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Cates v. Sparkman:

Individual Shareholder Right to Sue

Cates v. Sparkman: Texas Supreme Court affirms individual shareholder right to sue.

individual shareholder right

Cates v. Sparkman: When Does an Individual Shareholder Have the Right to Sue?

In the landmark case of Cates v. Sparkman,  the Texas Supreme Court upheld the dismissal of a minority shareholder’s lawsuit against the corporation and its directors and other shareholders for damages caused to the shareholder resulting from the decision to cease business operations and liquidate the corporation. The plaintiff filed suit claiming that the corporation and the other defendants breached duties owed to him as a shareholder. The defendants answered by general demurrer and special exceptions, and the trial court dismissed the lawsuit. The plaintiff appealed, and the Supreme Court affirmed the dismissal.

Re-examining Cates v. Sparkman

In the opinion, the Court wrote the classic statement of the business judgment rule in Texas:

It may be safely said that courts of equity have not, as a general rule, been disposed to exercise their jurisdiction through suits like the present to control or interfere in the management of the corporate or internal affairs of an incorporated company. The company’s business is left to the direction of the officers or managing board which, by the law creating it, may be clothed with the power and discretion to conduct its affairs in the manner which, in their judgment, is best calculated to promote its interests.

     . . . .

If the acts or things [challenged by a plaintiff shareholder] are or may be that which the majority of the company have a right to do, or if they have been done irregularly, negligently, or imprudently, or are within the exercise of their discretion and judgment in the development or prosecution of the enterprise in which their interests are involved, these would not constitute such breach of duty, however unwise or inexpedient such acts might be, as would authorize the interference by the courts at the suit of a stockholder. 

The Cates opinion is significant in three respects: First, it is the “seminal”  case in Texas describing the business judgment rule, has been cited consistently as authority for more than a century,  and has recently been reaffirmed by the Texas Supreme Court as the leading Texas authority in that regard.  Second, it describes the procedural elements necessary to bring a common-law shareholder’s derivative claim, which requirements have now been codified and superseded by statute.  Third, it describes the kinds of claims that a shareholder may bring individually against the corporation for corporate actions that damage him personally as a shareholder. This last aspect of the opinion, describing the individual shareholder right to sue, has been largely overlooked by Texas courts, but is of renewed importance in determining whether existing common law fills the gaps created when Ritchie v. Rupe eliminated shareholder oppression as an individual cause of action for damage done personally to minority shareholders.

Facts

Distinguishing the holding in Cates v. Sparkman regarding individual right to sue from the holding regarding derivative claims requires careful scrutiny of the procedural posture of the case, the Court’s reasoning, and the precise wording of the holding. The plaintiff in Cates was a shareholder in Wise County Coal Company and brought suit in his individual capacity against that corporation, together with its officers, directors, and remaining shareholders. The plaintiff claimed to have been the owner of certain tracts of land and the lessee of others that contained valuable coal deposits. He and the other individual defendants entered into an agreement to form the corporation for the purpose of developing the deposits. The plaintiff conveyed the land and leasehold interests to the corporation in exchange for stock. The defendants were unsuccessful in raising sufficient capital, and “after the defendants had expended about $15,000 in money, employed hands, purchased machinery, and placed the plaintiff in charge of the mines, as superintendent, to develop the same, the work under the directors continued for about two months, when, against his prote[s]t, some of the hands were discharged; [] the work was then continued for four months; and, at the expiration of that time, the development of the mines was arrested, and the machinery sold to one [shareholder] of the company.”  The plaintiff, having given up his valuable minerals interests holdings, was left only with worthless stock.

The plaintiff’s suit was based on two legal theories: the defendants’ “fraudulent acts” to devalue his stock and obtain his coal mining assets, and “their failure to comply with their contract” under which he original invested his assets into the corporation.  On the fraud claim, plaintiff’s petition alleged that the conduct of the directors “from the beginning were done for the purpose, and with the intent, to defraud plaintiff out of his property,” that the decision to cease operations was “for the purpose of financially ruining plaintiff, and defrauding him out of his property,” and that the “object of said defendants was to depreciate said stock and acquire the whole of said property for a nominal consideration.”  On the contract claim, the plaintiff’s petition alleged that “plaintiff has complied with his part of the agreement” and that “defendants had refused to comply with their part of said agreement; that, by such failure and refusal, they have damaged plaintiff.”  The plaintiff requested the relief of canceling his shares and an award of damages.

