reached a similar conclusion. In that case, controlling shareholder/directors and officers caused their corporation to dissolve without paying an architectural design bill for a nursing home the corporation intended but failed to build. The Supreme Court found that the fiduciary duty of the defendants to their corporation and its shareholders outweighed their duty to contract creditors. The Court noted that under the Illinois Business Corporation Act,8 the amount distributable to creditors upon dissolution would only have been the initial paid in capital, in this case $1,300.00. Therefore, a misstatement in the dissolution documents that all corporate debts had been accounted for and the failure to give notice to creditors were not sufficient to extend liability to the controlling persons for the unpaid corporate debts.

         In a later ruling, the Illinois Supreme Court extended the director and officer privilege to contract managers for a corporation. HPI Health Care Services, Inc. v. Mt. Vernon Hospital, Inc. ("HPI").9 In this case, contracted hospital management firms were sued along with the hospital it served, for unpaid service provider and pharmaceutical supplier debts. The management firms were responsible to collect revenue owed to the hospital and use the funds to pay the hospital's vendors and other creditors. The Plaintiffs claimed the management firms were liable for intentional interference with contract, unjust enrichment and fraudulent misrepresentation. The Illinois Supreme Court held that the management firms "played a role that is analogous to that played by corporate officers and directors in the management of their corporation." The Court acknowledged the management firms owed a duty to their hospitals to exercise business judgment in managing the hospital's affairs, including using discretion to choose when and to which creditors to pay to satisfy the hospital's debts. "As with corporate officers' and directors' duty to their shareholders, we deem that the duty owed by hospital management companies to their hospitals should take precedence over their duty to the hospital's contract creditors."10 As a result, the management companies' creditor payment decisions were found to be privileged.

IV.   Actions Must Be Lawful, Without Malice

         The Illinois Supreme Court in HPI, like the H.F. Philipsborn Court, also acknowledged the rule that the privilege is qualified. The privileged actions cannot be illegal, unjustified or done with malice. The Court stated that a defendant who is protected by a privilege is not justified in engaging in conduct which is totally unrelated, or even antagonistic, to the interest giving rise to the defendant's privilege. As an example, a Court stated that the management firms could not induce breaches of contracts solely for their own gain, or solely for the purpose of harming the Plaintiff "since such conduct would not have been done to further the hospital's interests."11

         The Appellate Court for the First District ruled similarly in Small v. Sussman.12 There, the Court said that allegations of a controlling shareholder/director acting "intentionally or with reckless indifference" towards the plaintiff does not rise to the level of intentional or malicious interference necessary to establish a case of tortuous interference with prospective economic damage. Citing Reuben H. Donnelley Corp. vs. Brauer,13 the Court stated that a "malicious" action sufficient to deny the controlling shareholder/director of his privilege, means an action done intentionally and without justification.

         To establish actual malice, a plaintiff must show more than ill-will. A plaintiff must show the defendant acted with a desire to harm the plaintiff which was unrelated to a desire to protect the acting party's rights, and which is not reasonably related to the defense of a recognized property or social interest. Estate of Ben Albergo vs. Hull.14 In IOS, the plaintiff failed to show that the controlling shareholder's actions were outside of his business judgment or done purposefully to harm the plaintiff. The decision to rely on the advice of counsel was appropriate given the dispute over contractual obligations and whether the copiers were operable. Notably, reliance on the advice of counsel has been a recognized right extended to corporate officers and directors, where they have no reason to know the advice is not sound. Roy v. Coyne15 and Jewish Hospital of St. Louis v. Boatman's National Bank.16

         In line with this rule, Justice Robert Cook, in his special concurrence, citing a Georgia case, LaRoche Industries, Inc. vs. AIG Risk Management, Inc.,17 stated that a claim of conversion "does not transform every breach of contractual obligation to pay money into a tort, comprised of withholding funds and exercising dominion over them."18

V.   Sarbanes-Oxley Considerations

         The IOS case did not involve a company which stock was publicly traded and those evaluating officers' and directors' liability with such public corporations must give some consideration to the 2002 Federal Sarbanes-Oxley Act19 ("SOX" hereafter). It is not within the scope of this article to fully discuss such Act.

         However, it is notable in the context of the matters discussed above that Section 302 of SOX requires CEOs and CFOs of issuers to prepare a statement to accompany audit reports and certifying the "appropriateness of the financial statements and disclosures" and that those financial statements and disclosures fairly represent, in all material respects, the operations and financial condition of the issuer. A violation of this Section must be knowing and intentional to give rise to liability to the certifier. Further, it is unlawful for the officers or directors to take any action to fraudulently (intentionally) influence, coerce, manipulate, or mislead any auditor so as to render the financial statements materially misleading. Another section of SOX prohibits the employer (and presumably its officers and directors) from taking any action (termination, demotion, discipline) against whistle blowers within the corporation. Similar to the qualification placed upon the privilege of directors and officers to influence corporate actions, they cannot take unlawful or ill-willed actions under SOX that will result in losses to public corporation shareholders.

