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Bench & Bar of Minnesota is the official publication of the Minnesota State Bar Association.

A Question of Identity: Direct v. Derivative Claims in Shareholder/Member Litigation

The idea of derivative claims is founded in corporate law and has significant, practical implications for LLCs, corporations, and sometimes partnerships. Special pleading requirements apply and such claims carry special risks and potential benefits.

Many lawyers view the concept of the “derivative claim” as a foreign, technical nuance that they do not anticipate encountering. In reality, the distinction between a direct and derivative claim arises more frequently than one would think, and it has very real consequences for litigants and their attorneys. Any attorney practicing in business or corporate litigation should understand this analysis or risk significant strategic disadvantage including a dismissal of claims regardless of their merit.

Claims & Entities

The concept of the derivative claim is rooted in the very foundation of corporate law: the distinction between the entity and the individual, and it has important practical implications. These implications clearly affect shareholders of corporations and also members of LLCs and in some cases, partnerships.

Corporations. It is well-established that the direct/derivative distinction applies in the context of a corporation. “Minnesota has long adhered to the general principle that an individual shareholder may not directly assert a cause of action that belongs to the corporation.”1 “When a shareholder asserts a cause of action belonging to the corporation, the shareholder must seek redress in a ‘derivative’ action on behalf of the corporation rather than in a direct action by the individual shareholder.”2

LLCs and Partnerships. Case law concerning the direct/derivative distinction is still overwhelmingly based on case law regarding corporations although other jurisdictions have recognized that the distinction applies to LLCs as well. To the extent a chapter 322B provision resembles a chapter 302A provision in substance, the case law and Reporter’s Notes of chapter 302A should be used to interpret and apply the chapter 322B provision.3 “Courts therefore look to the law governing claims on behalf of corporations for guidance in LLC litigation.”4

Courts understand that the direct/derivative distinction is rooted in the concept that the entity has an identity that is separate from the identity of its owners.5 An LLC is an entity separate from its members,6 and so it follows that the corporate approach to the direct/derivative distinction should carry over into the law of LLCs.7 Courts have applied the same analysis in the context of partnerships.8

The 8th Circuit held that the
Minnesota Supreme Court would conclude that the similar corporate governance structure between corporations and limited liability companies and the recognized distinction between the entity and the individual support such a distinction in the context of a limited liability company.9 “Although the Minnesota limited liability company statute does not expressly provide for derivative suits, it is likely that such suits would be recognized by the Minnesota courts … . It is therefore appropriate to look to the law governing claims on behalf of corporations for guidance…”10

In reaching this conclusion the 8th Circuit reasoned,

Senior Cottages is a limited liability company, not a corporation. However, Minnesota limited liability companies share many of the properties of corporations. Limited liability companies can sue and be sued in their own name, their directors and managers owe the company duties of care and loyalty, a limited liability company is an entity distinct from any of its members, members are not subject to liability for the company’s debts, and the limitation of liability may be forfeited under the same conditions that would warrant piercing the corporate veil.. Although the Minnesota limited liability company statute does not expressly provide for derivative suits, it is likely that such suits would be recognized by the Minnesota courts.11

It is therefore appropriate to look to the law governing claims on behalf of corporations for guidance. At least one district court in Hennepin County has observed this distinction in the context of an LLC and was not challenged.12 As the 8th Circuit court recognized, the similarities between corporations and limited liability companies support an application of the distinction in cases involving LLCs. Any other result would necessarily ignore the distinction between the LLC and its members.

Direct or Derivative?

In determining whether a claim is direct or derivative, the central inquiry is whether the complained-of injury was an injury to the shareholder or member directly as opposed to an injury to the company.13 In making this determination, the court will not “look to the theory in which the claim is couched, but instead to the injury itself.”14 Where the injury is to the company, and only indirectly harms the shareholder or member, the claim must be pursued as a derivative claim.15 A plaintiff “cannot defeat the traditional derivative claim analysis by simply seeking personal relief.”16 Rather, the alleged injury must be separate, distinct and independent from the company’s injury to constitute a direct claim.17

Claims based on taking of corporate assets or usurping corporate opportunities are the most common category of derivative claims.18 For example, in Wessin v. Archives Corp. the Minnesota Supreme Court held that the alleged claims were derivative. In reaching that conclusion the court reasoned, “[t]he injuries alleged by the Wessins hinge on the waste and misappropriation of corporate assets. The Wessins assert that the alleged wrongful waste and misappropriation ‘effectively diminished the net income of Archives.’”19

