Texas Business Dispute Blog

Tuesday, March 3, 2015

Texas Supreme Court Considers How Deep the Rabbit Hole Goes: Can the Shareholder of a Parent Company Bring a “Double Derivative” Action Related to a Corporate Subsidiary?

By Jason Fulton (Dallas)

After the Texas Supreme Court issued a precedent setting series of decisions last June regarding the rights of minority shareholders in private Texas companies, the Court is again set to take up a case involving the rights of private company investors.  The Court’s decision will further shape the legal contours of minority shareholder rights in Texas.  See Webre v. Sneed, 358 S.W.3d 322 (Tex.App.—Houston [1st Dist.], rev. granted March 21, 2014).

In Webre, the First Court of Appeals reversed the trial court’s dismissal order and reinstated a minority shareholder derivative lawsuit that had been dismissed based on lack of standing.  The appellate court found that the shareholder did have standing to bring a derivative lawsuit for a wholly owned subsidiary of the company in which the plaintiff owned shares.  On appeal, the court also refused to require a shareholder to plead and prove facts necessary to overcome the business judgment rule to show that he had standing to assert a claim. 

In its opinion last year in Richie v. Rupe, the Texas Supreme Court emphasized that the existence of derivative claims that minority shareholders can bring provided proof that there was no need for a shareholder oppression claim. In considering the Webre case, the Court will now have the opportunity to validate derivative claims or further constrain the rights of minority investors.

Facts

Webre was one of six shareholders in a parent company called Texas United, which wholly owned a subsidiary called United Salt.  Webre was a member of the board of directors of both Texas United and United Salt. Over Webre’s objection as a board member of Texas United, United Salt acquired a salt mining and storage facility in Virginia.

Webre filed both a direct action and a derivative action on behalf of Texas United and United Salt against the officers of United Salt related to this acquisition. Webre alleged that the officers of United Salt failed to properly investigate this transaction, and he also alleged claims for fraud and breach of fiduciary duty claims.  In this regard, he contended that the officers had made false statements about the acquisition and manipulated accounting records to induce the board to approve the acquisition. Webre further alleged that both Texas United and United Salt had suffered losses and that United Salt paid unjustified bonuses as a result of misleading financial forecasts related to the acquisition.

The defendant officers of United Salt and Texas United responded to the suit by asking the trial court to dismiss Webre’s lawsuit for lack of standing. The most interesting issues addressed on appeal were:  (i) whether Webre had standing to bring the lawsuit in a “double derivative” capacity as a shareholder of the parent company, Texas United, complaining about actions that related to the subsidiary, United Salt, and (ii) what Webre needed to plead to overcome the business judgment rule applied to the officers and board members in order to have standing.

Webre owned 24% of Texas United, and Texas United, in turn, owned 100% of United Salt. The Court of Appeals concluded that Webre had standing to assert claims on behalf of Texas United. As to the subsidiary, United Salt, the alleged bad acts by United Salt’s officers created a cause of action that belonged to United Salt.  Under the reasoning of the Fort Worth Court of Appeals in Roadside Stations, Inc. v. 7HBF, Ltd., & Nu–Way Distrib. Co., 904 S.W.2d 927 (Tex.App.-Fort Worth 1995, no writ), the Court of Appeals determined that Webre, as a shareholder of Texas United, also had standing to assert claims on behalf of United Salt.

Shareholders of a corporation are equitable owners of the assets of a corporation, including any stock or ownership held by that corporation. Thus Webre, as a stockholder in Texas United, also held an equitable ownership interest in United Salt because Texas United owns all stock in the subsidiary. The Court of Appeals examined the statute and case law outside Texas approving the concept of the “double derivative action.”

Defendants also sought dismissal because Webre had not complied with the prerequisites to bringing a derivative action set forth in the Texas Business Organizations Code (formerly the Business Corporations Act). The Texas Business Organizations Code (formerly the Business Corporations Act) requires shareholders to make written demand to the Board of Directors and comply with other procedural prerequisites before filing suit. But the Court of Appeals disposed of that standing objection because TBCA 5.14(L), now codified without substantive change as Texas Business Organizations Code 21.563, specifically exempts closely held corporations from the pre-suit procedural requirements that apply to corporations. A closely held corporation is one that has fewer than 35 shareholders and is not listed on a national exchange. TBOC §21.563(a).

The Court of Appeals also rejected two arguments by the Defendants based on the business judgment rule. First, the Court of Appeals held that Webre did not have to plead and prove fraud or self-dealing simply to have standing to bring suit. The Defendants had it backward. Standing is a prerequisite to seeking judgment on the merits, therefore “standing cannot, as a matter of law, depend on [Webre’s] proof of the merits of his case.” Id. at 336. Second, the Court of Appeals rejected Defendants’ attempts to bar Webre’s suit on the grounds that the Board of both companies had rejected Webre’s demand that they file suit and that Webre had not pleaded that the Board’s refusal to proceed with a claim was outside their business judgment. Again, the Court of Appeals rejected this argument as yet another attempt to impose pre-suit procedural requirements governing derivative actions in regular corporations to a closely held corporations.

What will the Supreme Court do?

This case seems an odd vehicle for the Supreme Court to consider the scope of derivative claims by minority shareholders.  First, under normal practice, the Court’s holding will be limited solely to the narrow issue of standing and this case should not provide a vehicle to conduct an analysis of the underlying rights of shareholders in a derivative suit. Second, the statutory exemption for closely held companies from various derivative lawsuit requirements is clear and concise.  Then again, the law that the Court addressed in Ritchie v. Rupe had seemed settled for decades, and that did not prevent the Court from providing an entirely new interpretation of this law.

The narrow issue here is whether a parent company shareholder has the right to bring a “double derivative” lawsuit to bring claims related to the parent’s wholly-owned subsidiary.  Unfortunately, if recent trends provide any indication, this will not be the only area that the Court addresses in its decision.   In light of the conservative bent of this Court, it is quite possible that the Court will inject a requirement that plaintiffs in closely held corporations who wish to bring “double derivative” claims, must first plead facts that, if proven, would permit the shareholder to survive the defense of the business judgment rule in order to proceed with the claim.


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