Minority shareholders in private Texas companies often find themselves in a precarious position if they failed to obtain a contractual right to exit the business — a “corporate pre-nup” — at the time of their investment. When minority owners do not secure a buy-sell term or some other type of redemption provision on the way in, they are likely to be locked into their investment with few options to market their stock. The recent Texas Supreme Court decision in Ritchie v. Rupe—recently described as “astonishing,” “bad law” and “bad policy” by the Yale Law Journal—only made things worse for minority investors because the decision permits majority owners to refuse to meet with potential buyers of the minority owner’s stock. See James Dawson, Ritchie v. Rupe and the Future of Shareholder Oppression, 124 Yale L. J. 89 (2014). Our previous Blog posts here and here analyze the Ritchie case in more detail.
Although the Court’s majority opinion in Ritchie fundamentally changed existing Texas law by refusing to recognize a statutory or common law claim for minority shareholder oppression, the Court emphasized that minority shareholders continue to have the right to file derivative suits. The Court held that “one or more shareholders can sue the directors [or majority owners] for breach of those [fiduciary] duties on behalf of the corporation through a derivative action.” A derivative suit is considered two causes of actions in which: (1) the shareholder seeks to compel the company to bring a lawsuit against its own officers and directors; and (2) the shareholder seeks to recover assets for the corporation or prevent the dissipation of its assets. In simplest terms, a shareholder in a derivative action “steps into the shoes” of the company to protect it from harmful decisions by the controlling persons. These claims are governed by Sections 21.551-21.563 of the Texas Business Organizations Code, which permits shareholders of a corporation, members of a LLC, and limited partners of a LP to bring a derivative lawsuit. See Tex. Bus. Org. Code §§ 21.551-.563 (corporations); Tex. Bus. Org. Code §§ 101.451-.502 (LLCs); Tex. Bus. Org. Code §§ 153.401-.405 (LLPs). The statute applicable to corporations and LLCs are substantially identical, although the LLP statute has several differences that are beyond the scope of this Post.
This Blog focuses on the derivative claims that remain available to minority shareholders after the Court’s decision in Ritchie and includes a discussion of: (1) derivative actions in corporations under the Texas statute with many shareholders; and (2) the special rules the Texas Legislature has adopted for the shareholders of a closely-held corporation, which (a) make it easier for the shareholder to bring a derivative suit on behalf of the corporation and (b) permit a recovery in the derivative action to be paid directly to the plaintiff shareholder.
Threshold Issue of Derivative Claims in Texas
A threshold issue in determining what rules apply to a shareholder derivative action in Texas is the size of the corporation. The Texas statute that governs derivative actions splits them into two categories. First, corporations that have more than 35 shareholders are required to complete certain pre-suit demands and are further limited in the manner in which they can pursue claims once a lawsuit has been filed. By contrast, shareholders of a “closely-held corporation”—defined by statute as being less than 35 shareholders—are not burdened by the same requirements or limits in bringing a derivative lawsuit.
Requirements for Derivative Actions When There Are More than 35 Shareholders
Shareholders of corporations with more than 35 shareholders must be aware of the following four statutory hurdles in bringing a derivative claim, because the failure to meet these requirements may halt or stall pursuit of the claim:
- sending a pre-suit written demand to the company, unless the “corporation is suffering irreparable injury.” Tex. Bus. Org. Code § 21.553(a), (b).
- getting board approval for the derivative lawsuit. Tex. Bus. Org. Code § 21.554;
- providing for a stay of the litigation if the corporation wants to investigate the claims. Tex. Bus. Org. Code § 21.555; and
- limits on discovery that may result in dismissal of the lawsuit. Tex. Bus. Org. Code §§ 21.556, 21.558)
There are few Texas appellate cases discussing these provisions, but at least one recent case applied TBOC §§ 21.556, 21.558 to limit a minority shareholder’s discovery requests to solely to information that would should how the corporation’s special committee investigated the facts underlying the derivative lawsuit. See In re Platinum Energy Solutions. Inc., 420 S.W.3d 342, 348-48 (Tex. App.—Houston [14th Dist.] 2014, no pet.).
