Who pays the legal fees of private company shareholders when they battle each other in court, often in a fight for control of the business? This is a key question, because the high cost of legal fees is critical, particularly in litigation among shareholders in private, closely-held Texas companies. All shareholders are therefore striving for ways to pay for or recover their legal fees when they litigate against the other shareholders of the company.
Generally, the majority owners of the company control the business, which provides them with control over the corporate purse strings and the ability to pay their legal fees in any disputes they have with minority shareholders. This Post looks at the question of whether the exercise of control by majority owners in directing the company to pay their legal fees will hold up when it is challenged in court by minority shareholders. The short answer is that there is good news and bad news for both majority and minority shareholders under Texas law regarding the payment of legal fees in these shareholder conflicts..
This Post reviews the following questions regarding the recoverability of legal fees under Texas law in litigation between or among private company shareholders:
- Whether majority shareholders will be required to reimburse the legal fees the company spent defending them against minority owner claims if the majority shareholders are found to have breached their fiduciary duties to the company.
- Whether minority shareholders can recover the legal fees they incurred in prosecuting their claims against the majority owners if they are able to establish that the majority owners breached their fiduciary duties to the company.
- Are fee shifting provisions enforceable if the parties choose to include them in their corporate governance documents or in a shareholders agreement.
Defense Costs Are Not An Element of Damages
Under the American Rule, the loser of a lawsuit does not have to pay the legal fees of the prevailing party. This well-settled rule was recently reaffirmed by the Austin Court of Appeals in a shareholder derivative action in which the Court stated that, “A prevailing party on a breach of fiduciary duty claim generally may not recover attorney’s fees against an adversary to the claim.”See DeNucci v. Matthews, No. 03-11-00680-CV, 2015 WL 1882469 (Tex. App.—Austin Apr. 23, 2015, no pet his.). The DeNucci case involved shareholder derivative claims for breach of fiduciary duty that the 40% minority shareholder filed against the the 51% majority owner, who also served as the President, treasurer, founder, and CEO of the business.
The DeNucci Court went on to state that “The general rule of law in this state is that, unless provided for by statute or by contract between the parties, attorneys fees incurred by a party to litigation are not recoverable against his adversary . . . in an action in tort.” Citing Turner v. Turner, 385 S.W.2d 230, 233 (Tex. 1964). In Texas, there are more than 150 statutes that include fee shifting provisions. See O’Connor’s CPRC Plus at 901 (2011).
The American Rule applies even when the majority owners lose a lawsuit in which they are found to have violated their fiduciary duties to the company. This liability finding will not require the majority shareholder(s) to pay for or reimburse the company for the legal defense costs the company incurred in defending the majority owners. Stated another way, the legal fees the company paid to defend majority owners against claims asserted by minority owners are not considered a“recoverable damage” that the majority owners have to repay to the Company if they are ultimately held liable for breaching their fiduciary duties to the company.
Prevailing Minority Shareholders Can Recover Their Legal Fees
When They Successfully Assert Claims In Derivative Litigation
On the other side of the coin, minority shareholders can recover their own legal fees when they prevail on their claims in derivative lawsuits. Under the Texas Business Organizations Code Section 21.561(b), the trial court is authorized to order the corporation to pay the legal fees the minority shareholder incurred in the derivative proceeding if the court finds that the case“has resulted in a substantial benefit to the corporation.”
Importantly, as case law has developed, substantial benefits to the corporation have been interpreted to includenon-monetary or “therapeutic-benefits.” These non-monetary benefits include improvements in the corporation’s governance and operation, but to avoid a windfall result, courts will also consider the actual time expended by counsel in the litigation. See the following Delaware case, which is consistent with Texas law in this respect. In re Sauer-Danfoss Inc. Shareholders Litigation., 65 A.3d 1116, 1135–36 (Del.Ch.2011). Trialcourts are given considerable discretion in shareholder derivative litigation in determining the amount to be awarded based on the benefit conferred.
Texas common law is also consistent with the statute in upholding fee awards to the prevailing plaintiff shareholder in derivative actions when the lawsuit confers a substantial benefit on the corporation. Lawyers colloquially refer to this as the bounty hunter rule, but in case law it is described as the “common fund doctrine,” or the “substantial benefits doctrine.” SeeBayoud v. Bayoud, 797 S.W.2d 304, 315 (Tex. App.–Dallas 1990, writ denied)(“Awarding costs and attorney’s fees to successful plaintiffs in shareholder derivative suits is a well-established practice,” citing Prudential-Bache Sec., Inc. v. Matthews, 627 F.Supp. 1986).
Contracts Also Permit Recovery of Legal Fees
The remaining basis for private company shareholders to recover their legal fees in disputes with their co-owners rests in contract. Courts will uphold the award of legal fees to shareholders based on the agreements set forth in the corporation’s governing documents and/or in a shareholder agreement that applies to shareholder disputes. Typically, these contract provisions are contained in corporate bylaws or in the shareholder agreement and provide for the prevailing party to recover in any shareholder dispute.
For example, in DeNucci v. Matthews, the appellate court upheld the company’s payment of the legal fees incurred by the majority owner in defense of claims asserted by the minority shareholder. The majority owner’s fees were paid based on indemnity provisions contained in the company’s bylaws. In efforts to require the majority owner to reimburse the fees paid by the company, the minority shareholder argued on appeal that the majority owner had failed to follow the proper procedures to secure this indemnification. The appellate court ruled, however, that the minority owner had failed to plead this theory of liability at trial, and also failed to present this theory of recovery to the trial court. Id. at p. 9.
The take away here is that shareholders can agree to provide for the recovery of legal fees in their internal corporate battles, but they must document their agreement in a contract. They will also need to comply with the contractual predicates to recover legal fees.
Final Question – Are Legal Fees Recoverable When the Litigation
Is Filed/Prosecuted by the Shareholders For an Improper Purpose?
There is an important statutory exception to the American Rule that has the potential to apply in derivative litigation, which all plaintiffs must seriously consider before filing suit and making demands on the corporation. Specifically, the court in a derivative action has the right to order the plaintiff to pay the corporation’s expenses in investigating and defending the case if the court finds that “the proceeding has been instituted or maintained without reasonable cause or for an improper purpose.” TEX. BUS. ORG CODE Section 21.561(b)(2).
This derivative litigation statute, in essence, incorporates the sanctions contemplated by Rule 11 and and authorizes trial courts to punish plaintiffs who bring bad faith derivative claims by requiring them to pay the corporation’s defense costs. The statute is arguable less forgiving than Rule 11, however, because it does not provide for any warning or other procedure to put the plaintiff on notice that this fee-shifting provision will be invoked. Derivative shareholder plaintiffs are therefore well-advised to make sure they that have a valid basis to pursue their claims against majority owners before they launch the legal battle.
Outside the derivative litigation context, it also stands to reason that if a majority owner violated his/her fiduciary duties in bringing a lawsuit against the minority owner for an improper purpose or in bad faith, the majority shareholder should be required to reimburse the legal fees the company incurred in pursuing this bad faith claim. This is not an American Rule situation based on the loser of the lawsuit paying legal fees. It is a finding by the trial court at common law that the majority owner should be required to reimburse the legal fees the company incurred when the majority owner caused the company to pursue a lawsuit against the minority owner in bad faith and without just cause. We expect to see future case law develop in this area.