Dissolved Corporations and the Survival Statute: Basics That Closely-Held Corporations Should Know

Stock Photo - 5 YearsSection 12.80 of the Business Corporation Act of 1983, 805 ILCS 5/12.80, is often called the “Survival Statute.”  The Survival Statute not only sets a five-year limit for filing claims against or on behalf of a dissolved corporation, but also limits the dissolved corporation’s rights and liabilities.  Once the five-year “survival period” ends, the corporation no longer exists and can no longer be subject to any claim.

The Survival Statute was discussed in Riley Acquisitions, Inc. v. Drexler, 408 Ill. App. 3d 397 (1st Dist. 2011) — a case that involved two closely-held corporations that were dissolved after the corporations’ owners ended their marriage.  Before the corporations were dissolved, the then-married owners signed personal guarantees to secure loans to the corporations.

At issue in Riley Acquisitions was whether the individual guarantors were liable for the dissolved corporations’ unsatisfied loan obligations.  The court explained that the dissolved corporations — not the individual owners — were the principal debtors, and the survival period expired before the plaintiff filed its lawsuit.  Thus, under the Survival Statute, the dissolved corporations were not liable.  Because “the liability of a guarantor is limited by and is no greater than that of the principal debtor” and also because the guarantees did not expressly provide for continuing liability in this situation, application of the Survival Statute meant that the individual guarantors were absolved of liability as well.

The Survival Statute makes clear that corporations, their owners and their counterparties should be aware of their rights and potential liabilities for the five years following a corporation’s dissolution, and should be prepared to forfeit their rights with respect to the dissolved corporation after those five years pass.

Contributing Author Amanda M.H. Wolfman

(This is for informational purposes and is not legal advice.)

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Can the Bankruptcy of One Partner Force the Dissolution of A Partnership?  

Bankruptcy for BlogA recent decision under Illinois law addresses the issue of whether one partner’s bankruptcy can force the dissolution of an Illinois partnership.  Like so many other things under the law, the answer is:  It depends.

In Sullivan v. Mathew, 2015 WL 1509794 (N.D. Ill. 3/30/15), a bankruptcy trustee sought judicial dissolution of a real estate partnership of which the debtor owned 25%.  The applicable partnership agreement expressly provided that the bankruptcy of a partner would not require dissolution.  If the partners elected to purchase the interest of the insolvent partner at fair market value, the partnership could continue.  However, if the other partners did not elect to purchase the interest, dissolution of the partnership was required.

In Sullivan, the court ruled that the partners did not timely elect to purchase the insolvent partner’s interest at fair market value.  Therefore, one would think that the court would allow the trustee’s claim to dissolve the partnership.  However, surprisingly, the court dismissed the trustee’s claim under a nuance of bankruptcy law.  In particular, the partners who opposed dissolution argued that the trustee “rejected” the partnership agreement and therefore could not invoke its dissolution provision.

The argument is based on the premise that a partnership is an “executory contract,” which means that it is not yet fully performed.  Under Section 365 of the Bankruptcy Code, a trustee must assume or reject all of the debtor’s executory contracts and, if the trustee does not timely assume one, it is rejected and the trustee cannot enforce it.

In Sullivan, the court ruled that: (a) the partnership agreement was an “executory contract,” meaning that it required mutual continuing obligations from the partners; and (b) the trustee failed to timely assume the contract.  Therefore, the court concluded, the trustee rejected it.

Having rejected it, the court ruled that the trustee could not enforce the partnership agreement to require the dissolution.  Had the trustee timely assumed the partnership agreement, he would have been able to pursue the judicial dissolution. 

(This is for informational purposes and is not legal advice.)

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Charging Orders and Illinois LLCs

Stock Photo - List of CreditorsWhen most states passed LLC acts in the 1990s, it was widely believed that LLCs would provide excellent asset protection because any judgment creditor would be limited to getting a “charging order,” under which the most a creditor could do was wait for distributions to be made and then collect those distributions pursuant to the charging order.

Under a charging order, a creditor has the right to collect distributions only.  It is a lien on future distributions.  “A charging order constitutes a lien on the judgment debtor’s distributional interest.”  805 ILCS 180/30-20(b).  The judgment creditor cannot force distributions to be made.  It has no right to vote the membership interests or otherwise participate in the management of the LLC.  See Bank of America v. Freed, 2012 WL 6725894 (Ill.  App. Ct. Dec. 28, 2012).

Many early asset protection plans for family businesses and other closely held businesses were based on this simple formula:  Transfer the business into an LLC, hold all or most of the interests in the LLC, and maintain all the benefits of the business while limiting the creditors to, at best, an ineffective charging order.