Three Important Points for Derivative Claims in a Closely-Held Texas Company
Shareholders in closely-held Texas companies still have a powerful statutory tool after Ritchie to bring derivative actions when the company’s majority owners overstep their bounds. As noted earlier, the statute defines “closely held corporation” as a corporation with fewer than 35 shareholders and no shares listed on a national stock market. Tex. Bus. Org. Code § 21.563(a)(1), (2). This classification does three important things to streamline the process for shareholders of closely-held companies in bringing a derivative claim: (1) the pre-suit requirements described above do not apply; (2) the suit can be treated as a “direct action” for the shareholder’s own benefit; and (3) the trial court has discretion to award damages directly to the plaintiff for the direct or derivative actions.
- The Removal of Pre-Suit Requirements Make It Easier to File Suit
The Texas derivative statute allows shareholders in closely-held companies to forgo pre-suit requirements that typically apply to derivative actions. The Supreme Court in Ritchie expressly recognized that shareholders can “more easily” bring a derivative suit because they do not need to meet pre-suit demands (i.e. written demand; show standing) and “without fear of a stay or dismissal based on actions of other corporate actors in response to the demand. Ritchie, — S.W.3d —, 2014 WL 2788335, at *15 (citing Tex. Bus. Org. Code §§ 21.552(2), 21.553-55, 21.558-.59). The Court’s discussion in Ritchie rejected a common law claim for shareholder oppression, but emphasized that shareholders still had viable options to bring derivative claims to redress the harm that the corporation had suffered.
- Claims May Be Treated As “Direct Action” For Shareholder’s Own Benefit
The Texas statute also gives the trial court discretion to modify the proceedings in the case for the shareholder’s benefit, providing that “if justice requires,” the trial court may (1) treat the derivative lawsuit as a “direct action brought by the shareholder for the shareholder’s own benefit;” and (2) any recovery obtained may be paid “directly to the plaintiff or to the corporation.” Tex. Bus. Org. Code § 21.563(c)(1), (2). In an opinion decided after Ritchie, the Supreme Court remanded a plaintiff shareholder’s case to the trial court, explaining that “a minority shareholder in a closely held corporation may recover equitable relief, in some cases individually as well as on behalf of the corporation, through a derivative action for breach of fiduciary duties.” See Cardiac Perfusion Servs., Inc. v. Hughes, 436 S.W.3d 790 (Tex. 2014) (per curiam) (citing Tex. Bus. Org. Code § 21.563(c)). Although Texas courts require derivative plaintiffs to plead and prove injury sustained by the company, there is conflicting, but fairly dated, Texas Supreme Court precedent in Patton v. Nicholas, in which the Court upheld a plaintiff’s claim for breach of fiduciary duty even when it stated: “we find no evidence . . . that [the corporation] was damaged.” 279 S.W.2d 848, 853 (Tex. 1955).
A recent Texas appellate case also permitted a plaintiff of a closely-held corporation to recover in his individual capacity. The dispute in Saden v. Smith involved two 50% owners of a technology company and the plaintiff owner (Smith) alleged fiduciary duty and contract claims against his co-owner. 415 S.W.3d 450, 461-64 (Tex. App—Houston [1st Dist.] 2014, pet. denied). The plaintiff in Saden alleged that his co-owner harmed the company by engaging in a course of conduct that included: (1) causing the company’s revenue to be deposited into the defendant’s personal bank account; (2) falsifying company records to misrepresent company finances; and (3) not distributing the company’s revenue equally. Id. at 463-64. The plaintiff proved (at a jury trial) that the company had been harmed, and the Saden court therefore approved a significant recovery for the plaintiff on his derivative claim, even though it would be remanded for certain adjustments to the award. Id. at 471-72. Importantly, Saden distinguished an earlier case from the San Antonio Court of Appeals that denied a plaintiff’s claim “based solely on [the plaintiff’s] individual damages, not on any damage to the corporation.” Guerra v. Guerra, No. 04–10–00271–CV, 2011 WL 3715051, at *5 (Tex. App.—San Antonio Aug. 24, 2011, no pet.).
