Two business partners are fighting. One hires a lawyer to represent the company to sue the other partner. Can he do that?
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Very frequently in business owner disputes, the company is deadlocked, but one of the parties remains in control. Typical examples include corporations with two directors, LLC’s with two managers (or two members, if member-managed). Sometimes, a minority shareholder or member will have negotiated a veto right at the board level. Almost always, one of the owners will still be functioning as the “president” or general manager and have day-to-day control. This situation is often an occasion for oppressive conduct. Very frequently, the officer remaining in control of the company will retain corporate lawyers to represent the company and sue the other owner or have the corporate lawyers defend against derivative claims by the other owner. Attorneys stepping into that representation should be cautious because the owner in control probably has no authority to retain counsel on behalf of the company.
Even in non-deadlock situations, there may be issues with the authority of corporate officers hiring corporate counsel, if the controlling owner fails to or does not wish to convene a board meeting. Also in disputes among owners of companies over control, or misconduct, the interests of the company may be very different from those of the individual owners. “A lawyer employed or retained by an organization represents the entity.” An attorney representing a corporation does not represent its directors, officers, shareholders, employees, members, or other constituents. The corporation’s lawyer has “but one client—the corporation.” Attorneys may not represent the interests of one group of owners against the interests of another under the guise of representing the corporation.
A Texas corporation or LLC may not direct litigation and hire an attorney unless sanctioned by its governing authority—i.e., a majority of the board of directors or managers. In Street Star Designs, LLC v. Gregory, two members of an LLC brought suit on behalf of the company against the remaining two members. The defendants moved to dismiss the complaint because a majority of the LLC’s governing authority—the four members—had not authorized the suit on behalf of the company. The Street Star Designs, LLC board was deadlocked two-to-two. The plaintiffs countered that as agents of the company, they were authorized to bring suit because it was in the ordinary course of the LLC’s business. The district court held that “ordinary course of business” meant a regular course of procedure in managing a business. Based on this definition, it found “no evidence or allegation from which the Court could reasonably infer that the filing of a lawsuit . . . falls within the ordinary course of Street Star’s business so as to make it the equivalent to the ‘habitual or mechanical performance of an established procedure.’” The court applied analogous Texas cases that forbade a corporation’s president from hiring a corporate attorney without first receiving the board approval. The LLC members lacked “authority to direct the filing and prosecution of this action in Street Star’s name because such activity is not within the ordinary course of Street Star’s business.”
In Square 67 Development Corporation v. Red Oak State Bank, the president of a corporation hired an attorney to prosecute a conversion action against a bank. The bank filed a Rule 12 Motion to Show Authority and attacked the attorney’s power to prosecute the action because the Square 67’s board of directors did not authorize the attorney’s employment. The trial court agreed with the bank and dismissed the action. On appeal, the president argued that, simply under his executive authority within the corporation, he was empowered to retain an attorney and file suit. The appellate court held that there was no basis for the claim that “the president of a corporation is authorized solely because of his office to initiate litigation on behalf of the company and employ legal counsel for that purpose.” Rather, the board of directors had the statutory right to manage the affairs of the corporation, and “the president of a corporation is not authorized to employ an attorney to conduct litigation for the company absent express authority or implied authority . . . set forth in the bylaws or by proper action of the board of directors.” The court ruled that the attorney did not have authority to prosecute the action, and upheld the dismissal.
A business entity has no legitimate business interest in a struggle amongst its owners over control of that business entity—the company must remain neutral. In fact, a business entity is not even a necessary party in a dispute between its owners over the dissolution of the company. The owners of one faction of an LLC may not use company resources to hire a company lawyer to defend their position against another faction, and a trial court abuses its discretion if it fails to bar the attorney attempting to do so.
In re Salazar arose from a struggle for control of the Corporation for the Episcopal Diocese of Fort Worth. Unhappy with the actions of the majority of the board of trustees, minority members hired attorneys and filed a lawsuit under the corporation’s name to recover corporate property from the majority. The majority challenged the attorneys’ authority under Rule 12, and the trial court granted the motion but did not bar the attorneys from appearing in the cause for the corporation. The majority sought mandamus to correct this error. The appellate court granted the relief, stressing that although the attorneys purported to represent the corporation, “a lawyer may not be hired to represent a corporation by one of two factions in the organization against the other faction.”
Individual members or shareholder may, of course, file derivative claims on behalf of the company against officers, directors, and other shareholders. While the company is usually required to be named as a nominal defendant on those derivative claims, it is the actual plaintiff. “A shareholder derivative suit is for the benefit of the corporation. Although a party joins a corporation as a nominal defendant, the corporation is actually a nominal plaintiff because any recovery inures to its benefit.” Especially when the derivative claims charge serious wrongdoing against the company by the officers controlling the company, the company as a party and the attorney representing the company must remain neutral regarding the dispute.
In Providential Investment Corp. v. Dibrell, the court held that the company could not appeal a judgment for the plaintiff in a derivative suit that resulted in a receiver being appointed over the company, because the “judgment is in its favor, not adverse to it. A party on appeal cannot complain of action by the court that is favorable to it.” The Dibrell opinion cited the New Jersey Chancery Court opinion of Solimine v. Hollander, which held that “where directors are charged with misconduct in office and are sought to be held accountable, the corporation is required to take and maintain a wholly neutral position, taking sides neither with the complaining stockholder nor with the defending director.” The Minnesota Supreme Court in Meyers v. Smith—also cited as authoritative in Dibrell—struck a corporation’s answer which contested the derivative claim on its merits:
The corporation is a nominal party only. It was properly joined as a party for the protection of the defendants, so that when final judgment herein is entered the two individual defendants may be thereby protected from a second suit on the same causes of action brought by the corporation, in case the control of the corporation should pass from these two defendants into the hands of others. But that does not vest in the corporation the right to here step in and, by answer, attempt to defeat what is practically its own suit and causes of action. Nor have the two individual defendants, in control thereof, any right to use the corporation for any such purpose or to impose on the corporation the burden of fighting their battle.