However, some states, such as Illinois, allow the creditor to go one step further.  In those states, the creditor may actually foreclose on the charging order or distributional interest.  E.g., 805 ILCS 180/30-20(b).  The creditor can file a motion to foreclose, requesting that the court appoint someone to sell the interest by scheduling either a public or private sale of it.  A foreclosure buyer will have the rights to receive future distributions, but like one holding a charging order, it will not have the right to vote or participate in the LLC.

So is this really a valuable right?  That may depend on whether the judgment debtor owns some or all of the membership interests.  If the debtor owns just some, is it a majority or a minority interest?

The right to foreclose on a charging order varies from state to state.  About a year ago, New Jersey amended its LLC act to eliminate the right to foreclose on a member’s LLC interest. (For more information, follow this link to the LLC Law Monitor post on the New Jersey amendment.)  The New Jersey Act continues to allow a judgment creditor to obtain a charging order, but that is the creditor’s sole remedy.

(This is for informational purposes and is not legal advice.)

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Fiduciary Duty Modifications

canstockphoto16131199When it comes to Illinois LLCs, one member’s allegation that the LLC’s manager has breached its fiduciary duty can quickly spiral into a full-blown claim for judicial dissolution, i.e., a business divorce.  Link.

Illinois LLCs are materially different than Illinois corporations when it comes to one member’s duties to another member. Notably, the Illinois LLC Act, 805 ILCS 180/1-1, et. seq., unlike the Illinois Business Corporations Act, expressly allows for owners to set parameters on the fiduciary duties that they owe each other.

For “member-managed” LLCs, the LLC’s operating agreement may: (a) identify specific types or categories of activities that do not violate fiduciary duties, as long as they are “not manifestly unreasonable”; and (b) specify the number or percentage of members or disinterested managers that may authorize or ratify, after full disclosure of all material facts, a specific act or transaction that otherwise would violate fiduciary duties.  805 ILCS 180/15-5(b)(6)(A) and (B).

Additionally, while an operating agreement cannot eliminate or reduce the managing member’s obligation of good faith and fair dealing, it may determine the standards by which the performance of the obligation is to be measured, if the standards are “not manifestly unreasonable.”  805 ILCS 180/15-5(b)(7).

A manager in a “manager-managed” LLC is held to the same standards of conduct prescribed for members in “member-managed” LLCs, but the manager may be relieved of certain duties if those managerial duties are expressly delegated to a non-manager member in the operating agreement.  805 ILCS 180/15-3(g)(2) and (4).

These provisions in the LLC Act are significant because they allow for the modification of duties that, if breached, might otherwise support grounds for a business divorce.  However, these provisions have not really been tested in Illinois courts.  LLCs are a relatively new business form.  They did not exist in Illinois until January 1, 1994, when the Illinois LLC Act became effective.

The LLC seems to have replaced the corporation as the most popular business form because it combines the pass-through taxation benefits of a partnership with the limited liability attributes of a corporation.  However, because LLCs are relatively new, and Illinois trial court opinions are not regularly published, Illinois courts have provided little guidance interpreting the above-mentioned provisions on the parameters of fiduciary duties.

It is inevitable that claims will be brought that will require Illinois courts to interpret these provisions, especially the “not manifestly unreasonable” standard.

(This is for informational purposes and is not legal advice.)

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The Market Approach to Valuation

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The market approach to valuation, which is sometimes called “comparative company analysis,” compares the target company to the operations and values of publicly traded companies of comparable size, growth, characteristics, industry, market area, profitability and overall financial condition.

The market value of the company being used as a comparable is calculated based on the number of shares outstanding multiplied by the current stock price.  The most important task for the appraiser in this approach is identifying comparable publicly-traded companies.  The appraiser then collects data on the comparable companies from public filings, such as the issuer’s annual reports, financial analysts who follow the company, and company reports published by Value Line, Moody’s and other financial services firms.

Stated simply, the appraiser will use the operating metrics and valuation multiples of comparable public companies to determine an appropriate valuation multiple for the privately held company.

Some consider the market approach superior to the others because the use of comparables will ensure the consideration of industry trends, business risks and market growth.

Proponents of the market approach also contend that market efficiencies make the trading values of comparable companies an excellent indicator of value.  However, no two companies are perfectly alike.  There is considerable discretion in selecting so-called comparable companies.  Therefore, appraisers that rely on this approach are often criticized for failing to do a true apples-to-apples comparison.

This concludes the Illinois Business Divorce Report’s multipart series on valuation approaches.

(This is for informational purposes and is not legal advice.)

