The general rule in Illinois is that by-laws constitute an enforceable contract between the corporation and its shareholders; and that shareholders who take their shares in reliance on the by-laws intend the requirements of the by-laws as written. That is, however, if the by-laws haven’t been ignored. Consider the August 2008 Illinois case of Kern v. Arlington Ridge Pathology, S.C.
Plaintiff, Susan B. Kern, M.D. (“Kern”), was secretary-treasurer and owned 166 shares of Arlington Ridge Pathology, S.C. (“Arlington”), an Illinois corporation engaged in the study, diagnosis and treatment of human ailments and injuries. Arlington was organized in 1994. Richard Regan, M.D. (“Regan”) was president. Kern and Regan, together with Kishen Manglani, M. D. (“Manglani”), were the three members of the board. Although a by-law provision called for a variable range Board of Directors, Arlington operated with a three-person Board.
In 2005, when this case arose, the shareholdings of Arlington were as follows:
Kern 166 shares 33.07%
Regan 170 shares 33.86% 66.93%
Manglani 155 shares 33.07%
100%
Arlington’s by-laws included the following provisions:
• Section 3.2 provided that the Board should consist of between four and nine directors, each of whom was required to be a licensed physician and shareholder employee of Arlington. (This is commonly referred to a variable range board of directors.)
• Section 3.3(b) provided that the Board could remove a director with the vote of 80% of outstanding shares.
• Section 3.9 set a quorum for the transaction of business as a majority of the directors, except where provided otherwise.
• Section 9.3 required a vote of persons holding at least 67% of outstanding shares for any of 12 listed “Major Decisions” to be valid. Included among the Major Decisions were several decisions with financial implications, making any material and substantial change in the purposes of the corporation or the character of its business, and . . . “(12) making any other decision which materially affects the Corporation or the assets or operations thereof.”
• Article XIV provided, “[e]xcept to the extent otherwise provided in the Articles of Incorporation, these by-laws shall be subject to alteration, amendment or repeal, and new by-laws may be adopted only by the affirmative vote of persons holding eighty percent (80%) of outstanding shares of the Corporation.”
Kern was of the opinion that her Board and employment positions in Arlington were safe for the following reasons:
• Section 3.2 of the by-laws required a quorum of directors to conduct Arlington’s business and, under Section 8.15 of the Illinois Business Corporation Act (“IBCA”), that meant a minimum of three directors, so meetings could not be called unless she participated. Section 8.15 of IBCA provides that “if a corporation has a variable range board of directors, a quorum shall consist of a majority of the directors then in office, but not less than a majority of the minimum number of directors specified for the variable range of the board unless the articles of incorporation or by-laws specify a larger number.”
• She knew that even if a director meeting were somehow called without her participation that she could not be removed as a director under Section 3.3(b) (requiring the vote of 80% of the shares) unless she voted FOR her removal, which she would never do.
• Similarly for the termination of her employment, which she believed was a Major Decision, thus requiring a vote of 80% of the shares. She certainly wouldn’t vote to fire herself. (If termination of a shareholder was not a Major Decision, the directors still could not call a meeting and terminate her employment because Section 3.9 of the by-laws required a quorum of directors for the transaction of any business, and that was three of the four required minimum number of directors under Section 3.2 of the by-laws as interpreted by Section 8.15 of the Act.)
Disputes arose between Regan and Kern. Regan then spearheaded an effort to terminate Kern’s employment and directorship. He obviously consulted competent counsel. He (Regan) and Manglani, owning 170 and 166 shares, respectively, representing 66.93% of the votes, met as Board members (and as shareholders) without Kern being present – they knew Kern would vote contrary, so they were of the opinion there was no reason to hold a formal meeting – and (1) signed a written consent to amend Arlington’s Articles of Incorporation to allow amendment of the by-laws by a two-thirds vote (66.67%) of outstanding shares and (2) adopted Board resolutions to change the voting requirements to two-thirds (66.67%) of outstanding shares for the by-laws with respect to the removal of a director, termination of corporate and physician employment, limitations on Board actions for Major Decisions, and the alteration, amendment or repeal of the by-laws.
This action by Regan and Manglani had the effect of nullifying the protection to Kern under Section of 9.3 of the by-laws (requiring 67% vote of shares for Major Decisions, including termination of a shareholder’s employment) and Article XIV (requiring 80% vote of shares to alter, amend or repeal the by-laws, and for the removal of a director.)
Kern filed an action to enjoin the Board action on the basis that no quorum existed for the Board action taken – she argued the absolute minimum quorum for valid shareholder action in this case was three because the variable Board requirement under Section 3.2 of the by-laws set the minimum of four Board members – and that the minimum voting requirements to amend the by-laws – 80% of the votes of shares, under Article XIV of the by-laws – was not met for proper action.
The Court ruled in favor of Regan and Manglani on the basis that the variable range requirement of Section 3.2 of the by-laws (not less than four directors) was abrogated by non-use, and, thus, a quorum (two of three directors) was present for the action taken by Regan and Manglani. The Court reasoned that Arlington had operated regularly over six years without compliance with its by-laws and that abrogation of the by-laws was informally completed by the Board’s course of conduct. Under that circumstance, and pursuant to Section 8.15 of the IBCA, a majority of a three person Board constituted a quorum.
Kern argued that even if the court found a quorum (two of three directors) existed for the meeting, the explicit 67% requirement for Major Decisions under Section 9.3 of the by-laws was not met, and that her employment and Board position were still safe. She was of the opinion that amendment of the Articles of Incorporation was a Major Decision even though it was not specifically mentioned as one of the 12 Major Decisions set forth in Section 9.3.
The Court, however, disagreed with Kern, and held, among other reasons, that, because Section 9.3 of the by-laws did not specifically mention amendment of the Articles of Incorporation or require any specific vote for such action, the wording in Article XIV of the by-laws – “[e]xcept to the extent otherwise provided in the Articles [of Incorporation]” – expressly reserved the possibility for the Articles of Incorporation to provide different requirements for the amendment of the by-laws, and that this was an opportunity for the directors – two-thirds (66.67%) of the directors –to amend the Articles of Incorporation at any time. That is exactly the strategy that was employed by Regan and Manglani: as directors, pursuant to Section 10.2 of the IBCA, which requires two-thirds (66.67%) vote of directors, they amended the Articles to allow amendment of the by-laws by a two-thirds vote of outstanding shares. Kern simply was ignorant of this opportunity, unaware of the significance of the words “except to the extent otherwise provided in the Articles.”
Corporations, limited liability companies and partnerships are often formed with painstaking review of the governing documents – the by-laws, operating agreements, and partnership provisions – but without reference thereto again for many years. This is a big mistake, if the owner is looking for the protection of those same provisions under different circumstances. As the Kern case implies, formation documents should be frequently reviewed at board and shareholder meetings, and modified to conform to current conduct, otherwise the owner is “flying blind,” as Kern was.
Please do not hesitate to contact us if you need modification of your formation documents to conform to existing circumstances, or interpretation of original documentation under present operating conditions.