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The Derivative Lawsuit

The procedural peculiarities of the derivative lawsuit. Understanding the procedure a shareholder must follow to bring a lawsuit on behalf of the corporation.

derivative lawsuit

The Derivative Lawsuit in Texas

Nature of the Action

A derivative action is a lawsuit brought by a plaintiff shareholder on behalf of the corporation. The plaintiff, suing in a representative capacity, asserts rights belonging to the corporation because the management of the corporation refuses to do so. Consequently, the corporation, not the shareholder, is entitled to any damages recovered in the suit. This is consistent with the general rule that a cause of action for injury to the property of a corporation is vested in the corporation, as distinct from its individual shareholders. Thus, any action to redress such injuries must be brought by the corporation or by a shareholder for the corporation.  The rule exists not simply to avoid a multiplicity of suits, but in order that any damages recovered may be available for the payment of the corporation's creditors. 

Necessity of Pre-Lawsuit Demand

Under federal and most states' laws, a derivative plaintiff must either first demand that the corporation's management assert the claim prior to filing suit or allege with particularity his effort to have the directors bring suit for the corporation or the reasons for not making such an effort. The demand requirement is not merely pro forma, but is a question of state substantive law. The plaintiff shareholder must make a serious effort to pursue the intra corporate remedy before bringing a derivative suit and must also make reasonable efforts to assist the corporation in bringing suit. On the other hand, traditionally, the plaintiff need not make a futile demand. Far example, a demand would traditionally be unnecessary where the directors are the wrongdoers and could not otherwise be expected to bring suit against themselves.   

Texas law governing derivative actions, now codified at Texas Business Organizations Code section 21.551 et seq., underwent a monumental transformation in the 1997 Legislative session--changing it from one of the more shareholder-friendly legislative schemes to perhaps the most restrictive statute in the country. Gone is the venerable legal principle that a shareholder is under no obligation to demand that the corporation bring the suit if such demand would be futile. Under the new statute, written demand must be made to the corporation setting forth with particularity the act, omission or matter that is the subject of the claim or challenge, regardless of whether such an act would be futile. BOC § 21.553. The corporation must have 90 days to act on the demand (unless irreparable injury would be suffered by the corporation during that period). The running of limitations is tolled until the earlier of 90 days after the demand or 30 days after the rejection of the demand, so that limitations cannot serve as an excuse for either the failure to give notice or the shortening of the notice period.

Adequacy of Demand

In In re Schmitz, a 2009 Texas Supreme Court opinion, the Court addressed the requirements of an adequate demand. There were two complaints about the pre-suit demand in Schmitz: the demand letter did not identify the shareholder making the demand (only his attorney), and the demand letter was not sufficiently "particular" in its description of its complaints. Article 5.14 (now BOC § 21.553) does not expressly state that a pre-suit demand must state the name the shareholder, but the Texas Supreme Court holds that the plain implication of the statute requires identification of the complaining shareholder. Furthermore, the court noted that a number of public policy reasons would also require that a shareholder demand could not be made anonymously. Among these was the concern that the use of anonymous demands could be abused and that the Board of Directors would need to know the shareholder's identity in responding to the demand. "In other words, a demand from Warren Buffett may have different implications than one from Jimmy Buffett."

Section 21.553 does require that the demand set forth "with particularity" the matter about which the complaint is made. The Texas Supreme Court held that the Schmitz demand letter was not sufficiently particular in its description of the claim. The demand letter urged the board to stop the merger because it had received a "superior offer" of one dollar more per share. The Supreme Court's problem with the statement of the demand seems to be primarily that the statement was very short -- two sentences -- and that the demand did not state explicitly why one dollar less per share made the offer "inferior." However, the court gives almost no guidance as to how particular the statement must be in order to qualify as a pre-suit demand. "We do not attempt today to explore all the ways in which a demand might or might not meet article 5.14's 'with particularity' requirements. Whether a demand is specific enough will depend on the circumstances of the corporation, the board, and the transaction involved in the complaint. But given the size of this corporation and the nature of this transaction, this demand was clearly inadequate."

