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Derivative Litigation Involving Shareholders of a Closely-Held Corporation

Special rules and procedures for derivative litigation in a closely-held corporation.

 

derivative litigation

Special Rules for Derivative Litigation Involving Closely-Held Corporations.

Section 21.563 of the Texas Business Organizations Code sets up an entirely different procedure for derivative actions in closely-held corporations from the general procedure. Unlike the general rules for derivative litigation, which is extremely anti-shareholder, the alternatively procedure for closely-held corporations is about as shareholder-friendly as one could imagine. The alternative procedure applies only to corporation with 35 or fewer shareholders and no shares listed national securities exchange or over-the-counter market.

No Demand Requirement

The common law required that a demand be made upon the management prior to initiating any shareholder derivative litigation. The reasoning was that the decision for the corporation to file a lawsuit is one that should be made by the corporation's management, and if a shareholder believed that the corporation had a claim, then he had a duty to inform the corporation and give the corporation the opportunity to pursue the claim. Only if the corporation refused to do so could a shareholder take action on the corporation's behalf. As the business judgment rule developed to prevent judicial scrutiny of honest business decisions within the legitimate exercise of the board's discretion, the notion developed that, not only must a shareholder notify the corporation and give it the first crack at asserting the claim, but the shareholder would be permitted to proceed only if the corporation's refusal to do so was not protected by the business judgment rule. These concepts developed as pleadings rules requiring that the plaintiff's petition to state with particularity that the corporation was given notice and refused to take action and also that the refusal was not a valid exercise of business judgment. The plaintiff might escape the obligation of notice by pleading "demand futility," in which the plaintiff would state with particularity why any demand on the board would be futile and any decision on the part of the corporation's management would not be disinterested--most commonly, that the majority of the board had committed a breach of their fiduciary duties to the corporation would could not be expected to vote to sue themselves.

The massive legislative changes enacted in 1997 eliminated the demand futility doctrine for larger corporations; now demand is required regardless of how futile, and there is a statutory procedure to determine the validity of the refusal. For closely-held corporations, the legislature went exactly the opposite direction: they eliminated the demand requirement altogether. In a closely-held corporation, a shareholder may file a derivative suit without any demand or prior notice whatsoever. Furthermore, there is no mechanism whereby a corporation can seek the dismissal of the derivative litigation, even if it believes that the lawsuit is not in the company's best interests. The Supreme Court's opinion in Ritchie v. Rupe emphasized the liberality of the derivative litigation mechanism for small companies in holding that a separate shareholder oppression doctrine was unnecessary. In the 2015 Sneed v. Webre opinion, the Texas Supreme Court held that the legislative scheme for derivative claims in closely-held corporations completely preempted the common law. The defendants in that case argued that even if shareholders in small companies were no longer required to give prior notice, the common law would still require them to demonstrate that the corporation's refusal to pursue the claim was not protected by the business judgment rule and that the corporation should be able to have the case dismissed, absent such a showing. The Supreme Court rejected the argument, holding that those common-law doctrines were superseded by statute.

No Contemporaneous Ownership Requirement

At common law, in order to have standing to bring derivative litigation, the shareholder was required to be a shareholder (1) at the time that the action complained of occurred, (2) at the time the lawsuit was filed, and (3) continuously through-out the lawsuit. Those three standing requirements, commonly termed the "contemporaneous ownership" requirement, were codified in the Business Organizations Code at section 21.552. However, § 21.552 does not apply to closely-held corporations. It is somewhat unclear what this means. It probably does not mean that anyone (shareholder or not) can initiate a derivative action on behalf of a closely-held corporation. As the Texas Supreme Court noted in Sneed, the reason that a shareholder may bring a derivative suit is because that shareholder is a beneficial owner of the property of the corporation, which includes its claims and causes of action. All civil actions have a minimum jurisdictional requirement that the plaintiff have standing, some stake in the dispute that entitles the plaintiff to seek relief from the court. Section 21.563 does specifically refer to "a derivative proceeding brought by a shareholder of a closely-held corporation." It would seem that a derivative plaintiff would at least be required to be a shareholder when the lawsuit was filed to satisfy the constitutional requirements of standing. However, a shareholder who was injured by the misconduct but lost his shares involuntarily shortly prior to filing might also satisfy the constitutional requirement of standing.

The other two requirements of standing appear to have no application to closely-held corporations. The requirement to be a shareholder through-out the litigation had already been modified in the common law to allow plaintiffs to continue to have standing if they lost their shares involuntarily. A favorite defensive maneuver by management sued in derivative litigation is to cause the minority shareholder to lose his share ownership through a reverse stock split or cash-out merger. As the Houston Court of Appeals held in Somers v. Crane, that tactic works in Texas in larger companies, but it would not work in closely-held corporations according to the holding in Sneed. The requirement that the shareholder be a shareholder at the time of the action complained of was based on the notion that persons who buy stock take the corporation as is, that the price of the shares probably reflects any prior injury suffered by the corporation, and that such shareholders will not be heard to complain about conduct that arose before they were there. Based on the reasoning of Sneed, the statute supersedes the common law in this area as well. Nevertheless, this doctrine might still apply to a specific shareholder's recovery resulting from a successful derivative proceeding based on notions of estoppel and unjust enrichment. Otherwise, there might be multiple shareholders who all have standing to assert the same claim for the same damages. If that happened, there could only be one recovery, and the court would have to make a determination of how the portion of the award attributable to those share should be apportioned among its various owners.

No Requirement of Adequate Representation

The other standing requirement imposed by § 21.552 is that the shareholder "fairly and adequately represent the interests of the corporation in enforcing the right of the corporation." This is a codification of the common-law requirement that was usually stated that the shareholder fairly and adequately represent the "interests of the corporation and of the other shareholders similarly situated." The Texas Supreme Court had held that, in smaller corporations, where there were no other shareholders similarly situated, a single shareholder could meet this test as "a class of one." However, the adequate representation requirement has been superseded by statute and does not apply to closely-held corporations. Therefore, a single shareholder might pursue derivative litigation, even though 34 other shareholders disagree.

Direct Recovery

Under the § 21.563, for shareholders in a closely-held corporation, actions that traditionally could only be brought derivatively may now be treated as direct actions if the court determines that "justice requires." Because the right to bring a direct action is subject to the court's discretion, a plaintiff almost certainly plead such claims in the alternative. Furthermore, there will be frequent instances in which plaintiff will prefer to bring a claim as a derivative claim. A payoff to the complaining shareholder may leave the situation which created the evil about which the shareholder complains undisturbed. Also cases involving only the recovery of one shareholder may not be economical to bring; whereas such cases are more attractive when recovery is sought on behalf of all shareholders. The provision allowing direct recovery to the shareholders, however, solves an important problem in derivative litigation-double taxation. If the corporation receives the recovery, the recovery is likely to be taxed at the corporate level and again when distributed to the shareholders as a dividend.

The provisions of the Business Organizations Code permitting recovery of attorneys' fees and court supervision of any settlement or nonsuit apply to all corporations. 

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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