In PJ Acquisition Corp. v. Skoglund, the court reached a similar conclusion by holding that claims for taking of corporate opportunity and assets under a theory of breach of fiduciary duty were derivative and subject to derivative claim pleading requirements.20 In Blohm v. Kelly, the court similarly held that claims for breach of fiduciary duty were derivative where the damages were based on a shareholder paying himself excessive compensation and commingling his assets with the company assets.21

As a matter of comparison, the court in Northwest Racquet v. Deloitte & Touche held that the plaintiff’s claims were direct.22 In reaching this conclusion, the court noted:

Northwest alleges very specific incidences of misrepresentation in Touche’s audit report on which Northwest directly relied. Thus, although Northwest asserts that Touche’s misrepresentation of the value of the FIR to Midwest indirectly affected Northwest, Northwest also alleges specific misrepresentations in the audit report that affected Northwest directly in its decision to purchase the debentures … . It is this claim of direct fraud and the resulting injury that is separate and distinct from any fraud claim belonging to Midwest and from any injury to the debenture holders generally.23

In determining whether a claim is direct or derivative, the court will focus on the claimed injury. If the injury is to the entity and causes the entity to be deprived of revenue or assets and only indirectly damages the shareholders, the claim is derivative. If the claimed injury is unique to the particular equity holder and is separate from any harm caused to the entity, then the claim is direct.

Why It Matters

The direct/derivative distinction matters for at least five practical reasons: (1) the statutory demand requirement, (2) the risk of dismissal for mistaking the distinction, (3) the special litigation committee, (4) the availability of attorneys’ fees for a victorious derivative plaintiff, and (5) the ownership of any damages recovered.

1. Statutory Demand Requirement

In order to assert a derivative claim, Rule 23.09 mandates that the plaintiff plead certain facts with particularity, including either making a demand on the company’s board of governors to assert the alleged claim or an allegation explaining why such a demand would have been futile. This requirement is compulsory. On a Rule 12 motion it is appropriate to dismiss derivative claims without prejudice where a plaintiff has not met the pleading requirements of Rule 23.09. Rule 23.09 states in relevant part:

In a derivative action brought by one or more shareholders or members to enforce a right of a corporation or of an unincorporated association, the corporation or association having failed to enforce a right which may properly be asserted by it … [t]he complaint shall also allege with particularity the efforts, if any, made by the plaintiff to obtain the desired action from the directors or comparable authority and, if necessary, from the shareholders or members, and the reasons for the plaintiff’s failure to obtain the action or for not making the effort … .24

Generally, to proceed with a derivative action, the shareholder must first make a demand on the corporation to enforce its rights.25 Despite this general rule, when the court determines that due to the circumstances a demand would likely be futile, the requirement is excused.26 “The determination of demand futility is a mixed question of law and fact left to the discretion of the district court.”27

When the accused perpetrators are in control of the corporation, as directors or shareholders, a demand is deemed futile and the demand requirement is excused. As a general rule, where directors are accused of self-dealing, demand is deemed futile per se.28 In the event that the plaintiff’s attorney decides to plead demand futility rather than provide Rule 23.09 notice; the complaint should express the factual basis for demand futility in detail.

2. Risk of Dismissal

Where a complaint fails to allege that the plaintiff demanded relief from the board of governors and fails to plead with particularity that the demand would have been futile, the court will dismiss the improperly pled derivative claims on a Rule 12 motion.29 In most cases, the dismissal will be without prejudice, allowing the plaintiff an opportunity to amend the complaint; however, if the facts underlying the complaint do not support a derivative claim, the dismissal will be with prejudice.30

3. Special Litigation Committee

If a court determines that a claim is derivative, members of the board of directors for the plaintiff entity, who are often conflicted as defendants in the lawsuit, can appoint a special litigation committee (“SLC”) to determine whether it is in the best interests of the company to pursue litigation, regardless of the merits of a particular claim.

Corporations may appoint SLCs consisting of one or more independent directors or other independent persons to consider the legal rights or remedies of the corporation and whether those rights and remedies will be pursued. Not surprisingly, the SLC can and often will recommend that the corporation not pursue the claim against the board of directors that appointed it.

Regardless of the merits of a claim, a decision by an SLC will serve as the basis for a motion to dismiss the claims if the corporation can establish: (1) that the committee was sufficiently independent from the board of directors that appointed it and (2) that the committee’s investigation procedures were adequate, appropriate, and pursued in good faith.31 In making this determination, a court is to conduct “a robust review of the SLC and its investigative procedures.32

An SLC is sufficiently independent “[i]f the board properly delegates its authority to act to the [SLC].”33 “[A] mere advisory role of the Special Litigation Committee fails to bestow sufficient legitimacy on the Board’s decision to warrant deference to the committee’s decision by a court.”34 The board of directors may properly appoint an SLC by resolution, which must delegate all of the board’s authority regarding the litigation including all power and authority to direct the corporation’s actions going forward. If the board merely asks the SLC for a recommendation, this delegation falls short of the independence requirement.