The court's holding and analysis raises many more questions than it answers. If the complaint in this case was that there were two offers, and one was more than the other, and that the shareholders would want a higher offer, but that the board took the lower offer, it is difficult to imagine how one could state that complaint with greater "particularity" than was done in this case. The Court acknowledges that "all things being equal" the greater offer would be preferred by the shareholders, but the court notes that in comparing competing offers for a merger, "all things are rarely equal." The court notes a host of reasons why a board might decide that the offer with a lower cash value is actually better for the shareholders. The court stated that a rule requiring the corporation always to accept nominally higher offers would result in harm sometimes to the shareholders and would subvert the business judgment rule in Texas. All of this is true, but all of it is completely irrelevant as to whether the demand stated its complaint with particularity. If a shareholder thinks the board should take the option that gives that shareholder more cash, then in responding to that complaints the board might justifiably decide that the complaint is unfounded for all the reasons and factors cited by the Court, but that does not mean that the board would not know the basis of the shareholders complaint, as the Court suggests. The purpose of a pre-suit demand is to give the board of directors the opportunity to determine whether the complaint is valid and to take corrective action. Inherent in this idea is the assumption that the board may disagree with the shareholder. the language used by the court seems to suggest that all the factors and evidence on which the plaintiff may ultimately base his case must be laid out in the demand letter, almost as if the Board of Directors would have no source of information or basis on which to respond other than the information contained in the demand letter. That is simply unrealistic. The Board of Directors will always have more and better information about a corporate transaction than is available to an individual shareholder. Demand futility is no longer a legal concept in Texas. Therefore, if the shareholder's complaint is that the Board of Directors is acting fraudulently or withholding information, under current Texas law, the shareholders still has to send the demand to the Board of Directors that it should sue itself and wait 90 days before filing suit. In that sort of situation, it will almost always be the fact that the shareholder does not have access to information, absent discovery, about the extent of management's wrongdoing.

The requirement of particularity in the demand simply cannot be as onerous as the language in the court's opinion seems to suggest. If, in the course of deciding between competing merger offers, a Board of Directors accepts a lower bid, and fully discloses to the shareholders the reasons for its decision, then clearly a demand merely stating that the board should have taken the higher offer is an adequate because any litigation will ultimately concern whether the board's reasoning was sound or falls within the business judgment rule. If the shareholder has a position as to why the board's evaluation of the offers was incorrect or not disinterested, then merely complaining that the price is lower does conceal the shareholder's true complaint. That may very well have been the situation in this case, but the opinion does not make that clear. However, if the board failed to disclose why it determined the lower offer was better or failed to disclose what about the non-cash provisions of the offers was deemed to be more valuable than difference in cash amounts, then truly all a shareholder can say is "you are not acting in the best interest of the shareholders because your decision gives us less money." If that is the real complaint, it is hard to get more particular.

One standard can be gleaned from the court's analysis. On appeal the plaintiffs had argued that it was proper to challenge the merger because there were personal benefits to the board of directors in the lower offer that may have induced them to violate their duty of loyalty in selecting that offer over the one that gave more benefit to the shareholders. The Supreme Court agrees that a derivative suit would be an important means of preventing a corporate board from enriching themselves at the shareholders' expense, but "the demand letter here said nothing about any of that." It would seem, at a minimum, that the particularity requirement would force a plaintiff to state in the demand letter all the claims, bases, and facts that are in the petition that is ultimately filed. Clearly, the board should be confronted at the demand stage with everything that the plaintiff is prepared to plead 90 days later at the litigation stage, and the plaintiff would have absolutely no legitimate reason to withhold that information. However, since Texas has no requirement that pleadings be stated "with particularity," something more is probably required. The Supreme Court's opinion makes clear that the plaintiff's basis for her complaint about the board's action must be fully disclosed. Hopefully, future courts will not interpret this decision as requiring a plaintiff to submit to the Board a document that could not possibly be created until after discovery in order to have standing to commence the suit and take the discovery.

Pace v. Jordan, had previously held that a demand must (1) identify the alleged wrongdoer, (2) describe the factual basis of the claim, (3) describe the corporation's injury, and (4) request remedial action. "A demand is sufficient if the board of directors had a fair opportunity to consider the shareholder's claims." Pace specifically held that the demand need not be as detailed as the plaintiff's pleadings in the lawsuit. The Supreme Court in Schmidt cites Pace on another point but does not even mention the opinion's discussion of this issue. However, Pace was determining the sufficiency of a demand under the version of art. 5.14 prior to the 1997 amendments, which did not have a requirement of particularity. The Supreme Court's ignoring of the Pace decision should probably be taken to mean that Pace is no longer good law on this point.