VI.   Conclusion

         In summary, Illinois courts continue to recognize the qualified privilege of controlling persons to lawfully direct their corporations even where such direction results in civil tort liability for the corporation. However, the umbrella of protection given by the corporate entity can be lost where the actions of the controlling person are ill-willed, motivated solely for personal gain, or initiate the unlawful course of conduct. When acting with proper business judgment, relying on advice and information, the duty of the controlling person(s) to their corporation and shareholders should be found to outweigh their duty to corporate creditors.

         Corporate attorneys should nevertheless be weary of situations where interference with corporate contracts or third parties' contractual expectations are suggested by opposing counsel. Counts to a complaint may be added to include the controlling persons of the corporation for actions sounding in tort (i.e., conversion or tortuous interference). In such circumstances, a good paper trail of facts showing the proper exercise of business judgment with the best interests of the corporation at its center is necessary. Attorneys' and other experts' written opinions and analyses would seem invaluable. When influence is justified, the Court's opinions in IOS and HPI serve as solid precedent to support the controlling persons' privilege, without liability, to provide such direction.

Footnotes

  1. IOS Capitol, Inc. v. Phoenix Printing, Inc., d/b/a Colortech Printing, et al. (4th Dist., 2004), 348 Ill. App. 3d 366, 808 N.E. 2d 606, 283 Ill. Dec. 640.

  2. In Re Abbott Lab Holders Litigation, 325 F.3d 795 (7th Cir. 2003).

  3. Turner v. Fletcher, (4th Dist. 1999) 302 Ill. App. 3d 1051, 706 N.E. 2d 514.

  4. HPI Health Care Services, Inc. v. Mt. Vernon Hospital, Inc. (1989), 131 Ill. 2d 145, 545 N.E. 2d 672.

  5. Page 372-3 and 612 of IOS case.

  6. H.F. Philipsborn & Co. v. Suson (1975), 59 Ill. 2d 465, 322 N.E. 2d 45.

  7. Swager v. Couri (1979) 77 Ill. 2d 173, 395 N.E. 2d 291.

  8. 805 ILCS 5/1.01 et seq.

  9. HPI Health Care Services, Inc. v. Mt. Vernon Hospital, Inc. ("HPI") (Ill. 1989) 131 Ill. 2d 145, 545 N.E. 2d 672.

  10. Page 158 of HPI case.

  11. Page 159 of HPI case.

  12. Small v. Sussman (1st Dist. 1999) 306 Ill. App. 3d 639; 239 Ill. Dec. 366.

  13. Reuben H. Donnelley Corp. vs. Brauer (1995), 275 Ill. App. 3d 300, 211 Ill. Dec. 779.

  14. Estate of Ben Albergo vs. Hull (2nd Dist. 1995) 275 Ill. App. 3d 439; 211 Ill. Dec. 905.

  15. Roy v. Coyne (1994) 259 Ill. App. 3d 269, 630 N.E. 2d 1024.

  16. Jewish Hospital of St. Louis v. Boatman's National Bank (1994) 261 Ill. App. 3d 750, 633 N.E. 2d 1267.

  17. LaRoche Industries, Inc. vs. AIG Risk Management, Inc. (11th Cir. 1992) 959 F. 2d 189.

  18. Page 377 and 615 of IOS case.

  19. 2002 Federal Sarbanes-Oxley Act, 15 USC 7201 et seq. Pub. L. 107-204, July 30, 2002, 116 Stat. 746.

About the Authors:

R. Stephen Scott is a partner with Scott & Scott, P.C., a private law firm in Springfield, Illinois. His practice is concentrated in commercial law, including corporate and business entity formation, representation and dissolution, business bankruptcies, commercial and bankruptcy litigation, estate planning and taxation. Mr. Scott is a Co-Editor of "The Corporate Lawyer" and is President-Elect of the American Association of Attorney-Certified Public Accountants.

Mark D. Thielen is an associate with Scott & Scott, P.C. and concentrates in commercial law, including collection, corporate and business formation and representation, and commercial and bankruptcy actions.

 

This article should not be construed as legal advice by the authors or their employer. This article is intended as an educational tool suggesting points of authority upon which the authors' opinions are based.