Lawsuits are often filed claiming company managers, officers, board members or those “in control” are stealing from the businesses entrusted to their care, or are running those businesses for their individual benefits to the detriment of minority shareholders or other equity owners (e.g., LLC members). Many times, these lawsuits are warranted. Equally often, they amount to “sour grapes” by those who got outvoted or didn’t get their way. Regardless, a large number of these cases are dismissed without any judicial determination of right or wrong. Why? Because the parties bringing the lawsuits forgot to ask the simple question, “Who ‘owns’ the claim?”
Companies are fictitious people. Like people, they have rights. A basic principle of corporate law is that directors (or managers, in the case of LLCs), rather than shareholders or members, manage the business and affairs of the organization. If a “bad” manager, officer, board member or majority shareholder does something to harm a company as a whole, the company, not any one individual owner or shareholder, owns the claim. Hence, only the company has the right or so-called “standing” to sue the wrongdoer. The decision whether to pursue litigation on behalf of the company is vested in the board of directors (or LLC managers) as an exercise of business judgment.
Companies, however, are controlled by living, breathing people. People sometimes abuse power to line their pockets or line the pockets of friends and family. In such cases, how can anyone reasonably expect wrongdoers to spend company money under their control to hire lawyers to sue themselves?
The solution is a “derivative” action. In such actions, individual shareholders take on the responsibility of doing what the alleged wrongdoers, out of self-preservation, will not do … seek justice on behalf of the company. To qualify to bring a derivative action, however, would-be plaintiffs must overcome several hurdles designed to prevent abuse of the derivative suit remedy. (Bader v. Anderson, 179 Cal.App.4th 775 (2009).) To start, with minor exceptions, they must prove they own company stock (or LLC interests) at the beginning and the end of the lawsuit. (Grosset v. Wenaas, 42 Cal.4th 1100, 1119 (2008).) Unless they can plead and prove “futility,” they must also show they first asked the company’s management to bring the suit and management refused.
In the latter regard, when a board of directors or LLC manager is asked to commit company money to fund a legal battle challenging an expenditure or other business decision made by an earlier board of directors or manager, it is hard to show futility. This is because, in evaluating whether it would have been pointless (futile) to ask management to file the lawsuit, California courts ask “whether, under the particularized facts alleged, a reasonable doubt is created that: (1) the directors are disinterested and independent [or] (2) the challenged transaction was otherwise the product of a valid exercise of business judgment.” (Apple Inc. v. Superior Court, 18 Cal.App.5th 222, 233 (2017), internal citation omitted.)
In addition, to bring a derivative lawsuit shareholders or LLC members must demonstrate they have “an interest and incentive” to fairly and vigorously prosecute the action. (Favila v. Katten Muchin Rosenman LLP, 188 Cal.App.4th 189, 214 (2010).) Thus, any would-be plaintiff who simultaneously claims the company owes him or her money would not qualify, as the existence of such an individual claim would give rise to a conflict of interest. In some instances, derivative plaintiffs might also be required to post a statutory bonds before their cases are allowed to proceed. And the list goes on …
To side-step such obstacles, aggrieved shareholders or LLC members often claim the right to sue as individuals. To succeed, they must prove the wrongdoing, and associated harm, described in their lawsuit were not “incidental” to any injury suffered by the company as a whole. That is, the right to sue as an individual exists only “where it appears that … injury resulted from the violation of some special duty owed the stockholder by the wrongdoer having its origin in circumstances independent of the plaintiff’s status as a shareholder.” (Sole Energy Co. v. Petrominerals Corp., l 28 Cal.App.4th 212, 229 (2005), internal citation omitted.)
All too often, plaintiffs suing as individuals lose because they can’t make this showing: i.e., they cannot prove “individualized” harm. Sometimes this happens after years of litigation. Sometimes it happens after hundreds of thousands of dollars of legal expense. Sometimes, tragically, it even happens after several weeks of trial.
The “take away” is always ask, “Do I own the claim?” If not, “Do I qualify to bring a derivative action?”
Author: David A. Robinson, President and Founding Shareholder, Enterprise Counsel Group