The key takeaway from Saden and Guerra is that courts will permit the recovery in a derivative lawsuit to be paid directly to the plaintiff. The current state of the law requires the shareholder to first plead and prove, however, that the company suffered harm, which is distinguished from harm that the shareholder suffered in his or its individual capacity.
- The Texas Statute Permits Recovery of Legal Fees in Derivative Litigation
The Texas Legislature has also included a provision in the derivative statute that could, depending on the outcome of the litigation, result in an award of attorney’s fees to either of the parties. See Tex. Bus. Org. Code § 21.561.
The statute describes recoverable expenses as being attorney’s fees, costs to investigate the subject of the lawsuit, or expenses to indemnify certain parties. Id. § 21.561(a). Upon the termination of the derivative proceeding, the trial court may order expenses to be paid in three circumstances: (1) the company may be ordered to pay the plaintiff’s expenses if the proceeding resulted a “substantial benefit” to the company; (2) the plaintiff may be ordered to pay the company’s expenses if the lawsuit was maintained “without reasonable cause”; or (3) any party may be ordered to pay expenses resulting from filing a pleading or motion in bad faith or without reasonable inquiry. Id. § 21.561(b)(1)-(3).
Texas courts have awarded attorney’s fees to a plaintiff when the prosecution of the plaintiff’s derivative action provided a “substantial benefit” to the company. See Biggar v. Palmer, No. 08-01-00468-CV, 2003 WL 22361068, at **11-12 (Tex. App.—El Paso Oct. 16, 2003, no pet.) (applying predecessor statute to TBOC § 21.561(b)(1); see also Prudential-Bache Secs., Inc. v. Matthews, 627 F. Supp. 2d 622, 625-26 (S.D. Tex. 1986) (applying Texas statute and common law). Courts across the country have awarded attorney’s fees to plaintiffs in similar circumstances—often where the corporation takes steps to moot the plaintiff’s claims. See, e.g., In re Oracle Secs. Litig., 852 F. Supp. 1437, 1445-46 (N.D. Cal. 1994) (awarding $4.8 million in attorney’s fees). On the other hand, Texas courts have awarded expenses to the defendants where the suit was pursued “without reasonable cause,” focusing mostly on the plaintiff’s pre-suit investigation (or lack thereof) into the claims. See, e.g., Bass v. Walker, 99 S.W.3d 877, 883-89 (Tex. App.—Houston [14t Dist.] 2003, pet. denied) (adopting objective standard); but see Pace v. Jordan, 999 S.W.2d 615, 625-26 (Tex. App.—Houston [1st Dist.] 1999, pet. denied) (concluding trial court did not abuse discretion in denying parties’ request for expenses under derivative action statute).
The Supreme Court’s ruling in Ritchie jettisoned the common law claim for shareholder oppression, and is particularly harsh to minority shareholders seeking a court-ordered buyout of their ownership interest. The Court stressed in its opinion, however, that minority shareholders will continue to have the right to assert claims for breach of fiduciary duties against those in control of the company under a statute that governs derivative claims filed by shareholders of closely-held Texas companies. This shift away from shareholders asserting claims for oppression to shareholder claims for breach of fiduciary duties in derivative lawsuits will necessarily change the focus of future litigation by shareholders in private companies. Specifically, rather than focusing on the harm that minority shareholders suffered individually from the majority owners’ oppressive actions, minority shareholders are now likely to allege that the majority owners harmed the company by improperly exploiting their controlling authority.
The elimination of the buyout remedy in Ritchie for oppressed private company shareholders, however, is what caused the Supreme Court to acknowledge that it was leaving a gap in the law regarding minority shareholder rights. The Court specifically left open the question of whether a minority shareholder’s successful claim against officers or directors for breach of fiduciary duties could ever give rise to a remedy authorizing a court-ordered buyout of the minority owner’s stake in the business by the majority shareholder. That is just one of the questions that courts will be answering as minority shareholders increasingly file claims against majority owners in derivative actions alleging breach of fiduciary duties.