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The Asset Value Approach to Valuation

Stock Photo - Assets Approach  111714The prior post discussed the discounted cash flow (“DCF”) method of valuation.  A business also may be valued based on the net value of its assets.  This is sometimes called the “book value” or “net asset value” of a business, and it is calculated by looking at the balance sheet of the business and subtracting liabilities from assets.

The main benefit of the asset value approach is that it is simple in comparison to other approaches, especially DCF.  However, there are several weaknesses.  An asset’s book value may not reflect current economic value because it may: (a) rely on outdated historical acquisition costs; or (b) have been adjusted in the past for depreciation.  Moreover, the asset value approach also is criticized for providing a static value — i.e., a value at one point in time — without sufficient consideration for the business’s value as a “going concern.”  In this regard, book value is similar to the “liquidation value concept” in accounting, in which assets are individually valued in anticipation of a liquidation of the business.

Further, the book value of a business may be dramatically different depending on accounting treatment, rather than economics.  Notably, a business that uses the cash basis accounting method assigns no asset value at all to its accounts receivable, whereas a business using the accrual method of accounting considers accounts receivable a valuable asset, typically once the services are rendered or goods are shipped.  Thus, book value may undervalue, for example, a law firm that uses cash basis accounting because the firm’s accounts receivables are not reflected as assets on its balance sheets.

“[T]he potential for inaccurate [asset] valuations and the fact that accounting practices do not always mirror future economic realities lead financial theorists to give less credence to this valuation method.”  Stockton, 2001 Colum. Bus. L. Rev. at 186.  Nevertheless, book value is an approach that has been accepted by Illinois courts.  E.g., Inst’l Equip. & Interiors, Inc. v. Hughes, 204 Ill. App. 3d 922, 150 Ill. Dec. 132 (2d Dist. 1990).

Moreover, “goodwill” is an intangible asset on a company’s balance sheet.  “In the purchase of a business, goodwill generally is the difference between the purchase price and the volume of the assets acquired.”  Black’s Law Dictionary (Sixth Ed. 1990).  Because the value of goodwill is highly subjective, there is always a risk that a company overvalues its goodwill in an acquisition.  Therefore, in disputes concerning book value, the value assigned to goodwill is often scrutinized.

(This is for informational purposes and is not legal advice.)

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The Income Approach — Discounted Cash Flow Analysis

Stock Photo - Income Approach 102714The prior post contained an overview of valuation methods.  This one addresses the income approach in particular.  The discounted cash flow (“DCF”) method is the income approach favored by most financial professionals.  In this approach, the value of the business is measured by estimating the expected annual future cash flows of the business, and then applying a discount rate to the future cash flows to determine the net present value (“NPV”) of the future cash flows.  The future cash flows are discounted to NPV because of the “time value of money.”  Receiving $100 today is worth more than receiving $100 a year from now.  Therefore, the present value of $100 in the future is less than $100.

In a DCF analysis, the future cash flows are projected out into the future using a series of assumptions about how the business will perform in the future.  While DCF analysis is widely accepted, its valuation output is extremely sensitive to the assumptions that must be made.  Therefore, small differences in assumptions can lead to very different valuation conclusions.  DCF analyses are often attacked by undermining the assumptions made by the appraiser, rather than the DCF concept itself.  That is, the opposing expert appraiser will often opine that the DCF method is valid, but the inputs were wrong.  As is often said, “garbage in = garbage out.”

The formula for a DCF analysis is complicated.  DCF models are typically prepared by financial experts.  To understand DCF valuation, one should have a working knowledge of the following terms:

  • Future Cash Flows: Projections of the amount of cash produced by a business’s operations, after paying operating expenses and capital expenditures.
  • NPV or net present value: The value of all of the future cash flows discounted to today’s dollars by applying the discount rate.
  • Expected annual growth: The rate the business is expected to grow.
  • Discount Rate: The cost of capital (debt and equity) for the business.  This rate, which acts like an interest rate on future cash flows, is used to convert them into current dollar equivalents.  This is sometimes called the Weighted Average Cost of Capital or “WACC”.
  • Terminal or Residual Value: The value of a business at the end of the projected period.  A typical DCF analysis uses a 5-year projection period or, occasionally, a 10-year projection period.

The DCF approach has been approved by Illinois courts.  E.g., Superior Inv. and Development Corp. v. Devine; Stanton v. Republic Bank of S. Chicago.

(This is for informational purposes and is not legal advice.)

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Valuation of Minority Interests in Closely Held Illinois Businesses

valuation art from can stock for MM Sept 2014Valuation of a business plays a critical role in adjudicating disputes among co-owners of closely-held businesses.  There are numerous circumstances where a court may be required to determine the value of a litigant’s interest in a business, such as under a buy-sell agreement or appraisal rights statute, or as a buy-out remedy for shareholder oppression.