Holdings

Cates v. Sparkman was not a derivative suit. It was a direct claim by a shareholder in his individual capacity asserting the violation of legal duties owed directly to himself—fraud and breach of contract. In rejecting those claims, the Texas Supreme Court also explicitly recognized the existence and validity of such an individual shareholder right to assert a claim for violation of such duties, in “a proper case.”  In order to understand the reasoning of the Court in the Cates opinion, it is necessary to look at Evans v. Brandon,  a similar case decided by the Texas Supreme Court just eight years prior to Cates v. Sparkman.

In Evans, the plaintiff was a shareholder in Texas Banking and Insurance Company and brought suit against the members of the board of directors of that corporation, claiming that “in the conduct of the company’s business the defendants were so careless, negligent, reckless, and imprudent in making loans and discounts, permitting the same to be made by the subordinate officers of the bank, as to impair the capital of the company to the amount of $170,000, and cause a depreciation of more than $50 per share in the market value of the stock, including the shares held and owned by plaintiff.”  The plaintiff sought damages in the the sum of $3,760 for the depreciation in the value of his stock.  The Supreme Court made short work of the plaintiff’s suit, holding: “On principle and authority, it is clear that the liability of directors for a breach of duty that injures the corporate property as a whole, is primarily to the corporation whose agents they are.”  The Court held that the plaintiff could not assert these claims in his individual capacity:

A recovery by the corporation for such an injury would inure to the benefit of its stockholders, and in that way they would be compensated for the indirect injury received. If the corporation refuses to sue, or is still under the control of the directors sought to be held responsible, a stockholder may maintain an equitable proceeding “to protect the interest of the corporation as the trustee for all its stockholders and creditors.”

A fatal defect in the plaintiff’s petition, both original and amended, is, that it seeks no recovery in behalf of the corporation, but seeks a direct recovery of damages for the plaintiff individually, the case stated not entitling him to such a recovery.

It would seem that the plaintiff’s claim in the Cates case suffered the same “fatal defect.” The first of eleven special exceptions filed by the defendants was that “an action of this kind cannot be maintained against the directors for damages to corporate property or stock, except in the name of the company.”  The Cates Court was clearly aware of the Evans decision, citing it twice.  Had the Supreme Court in Cates believed that there was no individual shareholder right to bring a claim for violation of legal duties owed to individual shareholders, and that shareholders could not bring suit in their individual capacities for damage to the value of their shares, the Court would simply have upheld the dismissal on the basis of the defendants’ first special exception and written a very short opinion, as it had done in Evans. It did not do so.

The Cates Court stated, “Applying to the petition the most liberal and reasonable construction of which its language is susceptible, there are but two aspects in which the case made by it can be properly considered.”  The case was either a claim by an individual shareholder against the corporation for damages for loss of the value of his shares caused by the misconduct of the officers,  or it was a claim by an individual shareholder against the corporation for cancellation of his shares and damages (i.e., rescission of the subscription agreement and restitution of the consideration) based on breach of the contract by which the plaintiff acquired his shares.  Neither of these alternatives describes a derivative claim asserted on behalf of the corporation. In both instances, the Court recognizes that there are situations in which a plaintiff would be able to assert a direct claim on his own behalf for damage done to himself as a shareholder under either a claim for breach of legal duties owed by the corporation to the shareholder or for breach of a contract to which the shareholder is a party.

The Court first analyzed the validity of the plaintiff’s “fraud” claim—“[t]reating it first as a suit in equity by an individual stockholder of shares in an incorporated company, against the latter [that is, against the company], to recover damages for the depreciation in the value of his stock and the corporate property, occasioned by the fraudulent practices and conduct of the officers and directors.”  The plaintiff’s argument was that “such a suit may be brought when said officers have fraudulently conspired together to take advantage of plaintiff, or where they have fraudulently misapplied corporate property or funds, and the stockholder has suffered loss by depreciation in the value of his stock, or special damage, when the corporation refuses to sue, or the allegations are such as show a virtual refusal by the company to sue,”  which is plainly wrong because these elements describe a derivative suit—an “equitable proceeding to protect the interest of the corporation as the trustee for all its stockholders and creditors,” as the Supreme Court had described in Evans.   