Importantly, if the SLC is not initially independent or its investigation is not adequate, neither the corporation nor the SLC will be allowed an opportunity to cure the defect and the SLC will be rendered powerless and its directive ineffective. On this point, the Minnesota Supreme Court stated, “[i]f the courts allow corporate boards to continually improve their investigation to bolster their business decision, the rights of shareholders and members will be effectively nullified.”35 Consequently, “if the initial SLC investigation and recommendation fail to satisfy [the business-judgment] standard, ‘the derivative suit proceeds on its merits’ with no opportunity to rectify any deficiencies.”36 The SLC can cut off meritorious derivative claims regardless of the merits of those claims; however, if the SLC does not pass the two-factor test the first time it will not be entitled to a second chance.

4. Attorney Fees

The plaintiff who advances a derivative claim may be entitled to reimbursement of the plaintiff’s attorney fees incurred in advancing the claims. In Bosch v. Meeker Cooperative Light and Power Association, the Minnesota Supreme Court established the standard for allowing costs and attorney fees in a shareholder derivative action.37 The court stated, in relevant part:

Where an action by a stockholder results in a substantial benefit to a corporation he should recover his costs and expenses. As to what is a “substantial benefit” is for the trial court to determine in the light of the facts and circumstances of the particular case. Without attempting in any way to define the term or circumscribe its application, we would say that a substantial
benefit must be something more than technical in its consequence and be one that accomplishes a result which corrects or prevents an abuse which would be prejudicial to the rights and interests of the corporation or affect the enjoyment or protection of an essential right to the stockholder’s interest.38

The Bosch court also stated:

It should be recognized that to grant an award of fees and expenditures against a corporation in every instance where the officers of the corporation act outside of their corporate powers would be to invite and encourage certain actions intended not to redress real wrongs but to realize upon their nuisance value. Nevertheless, it would be unrealistic to deny that derivative suits instituted in good faith to correct or prevent misconduct of corporate officers and directors may be of substantial benefit.39

A shareholder derivative action instituted in good faith requires a shareholder to seek the benefit of the corporation and not that shareholder’s individual interest.40 The Aiple court explained:

Fees and expenses incurred by a stockholder should not be chargeable against a corporation where the results benefit the stockholder personally rather than other stockholders of the corporation. A corporation should not be burdened with expenses incurred by stockholders to promote their individual interests and not for the immediate benefit of the corporation.41

“The reasonable amount to be allowed for expenses and attorneys’ fees rests in the sound discretion of the trial court.”42 The court is not required to award undisputed fees, but reasonable fees, and is accorded broad discretion in determining that amount; instead the court will apply the Lodestar analysis in determining reasonable attorney fees.43

5. Ownership of Recovery

If a shareholder plaintiff recovers on a direct claim, the recovery belongs to that plaintiff. If a shareholder plaintiff recovers on a derivative claim, that recovery, like the claim itself, belongs to the corporation.44 Although the victorious shareholder may recover attorney fees and costs, any damages recovered belong to the entity.45A minority stockholder may sue because the corporations is under the control of the alleged wrongdoers, but he must sue in a representative capacity for the benefit of the corporation, and not for damages to him individually.”46

The individual shareholders will only recover relative to their proportionate equity ownership in the company if those damages are distributed in the event of a dissolution and liquidation of the company or in the form of distributions or dividends. This is perhaps the most important consideration to keep in mind in framing claims and determining whether a particular shareholder should take on the burden of advancing a
derivative claim.

Conclusion

The concept of the derivative claim is rooted in the very foundation of corporate law and it has important practical implications. These implications clearly affect shareholders of corporations and members of LLCs and in some cases, partnerships. If this distinction is not well understood in advising clients and advancing litigation, the plaintiff’s case may be dismissed for failure to follow derivative pleading requirements or at the direction of a SLC. The plaintiff should understand the relative benefits and risks of advancing a derivative claim so that he or she is making an informed decision and navigate the gauntlet of litigation strategies that must be overcome.

 

Brett Larson  is a partner with Saliterman & Siefferman, PC in Minneapolis. He represents businesses and individuals in a variety of legal matters including close-corporation shareholder disputes, FINRA arbitration, and general commercial litigation. Brett also counsels his clients to avoid litigation through careful business planning. He was a contributing author and the production editor for Advising Minnesota Corporations and Other Business Organizations (Juris Publishing 2011).

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