Valuing stock in closely held businesses “is one of the most perplexing problems facing the courts.  Valuation techniques are complex.  Furthermore, the courts may not be sufficiently familiar with accounting and financial theory to effectively resolve the intractable details in a manner satisfactory to all constituents.”  The Stockton Anatomy of Valuing Stock in Closely Held Corporations:  Pursuing the Phantom of Objectivity into the New Millennium, 2001 Colum. Bus. L. Rev. 161, 162.

Because so many assumptions are inherent in a valuation, it is “not an exact science, as witnessed by the frequency with which appraisers differ in their opinions concerning the appropriate value to assign . . . .”  Hickory Creek Nursery, Inc. v. Johnston.

Basic Valuation Approaches              

There are generally three approaches to valuation: (1) the income approach; (2) the asset approach; and (3) the market approach.  Under what is called the “Delaware block approach,” an appraiser calculates value using all three approaches, assigns a weight to each approach, and the sum of each value multiplied by its assigned weight is the appraiser’s final opinion on value.  The concept is to use all three approaches to triangulate on the most accurate valuation.

These three approaches will be discussed in more detail in subsequent posts.

(This is for informational purposes and is not legal advice.)

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The Partner “Freeze Out”

Freeze Out Photo for MM Blog 081214The prior post introduced the concept of minority shareholder oppression, which may be grounds for the judicial dissolution (i.e., business divorce) of a privately held corporation.  A similar concept — called a “freeze out” — exists for partnerships.

In particular, a court may dissolve a partnership if a partner has engaged in conduct that makes it “not reasonably practicable to carry on the partnership business.”  805 ILCS 206/801(5).  Courts have used this standard as a basis to dissolve partnerships where one partner improperly blocks another partner from participating in the partnership or, in other words, “freezing out” the partner.

For example, in Susman v. Cypress Venture, the court dissolved five related real estate development partnerships because the petitioning partner established that his other partners improperly told him he was no longer a partner, altered the partnership tax returns to indicate his interest was reduced to zero, excluded him from partnership business, denied him information concerning the activities of the partnership, and refused to account for partnership expenses.  The court concluded that dissolution was warranted because the relations existing between the partners rendered it “impracticable for them to conduct business.”

These examples of misconduct in Susman are similar to those noted in the Gidwitz case concerning shareholder oppression and, thus, demonstrate some similarities in the grounds for dissolution when dealing with privately held corporations and partnerships.

(This is for informational purposes and is not legal advice.)

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Shareholder Oppression

Stock Photo Oppression 061714A non-controlling or minority shareholder in a close corporation who is the victim of “oppression” by the controlling or majority shareholder may petition a court for dissolution of the corporation or, in other words, a business divorce. 805 ILCS 5/12.56.

This remedy exists because the shareholder in a close corporation does not have the exit option available to the shareholder of a public corporation — who can sell his or her shares in a public securities market if unhappy with those in control.

So what is “shareholder oppression”? While there is no clear answer, courts define it as “arbitrary, overbearing and heavy-handed conduct,” that prejudices the minority shareholder, such as taking an excessive salary, failing to call meetings of the board of directors, or failing to pay dividends. However, defendants in these cases usually claim that these management decisions deserve protection under the “business judgment rule,” which provides that officers and directors cannot be held to a standard that ensures corporate success and, thus, courts will not second-guess business decisions made in good faith, with reasonable care and reasonably believed to be in the best interests of the corporation.

Further complicating matters is that conduct that may be considered oppressive under one set of circumstances may not be in another. As one court noted, the payment of large salaries to corporate officers may be justified where a corporation has large retained earnings, but oppressive where a corporation is rendered unable to pay dividends to minority shareholders because of large salaries paid to majority shareholders. The failure to pay dividends might be oppressive when the corporation retains large earnings for no reason except to “freeze out” minority shareholders.

The case Gidwitz v. Lanzit Corrugated Box Co., provides an example of oppression. The case concerned a corporation where the shares were split equally between members of two different families. However, one of the two families — the Gidwitz family — controlled the company through Joseph Gidwitz — the President and Chief Executive Officer of the company. For many years, he operated it as if it was a sole proprietorship. The court concluded that the following circumstances constituted oppression: officers were hired and salary increases were given without director approval, loans were made to corporations in which the President had an interest without board approval, a subsidiary was created without board approval, and the question of whether to pay dividends was never presented to the directors.

(This is for informational purposes and is not legal advice.)

 

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