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Limitations in a Derivative Action Lawsuit

Special statute of limitations doctrines in a derivative action lawsuit.

derivative action lawsuitDerivative Action Lawsuit Tolling of Limitations

Statute of limitations is an affirmative defense. Tex. R. Civ. P. 94. A defendant bears the initial burden to plead, prove, and secure findings to sustain its plea of limitations. Fraud and breach of fiduciary duties claims, the claims typically pursued in derivative action lawsuits, have a four year statute of limitations period from the day the cause of action accrues. Generally, the accrual date of a cause of action is a question of law. 

Adverse Domination Doctrine in the Derivative Action Lawsuit

A cause of action for injury to the property of a corporation or for impairment or destruction of its business is vested in the corporation, as distinguished from its shareholders.  To recover for wrongs done to the corporation, the shareholder must bring the suit derivatively in the name of the corporation so that each shareholder will be made whole if the corporation obtains compensation from the wrongdoer. In a derivative action lawsuit, the shareholder brings the claim in a representative capacity. The real party in interest is the corporation, not the plaintiff shareholder.  Therefore, under the discovery rule, the cause of action would accrue when the corporation, not merely the plaintiff shareholder, discovers the claim.

Notice Is to Disinterested Directors Only

When does the corporation (which presumably would be charged with knowledge of all the activities of its officers and directors) receive notice of a breach of fiduciary duty? In International Bankers Life Ins. Co. v. Holloway, the Supreme Court held that notice to the corporation for purposes of the statute of limitations is notice to its disinterested officers and directors rather than notice to the wrongdoers of their own conduct. This holding was considered at length by the Austin Court of Appeals in Allen v. Wilkerson.  In Allen, a creditor of a defunct corporation sought to enforce a cause of action belonging to the corporation against one of its former directors for misappropriation of corporate assets. The former director defended on the grounds that limitations had run on the cause of action. The Court held: "In order for limitations to run against a corporation’s right of action against one of its own directors, two things must concur: (1) notice (2) to a disinterested majority of its board of directors." The Allen Court affirmed a judgment for the creditor because there was sufficient evidence that the corporation had never had a disinterested majority on its board of directors after its cause of action arose; therefore, limitations never ran. Thus, under the doctrine of adverse domination, if a disinterested majority of directors does not exist, then limitations never begins to run.  This doctrine of adverse domination has been clearly recognized as controlling Texas law in recent federal decisions. 

Proving Absence of Disinterested Majority

The disinterestedness of officers and directors of a corporation is a fact issue. "In short, interestedness or disinterestedness does not turn on any technical form of legal status; it is a substantial fact question." However, the plaintiff shareholder does have the burden of proof that a majority of the board are not disinterested.  

The question remains what constitutes interestedness in the challenged transaction.  The Fifth Circuit has noted: “If adverse domination theory is not to overthrow the statute of limitations completely in the corporate context, it must be limited to those cases in which the culpable directors have been active participants in wrongdoing or fraud, rather than simply negligent.”  Other decisions have expanded this notion to require that the majority of the directors be guilty of intentional misconduct. One federal district court has suggested that even breach of fiduciary duty is not sufficient to satisfy the Fifth Circuit’s “active participation” requirement.  These federal decisions are extensions of Texas law and are not binding on Texas courts.  The federal courts are concerned that mere proof of inaction on the part of the board does not constitute proof of being interested in the transaction.  However, these cases should not be read to exclude adverse domination when the majority of the board benefits, directly or indirectly, from the challenged conduct, or where the controlling shareholder has stacked the board of directors with relatives, cronies or others who agree to give the malefactor a free hand.  The existing Texas cases certainly permit that kind of factual inquiry, even if a majority of the board silently acquiesce rather than actively participate.

Shareholder’s Knowledge Is Irrelevant

In a shareholders' derivative action, however, while the corporation might not legally have had notice of the wrong-doing, the shareholder initiating the suit might have had knowledge of the wrongdoing outside the limitations period. No Texas case has addressed the application of the tolling of limitations in the context of derivative actions, but the reasoning of the controlling authorities leads to the conclusion that prior notice of the claims to individual shareholders does not necessarily bar the derivative action. This conclusion is based, first, on the important principle that derivative claims belong exclusively to the corporation and not to the shareholders initiating the action.  The shareholders of a corporation are not agents of the company, and their knowledge is not imputed to the corporation. A shareholder has no power to act for or to bind the corporation.  An individual shareholder cannot settle, release or ratify a wrong done to the corporation by a director.   

Under the Texas law of adverse domination, notice to the shareholders should be immaterial for purposes of limitations:  “And where, as here, the management of a corporation's affairs are de facto under the domination and control of the adversary of such cause of action, or the corporation is de facto powerless to sue on such cause of action because of the lack of a disinterested majority of its board, mere notice to shareholders does not start running of limitations against the corporate cause of action.”  This principle is accepted in other jurisdictions. 

