Businesses often create additional new businesses, whether as joint ventures or subsidiaries. The flexibility and favorable tax treatment given to the limited liability company have made it fairly common that an LLC has other business entities as its owners. For the individual owner, however, this situation can present problems. The requirement that the members act at the company level often means less individual control and less ability to address acts of wrongdoing in the subsidiary or joint venture.
The individual owner’s recourse is the double derivative action, a complicated device in which the individual owner. asserts the rights of the parent to assert a claim as an owner of the subsidiary. It’s confusing, but the principle is generally well accepted.
An example that came up recently in our practice recently may help illustrate. Two corporations formed a joint venture, each owning 50 percent. The two corporations, lets call them A Corp. and B Corp., were each owned by two partners, 50 percent each. There were four individuals each with a 25 percent interest. However, the members could only act at the entity level, meaning that A Corp. had one vote and B Corp. had one vote. And, because both corporations needed the approval of both of its shareholders, the result was that all decisions had to be unanimous.
In addition, as is common, the principals were all appointed managers and had jobs in the business.The managers were elected and could be removed by a vote of the members. So when one of the managers became a problem, that manager could not be removed by a vote of the members because the problem manager could block the affirmative vote of one of the parent entities.
Consider the alternative as well. If one of the individual owners has a real grievance at the level of the subsidiary or joint venture – mismanagement of the joint venture or exclusion from management, for example – there is no easy way to address the grievance if the majority is in disagreement. The individual member is not an owner of the subsidiary.
Nature of Derivative Litigation
We hear most often about derivative suits in the context of large public corporations, but the same principles apply to the closely held corporation and they are commonly asserted in litigation among the owners. A derivative suit is a claim brought by one of the owners of a business (shareholder or LLC member) that asserts a right owned by the business itself.
For example, when the president of a corporation wastes money using the corporate jet for personal vacations, an individual shareholder may sue derivatively on behalf of the corporation. The recovery, if any, belongs to the corporation and the shareholder benefits only indirectly to the extent that the business recovers. But derivative actions are intended to prevent and deter wrongdoing by corporate insiders and the successful plaintiff in a derivative action can recover costs and legal fees.
In the double derivative, the individual seeks to enforce a right owned by the subsidiary (which the plaintiff does not own directly). A recent case in the Delaware Supreme Court (Opinion here in Lambrecht v. Oneal) provides a good example. In that case, Merrill Lynch was purchased by Bank of America for stock and all of ML’s stockholders received Bank of America stock for their ML shares. ML became a subsidiary of Bank of America. One of the former ML shareholders, now a Bank of America shareholder, brought a derivative claim alleging that the former ML management had damaged the corporation by, among other thins, paying huge bonuses to executives.
The plaintiff brought a claim that alleged that:
1) ML had a claim against its former management.
2) Bank of America, as a shareholder of ML, had a right to assert that claim derivatively against the managers.
3) Plaintiff as a shareholder of Bank of America had the right to assert Bank of America’s claim derivatively against the managers because both Bank of America and ML had failed to sue themselves.
Put another way, the plaintiff sought to assert Bank of America’s right to stand in the shoes of Merrill Lynch and sue the allegedly liable managers. The defendants attempt to dismiss the claim by arguing that the plaintiff did not have standing failed.
In the close corporation, individuals may have similar structural problems. They are affected as individuals, but the structure of the business presents an obstacle. Double derivatives are often their only real remedy.