The “Double Derivative” Conundrum: Who Has the Right to Bring a Derivative Claim Against the Officers of a Privately Held Texas Company

Sometimes what we take for granted is not so clear.  It had been axiomatic for years that only shareholders have the right to bring a derivative lawsuit in the name of the company.  Yet, the Houston Court of Appeals recently permitted a shareholder (of a parent company) to bring a derivative lawsuit on behalf of the parent’s wholly-owned subsidiary.  See Webre v. Sneed, 358 S.W.3d 322 (Tex. App.—Houston [1st Dist.] 2011, pet. granted) (No. 12-0045).  The appellate court’s decision approved what is known as a “double derivative” lawsuit in which a stockholder of a parent corporation seeks to recover for a claim that belongs to a subsidiary corporation. The Texas Supreme Court has recently granted review of this decision, which is of considerable interest because of the “double derivative” situation in which the shareholder in the parent company did not own any shares in the subsidiary. 

The dispute in Webre focused on an acquisition made by United Salt, a wholly owned subsidiary of Texas United.  Webre was a 24% shareholder of the parent, Texas United, and a member of the Boards of both companies and he opposed the acquisition.  The question presented was whether Webre—as a shareholder of the parent—could bring a shareholder derivative lawsuit on behalf of the subsidiary, United Salt, against its officers.  The trial court dismissed the lawsuit based on Webre’s lack of standing because he was not a shareholder of the subsidiary.  On appeal, however, the Houston appellate court held that: (i) for purposes of determining standing in a derivative lawsuit, the term “shareholder” includes equitable owners and (ii) all of the shareholders of the parent company have an equitable interest in the company’s wholly owned subsidiary. The Webre court provided the following reasoning:

  • We conclude that Webre, as a stockholder in Texas United [the parent company], is also an equitable owner of stock in United Salt [the wholly-owned subsidiary] because Texas United owns all of the stock in United Salt . . .  . Thus, Webre can properly be considered a stockholder for purposes of bringing a derivative lawsuit on behalf of United Salt.

Id. at 332-33 (citing Roadside Stations, Inc. v. 7HBF, Ltd. & Nu-Way Distrib. Co., 904 S.W.2d 927 (Tex.App.-Fort Worth 1995, no writ).  In addition to the Houston and Fort Worth appellate courts, there are several jurisdictions outside of Texas (including Delaware, Illinois, and New York) that permit a “double derivative” shareholder lawsuit to proceed where the shareholder is maintaining the derivative suit on behalf of the subsidiary because the parent or holding company has derivative rights to prosecute the cause of action that belongs to the subsidiary.

Another major issue presented in Webre is whether a shareholder in a closely held company (less than 35 shareholders) has to plead and prove fraud or self-dealing by the Board to establish standing to pursue claims in a derivative lawsuit.  On appeal, the appellate court rejected this contention and held that it is inconsistent with Texas law to require the plaintiff to prove the merits of his case in order to establish standing.  The Webre court therefore held that, at least at the pleading stage, the business judgment rule does not require the court to dismiss the lawsuit when a board has voted to reject the shareholder’s claims because factual disputes are present. 

The Webre court also reached the conclusion that the plaintiff did not need to comply with the statutory written demand requirement (i.e. sending formal notice before filing suit) because both entities were closely-held corporations as defined by the Texas Business Corporations Act.  See TBCA Art. 5.14 (providing “[t]he provisions of Sections B through H of this Article are not applicable to a closely held corporation,” explaining that Webre was not comply with the written demand requirement to pursue the claim). 

The appellate court’s apparent rejection of the notion that the business judgment rule applies to as a defense to claims by shareholders of closely held Texas companies (at least at the pleading stage) may be what triggered the Supreme Court’s grant of the writ. The Petitioner’s Opening Brief to the Supreme Court expressed significant alarm about the appellate court’s decision as follows: 

  • The court of appeals’ holding materially alters and overturns the traditional meaning and application of the business judgment rule followed in Texas for more than 100 years under Cates v. Sparkman, 73 Tex. 619, 11 S.W. 846, 849 (Tex. 1889) and its progeny.  If allowed to stand, small business corporations will now face a flood of costly shareholder litigation without the fundamental protections of the rule. . . .
  • The impact of the court’s decision is stunning, as it obliterates the protections of the business judgment rule not only to closely held corporations, but to all corporations in Texas.

In contrast to the warning bells that were sounded by the Petitioner in its brief, the Respondent argued in its Response Brief that the appellate court’s decision was consistent with the provisions of the Texas statute, in which the legislature chose to apply much less stringent standards to lawsuits brought by the shareholders of closely held companies.

Thus, it is clear that the Legislature’s intent, in order to foster a more modern, flexible, business economy, was to adopt the modern trend of exempting shareholders in close corporations from the traditional requirements and defenses attendant on derivative actions filed on behalf of publicly traded corporations.  This is what the plain language of the statute reveals.

The Supreme Court has not yet set Webre for oral argument, but by accepting the writ, the Court has indicated it plans to consider important issues that arise when private company shareholders file derivative lawsuits.  The Court is likely to address standing requirements as applied to private company shareholders who wish to bring derivative actions.  It is also a safe bet that the Court will consider the extent to which the business judgment rule provides officers and directors of closely held firms with a legal defense to claims based on their actions in the governance of these companies.