When a shareholder, LLC member or partner sues to recover for damages based on wrongs committed against the business entity, the claim is derivative and the recovery belongs to the business. Derivative claims have special procedural rules.
Courts have discretion to allow the owners of closely held businesses to sue individually on a derivative claim when the plaintiff can show “special injury” or when the direct action is not unfair to the business, its creditors or other equity holders. The right to bring derivative actions is available to corporate shareholders, LLC members and partners in general and limited partnerships.
A shareholder may bring a direct claim to enforce rights that are contractual in nature or which enforce some right as shareholder, such as the right to vote or elect the directors.
It is not always easy to determine whether the remedy for the injury suffered as a result of some wrong among the owners of a closely held business belongs to the entity – whether a corporation, limited liability company or partnership – or instead belongs to one or more of the owners.
The distinction is both procedural and substantive, and may be fatal to the plaintiff’s claim. Some claims can belong only to the company. In addition, there are specific procedures in place for bringing a derivative claim in which an owner seeks to assert a right owned by the company. These procedural and substantive requirements can be fatal to a plaintiff’s claim.
But the line is often blurred in the context of the closely held business, and courts can ignore the distinction in some circumstances. In this post, we look at some recent cases in New Jersey considering the distinction, one involving a limited liability company and the other involving a closely held corporation. Although most of the case law has developed in corporate derivative actions involving shareholders, derivative causes of action may also exist in claims brought by members of a limited liability company or partners in a partnership.
Derivative Lawsuits Assert Claims that Belong to the Business
A derivative action is a lawsuit in which the shareholder, member or partner sues on behalf of the business entity because the board of directors (or managers, or controlling partners) refuse to do so. Derivative litigation is frequently in the public view as part of the judicial battleground over merger and acquisition disputes. Shareholders of large corporations will challenge the particulars of a merger, claiming that the merger is a waste of corporate assets or that the deal unfairly benefits a group of insiders at the expense of the corporation.
Derivative claims involve a wrong to the corporation and the refusal of the controlling shareholders to pursue the claim. The derivative plaintiff, who seeks to pursue those claims, must follow specific procedural steps including making a formal demand. Except when the plaint can establish that it would be futile to do so, the claim must be presented to the board with sufficient clarity that it can pursue an action on behalf of the corporation. The board then has discretion to pursue pursue the action or not, and can appoint a special committee of the board to investigate the claim. The derivative plaintiff may also be required to meet a requirement for standing by being an equity holder at the time of the wrong and throughout the pendency of the lawsuit. Many cases are dismissed for failure to meet the demand requirement.
The situation can be complicated when the plaintiff brings a claim directly as an equity holder – whether shareholder, member or partner – and the court determines that it seeks a remedy that belongs to the business entity. The dividing line between the direct claim of an equity holder and the derivative claim can often be blurry. The more closely held the business entity, the more direct the harm from any wrong suffered by the corporation, and the more the derivative claim looks like a direct claim.
Courts May Disregard the Distinction Between Direct and Derivative Lawsuits
Consider a claim in which a majority refuses to take action against an officer or manager who has misappropriated assets or that is involved with a competing venture. In a closely held corporation, the distinction between direct and derivative disappears. In a company owned by two individuals, half of every dollar lost to the misconduct is lost to the other partner. But the mere fact of the diminished value that results from the wrong usually is not sufficient to permit a direct suit and avoid dismissal as a derivative claim.
Courts have adopted the “special injury” test to determine whether a claim states a direct or a derivative action. An individual plaintiff is required to show that the injury suffered is separate from the harm suffered by the shareholders generally or that its contractual rights as a shareholder are involved, e.g., the right to vote. New Jersey follows Delaware law, holding that the purpose of the derivative suit is to provide the shareholders with the ability to protect the interests of the corporation. The principal case on the topic is the New Jersey Supreme Court’s 1996 decision Strassenburg v. Straubmuller (opinion here), in which the court declined to let shareholders challenging the consideration paid in a merger to sue directly.
“The statement of such principles is easy,” the court noted. “The actual determination of whether a suit involves derivative or individual claims of shareholders is not.” In Brown v. Brown, a 1999 decision (opinion here) involving a divorced couple who had owned a business, the Appellate Division adopted the test articulated in the American Law Institute’s Principals of Corporate Governance that the court may treat a derivative claim as a direct action in limited circumstances.
In the case of a closely held corporation… the court in its discretion may treat an action raising derivative claims as a direct action, exempt it from those restrictions and defenses applicable only to derivative actions, and order an individual recovery, if it finds that to do so will not (i) unfairly expose the corporation or the defendants to a multiplicity of actions, (ii) materially prejudice the interests of creditors of the corporation, or (iii) interfere with a fair distribution of the recovery among all interested persons.