The Court’s analysis following this statement is somewhat confusing because the Court accepts without examination the plaintiff’s position that the individual claim for fraud against the company required satisfying the three elements necessary for a derivative claim. “The concurrence of three things is regarded as indispensable as the basis for such a suit: The company must refuse to sue; there must be a breach of duty; there must be injury to the stockholder.”  However, the Court does this with the proviso that is determining whether the plaintiff’s petition satisfies its own theory because the authorities cited were not “altogether reconcilable.”  The Court’s application of the rule is telling. The first element, demand futility, was “comparatively free from difficulty” as the plaintiff is claiming that the entire board was guilty of wrong-doing.  The “more serious question arises” as to whether the plaintiff has adequately pleaded breach of duty and harm.  In analyzing whether or not a breach of duty has been alleged, the Court clearly articulates the business judgment rule that actions that are “done irregularly, negligently, or imprudently, or are within the exercise of their discretion and judgment in the development or prosecution of the enterprise” are not a breach of duty “however unwise or inexpedient such acts might be,”  and that shareholders may not bring a lawsuit just because they “might be dissatisfied with the progress of the work or enterprise in which the company was engaged, or the manner in which it might be conducted by the directors or board authorized to conduct it . . . upon the ground that the enterprise or work of the company was not being carried on, or was being delayed or arrested in a manner not, in his judgment, conducive to the interests of stockholders.”  But, nowhere does the Court inquire as to whether the board members were disloyal to the corporation or “fraudulently misappropriate[d] the corporate property in any manner, or obtain[ed] any undue advantage, benefit, or property for themselves by contract, purchase, sale, or other dealings under cover of their official functions, or in any manner commit[ted] a breach of their obligations” to the corporation,  which omission is surprising given that the petition specifically alleged that the “object of said defendants” was to “acquire the whole of said property for a nominal consideration” and that the defendants had “sold all tools and machinery to defendant Carpenter for less than their value.”  However, the plaintiff did not sue for that alleged misappropriation of corporate property; he sued only for his own individual loss. The Court rejected the plaintiff’s petition as not stating a breach of duties based on the fact that the conduct about which he complained constituted nothing more than actions that “the majority of the company have a right to do,”  not because the plaintiff had failed to allege a breach of duty to the corporation, but because the plaintiff had failed to allege any “illegal exercise of discretion subversive of the plaintiff’s rights.”  Likewise, on the third element of harm, the Court concludes, not that the petition had failed to allege harm to the corporation, but that the petition had not adequately alleged individual harm to the plaintiff: “The value of the plaintiff’s stock is at no time clearly stated, nor what its value would have been if the undertaking had been successful.”

It is important to keep in mind throughout the discussion that the case was not brought as a derivative action; it was brought individually by the plaintiff for damages suffered by him personally as a result of the loss of the mining assets he invested. No harm to the company was alleged, only harm to the plaintiff. No claim was made on behalf of the company; rather, the company was a defendant from which the plaintiff was seeking damages. The Court makes clear in the second sentence of the opinion that it is analyzing the claim as “a suit in equity by an individual stockholder of shares in an incorporated company, against the latter, to recover damages for the depreciation in the value of his stock and the corporate property, occasioned by the fraudulent practices and conduct of the officers and directors” —a claim by a shareholder against the corporation for damage done to the shareholder, not a claim by a shareholder on behalf of the corporation for damage done to the corporation. And, most importantly, the holding of the Court was not that the claim should have been brought derivatively, as had been the holding in Evans, but that the “the petition does not allege such facts as would authorize the suit by plaintiff, as an individual stockholder, against the company for damages in the depreciation of the value of his stock.”

In defining such individual claims, the Court states that the general policy not to interfere with the authority of the management of a corporation to conduct business  is subject to certain exceptions.  Two categories of such claims “justify the interposition of the courts.”  First, there are derivative claims, which the Court defines as claims against officers and directors for harm to the corporation caused by “negligence or culpable lack of prudence, or a failure to exercise their functions, or fraudulently misappropriate[ing] the corporate property in any manner, or obtaining] any undue advantage, benefit, or property for themselves . . . or in any manner commit[ing] a breach of their obligations,”  which claims must be brought by the corporation, no matter what the indirect loss suffered by the shareholder, or by a shareholder “suing representatively for all others similarly situated,” but if, and only if, the corporation refuses to bring the suit.  Second, in certain limited circumstances, there are claims that an individual shareholder may bring for “damage in the depreciation of his stock”:

 The breach of duty or conduct of officers and directors which would authorize, in a proper case, the court’s interference in suits of this character is that which is characterized by ultra vires, fraudulent, and injurious practices, abuse of power, and oppression on the part of the company or its controlling agency clearly subversive of the rights of the minority, or of a shareholder, and which, without such interference, would leave the latter remediless.

