Under Illinois law, transactions that benefit interested directors or shareholders of a company are enforceable if approved by the company’s disinterested directors or shareholders who have knowledge of and review all material facts of the transactions. In the absence of such knowledge and review, an interested director or shareholder who will personally benefit from the transaction must sustain the burden of proving that the approved transaction is in the company’s best interest. If there is such knowledge and review, a party questioning the approval of a transaction must carry the burden of proving the transaction is not in the company’s best interest. The recent decision in Fait v. Hummel illustrates application of these rules.
Fait arose from a stock offering approved by the directors of Pentech Pharmaceuticals, Inc. (“Pentech”) in an attempt to avoid bankruptcy. The offering diluted the voting power of the common shareholders, allowing the preferred shareholders to wrest control of the company from Robert Fait (“Fait”). Fait and Pentech founder Ragab El-Rashidy (“El-Rashidy”) owned more than two-thirds of Pentech’s common stock at the time of the offering.
The preferred shareholders received their shares in 1998. At the time of their investment, the preferred shareholders were granted a right of first refusal on any newly issued stock. They also were granted the right to elect two of the five board members and the power to elect four of the five board members for a period of two years if Pentech violated certain covenants. In the Fall of 2000, following violation of the covenants, the preferred shareholders replaced Fait and another director and relieved El-Rashidy of his duties as CEO. El-Rashidy resigned as a director soon thereafter and was not immediately replaced, leaving just four directors, all elected by the preferred shareholders: Dr. Bruce Ronsen (“Ronsen”), James Lumsden (“Lumsden”), Albert Hummel (“Hummel”), and Howard Myles (“Myles”).
In May 2001, directors Ronsen, Hummel, and Myles approved an offering of 4,220,921 shares of common stock at $1 per share, with Lumsden abstaining due to his close ties to many of the preferred shareholders. With Lumsden’s advice, the preferred shareholders exercised their right of first refusal and bought all of the available shares. Fait challenged the transaction, claiming it was unfair because it diluted the interest of the common shareholders and because the price was inadequate.