Protecting the Interests of Creditors
The Appellate Division sorted through competing derivative and direct claims in Tully v. Mirz (opinion here), a November 2018 decision involving claims between former shareholders, also brothers in law, who owned half of Interstate Fire Protection, Inc. The business ran into financial difficulties and ultimately defaulted on a loan that the principal shareholders had personally guaranteed. After judgment was entered for approximately $530,000, one of the owners entered into a settlement with the bank for $300,000 and was released from liability.
The shareholder who settled with the bank then brought a lawsuit claiming that the company owed debts to him and a business he controlled and that his brother-in-law had engaged in various acts of misappropriation, mismanagement and waste while he was in control of the business. He also sought repayment of the defendant’s proportionate share of the debt paid to the bank.
The court treated the lawsuit as a direct rather than a derivative action. After a motion to dismiss was denied, the defendant answered and filed counterclaims. The court, after a one-day trial, dismissed the case as having been improperly brought as a direct action and that, accordingly, the plaintiff lacked standing to pursue the claim.
The trial court had reasoned that the lawsuit sought to enforce rights owned by the corporation and that allowing the plaintiff to collect directly from the defendant would prejudice the corporation’s creditors, reasoning as follows:
Although this [c]ourt does have the discretion to treat [p]laintiff’s claim as a direct action since IFP was a closely held corporation, the fact that IFP has creditors who are still seeking recovery from IFP funds precludes [p]laintiff’s recovery as an individual.
Allowing [p]laintiff to personally recover funds that were assets of the corporation could affect the recovery of the existing judgment creditor, TD Bank, and potential future judgment creditor, Ideal Supply Co.
Since the case was a derivative action and the plaintiff had not complied with the requirements to sue derivatively under N.J.S.A. 14A3-6.3, the trial court dismissed the case. The appeals court, however, reversed in part, noting that some of the wrongs were based on direct claims the were properly brought as direct actions. Insofar as the plaintiff alleged that defendant had failed to contribute his fair share to the debts of the corporation or had breached the covenant of good faith and fair dealing owed among the members to a limited liability company.
The court noted that claims of waste, mismanagement and breach of fiduciary duty are derivative in nature and thus in order to proceed in an individual action, the plaintiff would have to establish special injury, and that there was inadequate evidence in the record to do. It remanded on the breach of contract and breach of the covenant of good faith and fair dealing as claims that may be brought directly by a shareholder.
Misappropriation and Waste of LLC Assets is a Derivative Claim
The Revised Uniform Limited Liability Company Act (RULLCA) as adopted in New Jersey permits the members of an LLC to bring derivative claims. In a March 2019 case brought by investors in the Bensi restaurant chain, Cajoeco, LLC v. Bensi Enterprises, LLC (opinion here) a trial judge in the Law Division of Superior Court dismissed all of the plaintiff’s claims in an action brought by investors seeking recovery from various limited liability companies for misappropriation and waste. The investors contended that funds had been improperly funneled to insiders.
The court noted that New Jersey corporations law does not permit a shareholder to sue directly for harm suffered by all shareholders unless it can establish special injury or a contractual right, and that the RULLCA contains similar provisions. (See N.J.S.A. 42:2C-68.) Applying cases involving corporations, the court held that:
In the instant matter, Plaintiffs allege that John Osso transferred and commingled funds among the various Bensi entities and acted without the authority to do so. These claims, if meritorious, belong to the various corporate entities and LLCs and not Plaintiffs, as these entities directly suffered financial harm. Plaintiffs therefore lack standing.
Only the individual Bensi entities have standing to sue to recoup their lost funds. Furthermore, if allegedly misappropriated funds were recovered, they would go to
the business entity, and following that perhaps to all shareholders or equity holders. The Plaintiffs would not be solely entitled to such funds. For the foregoing procedural reasons, all of Plaintiffs’ claims as to Defendants are dismissed.
The trial judge went on to dismiss various other fraud and breach of contract claims.
Derivative Nature of Claims is an Overlooked Defense
Damages claims that arise out of wrongful conduct committed by owners of a business should always be examined carefully. The first issue, and the one that courts look at directly, is whether allowing a direct recover will damage any creditors or the interests of other shareholders. That is not to say, however, that one should ignore wrongful conduct that is a legitimate claim against the company, or which has damaged the interests of shareholders.
It may be necessary to assert damages claims of this type directly by the corporation or, if there is no majority consensus to do so, then to adhere to the demand requirements of the relevant statute.
One final note. The rules about direct and derivative claims may not be at applicable in cases alleging oppression or other types of corporate governance disputes. In those cases (an oppressed shareholder action or a claim to expel a member of an LLC, for example), the standing requirements will be specified in the applicable statute governing the business in general.