As 2016 begins, the anecdotal evidence indicates that derivative lawsuits filed by private company shareholders in Texas are increasing. This rising tide of shareholder derivative litigation was easy to foresee after the Texas Supreme Court’s Ritchie v. Rupe decision in June 2014 rejecting court-ordered buyouts for shareholder oppression and leaving only receivership as a remedy for oppressive conduct by majority owners. Minority owners, however, are still permitted to pursue shareholder derivative lawsuits filed in the name of the company to recover for injuries sustained by the business.
The Ritchie case remains on remand from the Supreme Court before the Dallas Court of Appeals, and the appellate court could decide that trial courts are authorized to order buyouts of minority shareholders based on claims for breach of fiduciary duty. Such a ruling would significantly improve the legal position of minority shareholders after Ritchie. Yet, even if the Dallas Court of Appeals does not go that far, derivative lawsuits based on breach of fiduciary duties will remain an effective claim for minority shareholders whose rights are being abused by majority owners and their affiliated officers and directors. This claim for breach of fiduciary duty brought in a derivative capacity – if based on facts that demonstrate significant misconduct by company management – can also lead to a business negotiation resulting in a voluntary buyout of the minority investor’s interest by the majority owner.
Shareholder Derivative Litigation – Key Points
As shareholder derivative claims for closely held businesses play a larger role in the post-Ritchie world, it is important for minority and majority owners to be familiar with the way these claims work under Texas law.
In most cases, shareholders of a Texas company who believe that the company’s officers and directors have breached their fiduciary duties must file a derivative lawsuit to pursue a claim. A derivative lawsuit is required, because under Texas law, company directors, officers, and other managers and advisors of the business owe fiduciary duties to the company rather than to the individual shareholders. As a result, most breach of fiduciary duty claims belong to the company, and the shareholders can pursue these claims only by filing a derivative suit in the company’s name to recover damages for the injuries the company has suffered.
Although the Ritchie decision was a significant setback for minority shareholders who have been oppressed by majority owners, the good news for minority shareholders is that the Texas derivative statutes provide them with some important advantages that do not exist in other states. Specifically, the procedural impediments that apply to derivative lawsuits in most states make it very difficult to successfully pursue derivative claims. By contrast, the Texas Business Organizations Code provides a straightforward path for minority owners of closely held corporations and Texas limited liability companies who seek to pursue derivative claims against the company’s officers and directors who abuse their authority.
Consistent with other states, Texas has a number of default procedural hurdles before a shareholder of a Texas company or a member of a Texas limited liability company is allowed to pursue claims that belong to the business:
- First: The shareholder/member must have been an owner at the time of the act or omission complained of;
- Second: The shareholder/member must establish that he/she will fairly represent the interests of the company in the proceeding.A judgment in a derivative lawsuit binds all stakeholders in the business, even those who do not participate in the lawsuit.Courts therefore want to ensure that the plaintiff is leading the action (not the lawyers) and that he/she is not pursing the derivative claim for ulterior motives, e.g., in an attempt to gain leverage for a direct claim the plaintiff has against the company; and
- Third: The shareholder/member must first make a written demand on the company stating with particularity the act or omission that is the basis of the claim and requesting that the company take action.The shareholder/member cannot file a derivative lawsuit for 91 days after making this demand.Further, if the company’s management decides to investigate the demand, all discovery is stayed until the investigation is completed.Most importantly, once the company’s management has decided that pursuing the claim referenced in the demand is not in the best in interest of the company (as it almost always does), the court is required to dismiss the derivative lawsuit if management’s decision not to pursue the claim was made by the majority of the independent and disinterested directors (or managers), a similar committee, or a court-appointed panel.
Few derivative claims survive these procedural safeguards that protect the company’s management. The demand requirement is particularly onerous and is often the death knell for derivative lawsuits. The key point here in Texas, however, is that, for closely held companies, all of the above restrictions on pursuing derivative claims are waived. Simply stated, shareholders and members of Texas closely held companies do not need to meet any of the demand requirements discussed above, establish himself/herself as an “adequate” plaintiff, or show that he/she was an owner at the time of the act or omission that forms the basis of the claim. A closely held company or LLC is one that has fewer than 35 shareholders or members and its equity is not publicly traded on an exchange.
Compared to other states, Texas is unusual in waiving the procedural requirements discussed above, including the demand requirement, for owners of closely held companies and LLCs asserting derivative claims. This “waiver” for owners of closely held companies and LLCs has important implications for litigating in the post-Ritchie world. First and foremost, minority owners of Texas closely held companies and LLCs always have the right to promptly pursue breach of fiduciary duty derivative claims on behalf of the company or LLC.
Texas law also makes personal recovery of money damages easier for derivative plaintiffs pursuing claims on behalf of closely held companies and LLCs. Ordinarily, a recovery of money damages in a derivative lawsuit goes to the business, not to the shareholder or member pursuing the claim. That is because the claim technically belongs to the company.
For example, if a shareholder successfully brings a derivative claim against the CEO for misappropriating $1 million of the company’s funds, the $1 million damages award against the CEO would be returned to the company coffers and would not be paid to the shareholder who filed the lawsuit, and no requirement would exist for the company to declare a dividend or distribution of any of these funds to shareholders or members. The shareholder’s benefit in this example is indirect as the minority owner’s investment in the company becomes worth more once the $1 million has been recovered by the company. Texas law authorizes judges in derivative lawsuits involving closely-held companies, however, to treat a derivative claim as a direct claim of the shareholder (or member) and to direct that the recovery obtained in the lawsuit be paid to the shareholder/member “if justice requires”. In the above example, if the shareholder owned 20% of the company, he/she would have a strong argument that justice requires that at least $200,000 of the award should be paid to him/her personally, and not to the company.
Derivative lawsuits are also increasing in the post-Ritchie world because a minority shareholder/member can recover his/her attorneys’ fees from the company if the court finds that “the proceeding has resulted in a substantial benefit to the [company or LLC].” For most successful breach of fiduciary claims, a compelling argument can be made that the relief obtained in the lawsuit, whether as money damages or an injunction issued by the court, provided a substantial benefit to the company. The specter of the company having to pay the plaintiff’s attorneys’ fees affords a minority shareholder/member additional leverage vis-à-vis the majority owners.
Finally, this post is applicable to both Texas companies and LLCs, but not to Texas limited partnerships. Texas has different rules for derivative lawsuits that are filed by limited partners. Most importantly, there is a demand requirement for all limited partners who want to pursue a derivative claim on behalf of the partnership. There is no special treatment for “closely held” limited partnerships, although the demand requirements are less onerous than for shareholders/members of non-closely held companies and LLCs.
While we continue to await the remand decision in Ritchie, breach of fiduciary duty derivative claims will remain a cornerstone of minority/majority owner disputes. This is likely to remain the case even after the Dallas Court of Appeals resolves the issues in Ritchie due to the procedural advantages that are available to shareholders and LLC members of closely-held companies under Texas law.