Procedural Issues in Presuit Demand

The Supreme Court in Schmitz also did address an important procedural issue. If a plaintiff's lawsuit is dismissed because the court determines that the plaintiff failed to give an inadequate pre-suit demand, then the plaintiff has an immediate right to appeal. However, if the trial court fails to enforce that demand requirements of the statute, the lawsuit goes on, and there is no right to an interlocutory appeal. However, the Supreme Court holds that mandamus review is available. The court notes that the availability of mandamus must be decided on a case-by-case basis. The court notes that mandamus might be inappropriate if another shareholder has made a proper demand, or if the lawsuit will go forward regardless on other non-derivative claims, or if recovery of expenses from the shareholder is an adequate remedy. 

The shareholder may file the lawsuit on the 91st day after demand, regardless of the corporation's response. However, after the lawsuit is filed, all proceedings, including discovery, are stayed for 60 days if the corporation provides a written statement to the court that it is investigating the matter. 

Dimissal by the Corporation

If the corporation proposes to dismiss the action, the discovery is limited to the independence, good faith and reasonableness of the corporation's inquiry and decision to dismiss, and discovery may only be expanded thereafter if the court determines that the decision to dismiss was improper. The court shall dismiss the action on a motion by the corporation if the corporation has reached a decision that the action is not in the best interest of the company. This decision must be made by (1) a majority vote of independent and disinterested directors at a meeting of the board of directors at which the interested directors are not present at the time of the vote and at which the disinterested directors constitute a quorum; or (2) a majority vote of a committee consisting of two or more independent and disinterested directors appointed by a majority vote of one or more independent and disinterested directors (whether or not these directors make up a quorum); or (3) a panel of one or more independent and disinterested persons appointed by the court on motion by the corporation where the panel is selected from names submitted to the court by the corporation after a finding by the court that the members are independent and disinterested and otherwise qualified. The decision-makers must reach the conclusion that the action is not in the best interest of the company after reasonable inquiry and based on "the factors as the person or group deems appropriate under the circumstances." If the a majority of the board of directors is independent and disinterested or if the decision to dismiss is made by a court-appointed panel, then the action must be dismissed unless the plaintiff proves that the decision makers actually were not independent and disinterested or that the inquiry was not reasonable or that the decision-maker did not actually conclude that the action was not in the best interest of the corporation based on factors that the decision-maker deemed appropriate. In all other circumstances, the corporation bears the burden of proving that an the decision to dismiss was made properly; except that the burden switches back to the plaintiff upon prima facie evidence that a committee of disinterested directors was in fact disinterested and independent.

Separate procedure for small corporations

These new procedures do not apply to “closely held corporations,” which the statute defines as corporations with less than 35 shareholders and with no shares listed on any national securities exchange or over-the-counter market. The special derivative procedures for closely-held corporations is discussed separately.

Contemporaneous ownership requirement

Whether suing in federal or state court, the derivative plaintiff must specifically plead either that she was a shareholder of the corporation at the time of the transaction forming the basis of the complaint, or that her shares devolved to her by operation of law from one who was a shareholder at that time. A failure to meet this requirement may result in dismissal. 

Texas courts impose a three-part test to determine whether the plaintiff satisfies the contemporaneous ownership requirement. The plaintiff must prove that he: (a) owned stock in the corporation at the time of the transaction of which he complains; (b) continued to own stock at the time of the bringing of the suit; and (c) maintained status as a stockholder during the ensuing prosecution of the derivative suit. If a plaintiff voluntarily relinquishes his status as a shareholder during the pendency of the action, he loses his standing to further prosecute the derivative suit.

An unusual sequence of ownership was at issue in Zauber v. Murray Sav. Assn. The derivative plaintiff in that case was a shareholder both at the time of the alleged wrongful transaction and at the time the action was filed. During the pendency of the suit, however, the corporation authorized a reverse stock split, which reduced plaintiffs ownership to less than one share, and tendered a cash payment to plaintiff for his fractional share. The court remanded the case for a determination of whether the plaintiff had voluntarily relinquished his shareholder status. In the event the trial court determined that the disposition was involuntary, the court stated that the plaintiff would be allowed to proceed with the suit, unless the reverse split was intended to accomplish a valid business purpose.