The argument that the doctrine of adverse domination should not apply when the shareholder could have earlier prosecuted the claim by a derivative action was made by the former director in Allen v. Wilkerson and was rejected by the court: “Whatever right Chester Lankford [a shareholder and director] might have somehow perfected to bring a shareholders derivative suit for recovery on a corporate cause of action, he himself could neither have expressly released such cause of action, nor have sued directly on the cause of action, which belonged to the corporation and was under the control of its board of directors.” Some other jurisdictions have applied the adverse domination doctrine in a way that might preclude its application in derivative suits. Texas follows what has been termed the "majority test" theory of adverse domination in which adverse domination tolls the statute of limitations when a majority of the board of directors are adverse to the cause of action. The competing theory, which has been adopted by some jurisdictions, is called the "complete domination test." The leading case on this theory is International Rys. v. United Fruit Co., a case out of the Second Circuit.  This theory requires proof that the corporation is in the "full, complete and exclusive control" of the defendants and requires that the plaintiffs to "negate the possibility that an informed stockholder or director could have induced the corporation to sue."  Under the "complete domination test," adverse domination would generally not apply in a derivative case, but that test is simply not the law in Texas.   

Furthermore, there is no policy reason for requiring shareholders to use the same diligence in enforcing corporate claims that the law imposes on officers and directors. A shareholder has no duty to protect the corporation or to institute a derivative action. A shareholder is free to act in his own self interest. Furthermore, the shareholder's right to bring a derivative suit is far from unfettered. The rules of procedure governing derivative actions are "designed to prevent shareholders from interfering with legitimate discretion in corporate governance.“ 

A corporation that is dominated by dishonest officers and directors is considered by the law to be under a "disability" similar to that of a minor or mentally incompetent party. A shareholder who brings a derivative action to assert a cause of action for the corporation is the same representative capacity as a guardian or parent who brings an action as "next friend" on behalf of a minor or incompetent.  “The cause of action which such a plaintiff brings before the court is not his own but the corporations. It is the real party in interest and he is allowed to act in protection of its interest somewhat as a "next friend" might do for an individual, because it is disabled from protecting itself.” Texas law is clear that the knowledge or lack of diligence by one who brings an action in a representative capacity does not affect tolling of limitations. In a suit brought by the next friend for a minor, the minor and not the next friend is the real plaintiff. The Supreme Court has held that the capability of a parent to bring a suit within the two year limitations period does not affect the tolling of limitations on the claim of a minor. In Hopkins v. Spring Ind. Sch. Dist., the knowledge of the accident by the mother who brought suit as next friend for her daughter did not affect the tolling of limitations.  In Simpson v. City of Abilene, claims brought by the father as next friend for his son were not barred by limitations even though the father's individual claims arising from the same accident were barred by limitations.  Similarly, the corporation's rights in connection with a claim asserted in its behalf in a stockholders’ derivative suit are the same as if the corporation sued directly. Liken v. Shaffer, “Where a claim is asserted in behalf of a corporation in a stockholders derivative action in order for matters to be a bar to the claim, they must be such matters as relate to the corporation itself, and the conduct of a particular stockholder is not material.” 

The only reported Texas authority which reaches an inconsistent result is Alice Roofing & Sheet Metal Works, Inc. v. Halleman.  In that case, a cause of action brought by the new owners of a corporation against the former owners was held to be time-barred. The court reasoned that a change in ownership did not re-start the limitations clock after it has run. The court did not consider whether the running of the limitations clock had been tolled for any period of time. This case has been held not to be applicable to a claim of adverse domination. “Alice Roofing did not involve the adverse domination rule.... Although the adverse domination rule might have been relevant, nothing in the opinion indicates that appellants argued adverse domination before either the trial court or the court of appeals." The unreported Texas case of Gibney v. Culver, likewise reaches an inconsistent result on the facts, but without mention or consideration of the doctrine of adverse domination. 

Laches May Disqualify Shareholder as Representative

While delay on the part of a shareholder does not affect the corporation’s claim, unreasonable delay may be relevant on the issue of whether the individual shareholder may represent the corporation in the derivative action. One court has held: “Thus, a particular stockholder who institutes a stockholder's derivative suit, may have participated in the wrong complained of, or may have ratified the wrong complained of or acquiesced in it, or have had knowledge of the wrong complained of under circumstances which would make him guilty of laches. In such cases, a court of equity will not recognize him as a proper suitor in a court of equity and will abate the action without reference to the merits of the claim sought to be asserted in behalf of the corporation.” Limitations, however, is not the issue. The shareholder's right to represent the corporation is not a cause of action for which there is a limitations period. It is an equitable remedy to allow the bringing of a claim belonging to the corporation. A challenge to a shareholder's representative status must be pleaded under the doctrine of laches. Moreover, laches requires proof of more than mere delay. The defendant directors must also prove that the delay was unreasonable, and that the defendants changed their position to their detriment in good faith because of that
 delay. The defense of laches and undue delay are factual, not legal questions. Furthermore, laches must be proved against every shareholder involved in the derivative action. "The fact that one stockholder has discovered fraud and is guilty of laches does not prevent another stockholder who is not guilty of laches from instituting a stockholder's derivative suit." Even if every plaintiff is guilty of laches, the remedy is not to bar the claim of the corporation but to abate this action to allow another shareholder to intervene.  

Houston Business Lawyer Eric Fryar 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

 

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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.

 

 

 

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