While Texas authority is limited on this issue, the overwhelming authority in other jurisdictions holds that officers and directors accused of wrongdoing in a shareholder derivative suit may not use corporate counsel to defend the suit on the merits. For example, in a derivative claim against officers for misappropriating corporate funds, a clear conflict of interest exists between the company, whose money was taken, and the individual defendants, who are defending against claims of taking the money. If the same attorney actually represented both the company and the individual defendants, that attorney would have to be disqualified for the conflict of interest.
Rule 12 of the Texas Rules of Civil Procedure provides:
A party in a suit or proceeding pending in a court of this state may, by sworn written motion stating that he believes the suit or proceeding is being prosecuted or defended without authority, cause the attorney to be cited to appear before the court and show his authority to act. The notice of the motion shall be served upon the challenged attorney at least ten days before the hearing on the motion. At the hearing on the motion, the burden of proof shall be upon the challenged attorney to show sufficient authority to prosecute or defend the suit on behalf of the other party. Upon his failure to show such authority, the court shall refuse to permit the attorney to appear in the cause, and shall strike the pleadings if no person who is authorized to prosecute or defend appears. The motion may be heard and determined at any time before the parties have announced ready for trial, but the trial shall not be unnecessarily continued or delayed for the hearing.
“Rule 12 allows a party to argue before the trial court that a suit is being prosecuted or defended without authority.” Once challenged, the attorney must appear before the court and show his authority to act. At the hearing on the motion, the challenged attorney has the burden to show sufficient authority to prosecute or defend the suit on behalf of his client, a party to the lawsuit. “Upon his failure to show such authority, the court shall refuse to permit the attorney to appear in the cause, and shall strike the pleadings if no person who is authorized to prosecute or defend appears.” “[O]nce the trial court finds the challenged attorney has not met her burden of proof, the trial court ‘shall’ take two additional steps: (1) bar the challenged attorney from appearing in the case and (2) strike the pleadings if an authorized person does not appear.” “[T]he requirements of rule 12 that follow from a finding that the attorneys failed to discharge their burden of proof to show their authority are mandatory.”
The Court may also order the disqualification or replacement of counsel or restrict the positions that counsel may advance using its inherent authority over the attorneys practicing before it. A trial court has inherent power to issue and enforce orders that “aid in the exercise of its jurisdiction, in the administration of justice, and in the preservation of its independence and integrity.” Such power has existed in common law courts for centuries, and “it is beyond dispute that lawyers are officers of the court and that the courts have the inherent authority to regulate their professional conduct.” More importantly, courts have a duty to protect the rights of all parties to the litigation.
In Lewis v. Shaffer Stores, Co., the federal district court ordered the corporation to obtain separate, independent counsel to represent the company in the derivative suit, “who have had no previous connection with the corporation,” and who were to file an answer on behalf of the corporation after their own investigation of the facts. The federal district court in Messing v. FDI, Inc., faced with a similar situation, held that the corporation was required to obtain independent counsel, “unshackled by any ties to the directors,” to advise it of its most favorable course of action. In Rowen v. LeMars Mut. Ins. Co. of Iowa, the Iowa Supreme Court ordered the trial court to appoint independent counsel for the corporation.
Assume a two-person LLC in deadlock. One member has the company hire an attorney to file suit against the other. The other member hires his own attorney and files a derivative claim against the first. The second member also files a Rule 12 motion. After hearing the motion, the trial court should hold that the company’s attorney had no authority to represent the company, bar that attorney from appearing, and strike the lawsuit, leaving the second member as the plaintiff on his derivative claims. Presumably, the first member then hires his own attorney and may file derivative claims of his own against the second member. All of this leaves a strange situation: The company is normally considered a necessary party to a derivative suit. However, in this case, nobody has authority to hire an attorney on behalf of the company, and the company may not appear as a party except through counsel. “Legal entities, such as a corporation or a limited liability company, generally may appear in a district or county court only through a licensed attorney.” The court could appoint an attorney ad litem for the corporation. However, the court would more likely resolve the issue under Rule 39(b), which provides that if a person, who is otherwise necessary for just adjudication, cannot be made a party, then “the court shall decide whether in equity and good conscience the action should proceed among the parties before it.” Undoubtedly, the court would conclude that all interests are represented, since all members of the company are parties. The court would likely also conclude that the dueling derivative claims should be treated as “a direct action brought be the member for the member’s own benefit”—in which case, the company would not be a necessary (or arguably even a proper) party.
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|About the author: Houston Business Lawyer Eric Fryar is a published author and recognized expert in the field of shareholder oppression and the rights of small business owners. Eric has devoted his practice almost exclusively to the protection of shareholder rights over the last 25 years. Learn more|
This post represents our opinion regarding the relevant shareholder oppression and minority ownership rights law. However, not everyone agrees with us, and the law is changing quickly in this area. This page may not be up to date. Be sure to consult with qualified counsel before relying on any information of this page. See Terms and Conditions.