Recognizing the Individual Shareholder Right to Sue

This often-quoted  (or misquoted) sentence does not describe the limits of the business judgment rule applicable in derivative suits, nor does it describe the threshold requirements for a shareholder to bring a derivative action, and grammatically could not be so interpreted. The sentence describes those kinds of misconduct that would permit suit by a plaintiff, “as an individual stockholder, against the company for damages in the depreciation of the value of his stock.” 

The kinds of situations in which an individual shareholder has the right to assert such a claim are three: First, shareholders may sue directly for misconduct “characterized by ultra vires.”  Second, shareholders may sue directly for “fraudulent” misconduct.  Third, shareholders may sue directly for “injurious practices, abuse of power, and oppression on the part of the company or its controlling agency clearly subversive of the rights of the minority, or of a shareholder, and which, without such interference, would leave the latter remediless.” This third catergory cannot mean anything other than a direct action by the shareholder for breach of duties owed to the shareholder. These claims are based on misconduct on the part of “the company or its controlling agency” that are “clearly subversive of the rights of the minority, or of a shareholder”—not for harm to the company or violation of duties to the company but impairment of the “rights of the minority” or even of a single shareholder—and only in situations where, if the individual shareholder could not sue directly, he would be left “remediless.”

The Court reviews of the allegations in the plaintiff’s petition to determine whether the type of misconduct alleged states a “breach of duty authorizing a suit by an individual stockholder for damage in the depreciation of his stock.”  The lawsuit was based on decisions by the directors in running the business, “[b]ut it is not alleged that this was done in any manner other than that which the directors may have had a right to do, or ought to have done,”  and there was no allegation consistent with “fraud, oppression, or abuse of power.”  The Court concludes that the “character of fraudulent practices, oppressive conduct, abuse of power, and an illegal exercise of discretion subversive of the plaintiff’s rights are not shown on the part of the officers and directors of the company which are held to be necessary to maintain a suit of this kind” —again, “this kind” of suit, the Court states repeatedly, is an individual claim by a shareholder against the company. The Court holds: “As the case is presented, we are of the opinion that the petition does not allege such facts as would authorize the suit by plaintiff, as an individual stockholder, against the company for damages in the depreciation of the value of his stock, and injury to the corporate property.”

Finally, the Court turns to the plaintiff’s other individual claim, breach of contract: “Treating the case as one for damages for the breach of a contract by the defendants, and for the recovery of prospective profits which might have been realized if the contract to develop the mines and construct the railroad had been carried out . . . .”  The problem with this claim is not want of a duty, but proof of damages. “[I]t is only necessary to say that what his stock would have been worth, and the probable enhanced value of the corporate property if the enterprise embarked in had been successful, are elements of damage too remote to form the basis for a recovery, even if they had been alleged with sufficient certainty.” 

Subsequent Treatment-Ignoring the Individual Shareholder Right

The language used by the Cates court to describe the few types of situations in which a shareholder has an individual cause of action against the company has been grossly misconstrued in some subsequent cases. In Langston v. Eagle Publishing Co., the court indicated that a shareholder had standing to bring a derivative action only in the extremely narrow instances where Cates had ruled the shareholder had an individual claim: “Before a shareholder can bring a derivative suit in the right of a corporation, . . . the shareholder must plead and prove that the board of directors’ refusal to [pursue the claim] was ‘characterized by ultra vires, fraudulent, and injurious practices, abuse of power, and oppression on the part of the company or its controlling agency clearly subversive of the rights of the minority, or of a shareholder, and which, without such interference, would leave the latter remediless.’”  On its face, the statement could not possibly mean that. A derivative suit is brought by the shareholder on behalf of the corporation against officers and directors who have violated duties to the corporation that resulted in harm to the corporation. Requiring the shareholder to plead and prove that “the company or its controlling agency [had] clearly subvert[ted] of the rights of the minority, or of a shareholder” would be wholly immaterial to the corporation’s cause of action. Construing the limited instances in which a shareholder has an individual claim as being the only instances in which a shareholder can bring a derivative action cannot be reconciled with Cates description of a shareholder derivative action just a few pages before in which the Court described a broad range of situations in which “corporation is the party to bring the suit in equity” against officers and directors who “cause a loss of corporate property by negligence or culpable lack of prudence,” fail to exercise their functions, misappropriate the corporate property “in any manner,” obtain “any undue advantage, benefit, or property for themselves,” or “in any manner commit a breach of their obligations.”  In all of these situations, the corporation may sue the officers and directors, but a “shareholder suing representatively for all others similarly situated,” may not “unless the corporation, either actually or virtually, refuses to prosecute.”  If a shareholder could bring a derivative suit only after pleading and proving “ultra vires, fraudulent, and injurious practices, abuse of power, and oppression on the part of the company or its controlling agency clearly subversive of the rights of the minority, or of a shareholder, and which, without such interference, would leave the latter remediless,” then a shareholder could not possibly “sue representatively” when the corporation refuses to do so in all the situations mentioned in the Cates opinion. This specious construction was recently argued to and rejected by the Texas Supreme Court in Sneed v. Webre.  Without stating whether or not it had ever been the law that derivative claims were so limited, the Court held that the common-law standing requirements for derivative claims have now been superseded by statute.