Adequacy of representation

Under both Fed. R. Civ. P. 23.1 and BOC § 21.552(2), a plaintiff must fairly and adequately represent the interests of other shareholders similarly situated in enforcing the right of the corporation. The question of whether the sole dissenting shareholder in a closely-held corporation may bring a derivative action when the remaining shareholders deny that the shareholder adequately represents their interests has been frequently litigated. The Texas Supreme Court has joined a majority of jurisdictions holding that the sole dissenting shareholder in a closely-held corporation does have standing to pursue the corporation's claims even where all the remaining shareholders deny that he represents their interests. 

Special Litigation Committees

Traditionally, one defense tactic to derivative claims was to set up a "special litigation committee" to seek to dismiss or otherwise limit the derivative lawsuit. In Sonics International, Inc, v. Dorchester Enterprises, Inc., the court concluded that the business judgment decision of an independent committee of directors could not defeat the derivative plaintiffs standing to sue for a temporary injunction. According to the court, the trial court would have the discretion at a later stage of the litigation to determine the ultimate effect of the committee's decision on the plaintiffs right to relief. In Zauber v. Murray Sav. Ass'n, the court held that the board has no such power to dismiss the suit if the plaintiff has not made a demand on the board of directors to prosecute the action. Instead, the only issue is whether or not the plaintiff was excused from making such a demand; thus, the plaintiff is required to plead with particularity the reasons why no demand was made. Significantly, however, the Texas Supreme Court in refusing the application for writ of error in Zauber, specifically declined to address the issue of the board's power to dismiss the action when demand is excused.

The use of special litigation committees in Texas has almost completely been displaced by the statutory procedure which specifies the special committee procedures and essentially makes that procedure automatic and at the very outset of the lawsuit.

Payment of Expenses

Under the old statute, the TBCA allowed the court to require derivative plaintiffs to post security for expenses, which would serve as a source of payment to the defendant for attorneys fees and expenses of the litigation if the defendant prevailed in the suit and the court determined that the suit was brought without reasonable cause. The threat of having to post security for expenses served as a significant deterrent to the bringing of derivative actions. That procedure was completely abolished by the 1997 amendments. Under Business Organizations Code, the court may order the payment of attorneys fees, expenses incurred in investigating the claim and incurred in the litigation and any expenses for which the corporation was required to indemnify. However, that order is made at the termination of the derivative proceeding, and there is no provision for the posting of security or bond. Furthermore, the act provides that the corporation may be ordered to pay the expenses of the plaintiff if the court finds that the proceeding resulted in substantial benefit to the corporation; the plaintiff may be ordered to pay the expenses of the corporation or any defendant if the court finds that the derivative proceeding was commenced or maintained without reasonable cause or for an improper purpose; and any party may be ordered to pay expenses of any other party relating to any motion, pleading or paper filed in the action which the court finds was not well grounded in fact after reasonable inquiry, was not warranted by the law, or was interposed for an improper purpose.

In addition to the statutory provisions, the common law provides for payment of the plaintiff's attorneys fees either under the common fund doctrine or the substantial benefits doctrine. It is well-established in the common law that one who prosecuted a shareholders derivative action may receive reasonable attorneys' fees and expenses. The award of such fees is conditioned upon proof that the suit conferred a substantial benefit upon the corporation. Furthermore, the rule is one of equity.  And, being equitable, it is one applied by the court, not a jury.  Also, under the "common fund" doctrine, if a few succeed in securing a benefit for a group, the entire group shares the cost of procuring the benefit. With regard to shareholder derivative suits, the plaintiff is treated as a representative of the group of shareholders benefitted and the corporation may be required to pay the reasonable costs and attorney's fees incurred by the plaintiff during the litigation. The courts have held that the winning plaintiffs recovery of attorney's fees under the common fund doctrine depends on a finding that a substantial benefit has been conferred on the corporation or group of shareholders. However, there is now no source of authority for the payment of defense expenses in litigation involving closely-held corporations, even when the action was brought without reasonable cause of for an improper purpose, over than a motion for sanctions under Rule 13 or Tex. Civ. Prac. & Rem. Code § 9. 01 et seq.

Settlements

The federal rule requires notice to other shareholders and judicial approval before a derivative action can be dismissed or compromised. Under the Business Organizations Code, no derivative proceeding may be discontinued or settled without approval by the court, and notice to the remaining shareholders is required if the court determines that the settlement may substantially affect the interests of the other shareholders. 

Houston_Business_Lawyer_Eric_Fryar.jpg 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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