In another regard, the Sneed v. Webre Court’s discussion of Cates raises serious questions. The Supreme Court in Sneed made clear that, although the language in Cates had no application as to derivative standing, it may have application in the determination of the merits. “[T]he business judgment rule traditionally is implicated twice within the life cycle of a shareholder derivative proceeding brought on behalf of a corporation. First, the business judgment rule applies to the board of directors’ decision whether to pursue the corporation’s cause of action. Second, the business judgment rule applies as a defense to the merits of a shareholder’s derivative lawsuit that asserts claims against the corporation’s officers or directors for breach of duties that result in injury to the corporation.”  The Sneed opinion states the principle in Cates that “an officer or director’s breach of duty that would authorize court interference ‘is that which is characterized by ultra vires, fraudulent, and injurious practices, abuse of power, and oppression on the part of the company or its controlling agency clearly subversive of the rights of the minority, or of a shareholder, and which, without such interference, would leave the latter remediless’” is still the law.  “Accordingly, the pronouncement of the business judgment rule in Cates, with respect to breaches of duty, goes ‘in reality to the right of the plaintiff to relief rather than to the jurisdiction of the court to afford it.’”  Therefore, the question remains as to whether the statement “ultra vires, fraudulent, and injurious practices, abuse of power, and oppression on the part of the company or its controlling agency clearly subversive of the rights of the minority, or of a shareholder, and which, without such interference, would leave the latter remediless” defines the very limited circumstances in which a shareholder may have a direct claim against the corporation or describes the application of the business judgment rule in a derivative claim brought for the benefit of the corporation. Several cases have incorrectly seized on this language as a description of the business judgment rule applied in a derivative action: “Texas courts to this day will not impose liability upon a noninterested corporate director unless the challenged action is ultra vires or is tainted by fraud.” 

“In Texas, the business judgment rule protects corporate officers and directors from being held liable to the corporation for alleged breach of duties based on actions that are negligent, unwise, inexpedient, or imprudent if the actions were ‘within the exercise of their discretion and judgment in the development or prosecution of the enterprise in which their interests are involved.’”  The business judgment rule may be interposed as a defense in a suit instituted by the corporation as well as a derivative suit brought on behalf of a corporation.  There is a huge gulf between not imposing liability on officers and directors when they are merely “negligent, unwise, inexpedient, or imprudent” and only imposing liability on officers and directors when their actions are “characterized by ultra vires, fraudulent, and injurious practices, abuse of power, and oppression on the part of the company or its controlling agency clearly subversive of the rights of the minority, or of a shareholder.” If Cates meant to limit officer and director liability to the corporation only to the latter, then the Court’s other statement that the corporation had a claim against officers or directors who “cause a loss of corporate property by negligence or culpable lack of prudence,” fail to exercise their functions, misappropriate the corporate property “in any manner,” obtain “any undue advantage, benefit, or property for themselves,” or “in any manner commit a breach of their obligations”  is nonsense. The Texas Supreme Court in Ritchie was at pains to emphasize that officers and directors “owe a fiduciary duty to the corporation in their directorial actions, and this duty ‘includes the dedication of [their] uncorrupted business judgment for the sole benefit of the corporation.’”  The majority opinion repeats that standard of liability no less than five times.  The court states that “when a corporate director violates the duty to act solely for the benefit of the corporation . . . minority shareholders are entitled to relief, either directly toHouston business lawyer Eric Fryar the corporation or through a derivative action.”  The same standard is repeated in Sneed.  Again the notion that directors are liable directly to the corporation or through a derivative suit whenever they fail to “act solely for the benefit of the corporation” cannot be reconciled with the notion that they are only liabile for acts “characterized by ultra vires, fraudulent, and injurious practices, abuse of power, and oppression on the part of the company or its controlling agency clearly subversive of the rights of the minority, or of a shareholder.” Sneed leaves the matter somewhat ambiguous.

Next: Stinnett v. Paramount>

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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