North Carolina Business Court Holds that Shareholders Cannot Directly Sue Officers and Directors in Merger Challenge

by Smith Anderson
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A recent decision by the North Carolina Business Court potentially makes it more difficult for shareholders to challenge mergers and acquisitions in North Carolina. The Court held that an action against a company’s officers and directors based on alleged breaches of fiduciary duty in failing to obtain a higher price for the sale of the company was a derivative, rather than a direct, claim.  Such an action is accordingly subject to the significant procedural restrictions governing derivative claims.

The case, Gusinsky v. Flanders Corp. (2013 NCBC 46), arose out of a merger agreement between Air Acquisition and Flanders Corporation, a publicly-traded North Carolina company that manufactures air filters.  As is common in public-company mergers, litigation was filed claiming that Flanders’ officers and directors breached their fiduciary duties by: (1) conducting a sale process that did not maximize the price of the company, and (2) making inadequate disclosures to Flanders’ shareholders in connection with the shareholders’ vote on the merger.  The defendants moved to dismiss the complaint, contending that the fiduciary duties of Flanders’ officers and directors were owed to the company, not to the individual shareholders, and therefore the shareholders’ claims were derivative. 

The North Carolina Business Court (Judge Gale) agreed with the defendants that, as to the claims relating to the sale process, the plaintiffs’ claims were derivative.  The Court explained that a cause of action for a director’s breach of fiduciary duty generally belongs to the corporation rather than the individual shareholder.  The Court noted two exceptions to this general rule, stating that a shareholder may maintain a direct, individual action if: “(a) the shareholder can show that he was owed a special duty by the wrongdoer or (b) the injury suffered by the shareholder is separate and distinct from that sustained by other shareholders or the corporation itself.”  The Court held that the “special duty” exception was inapplicable, noting that this exception usually applies only in the context of closely-held companies or companies where there is a controlling or majority shareholder.  The Court held that the second exception also was inapplicable because the allegedly inadequate consideration received by plaintiffs was the same consideration received by all other shareholders. 

The Court’s holding that claims of breach of fiduciary duty in connection with the sale process are derivative rather than direct has significant practical consequences.  It means that a demand (asking the corporation to pursue the fiduciary duty claims against the officers and directors) must be made on the corporation prior to filing a lawsuit, or the case will be dismissed.  See N.C. Gen. Stat. § 55-7-42(1).  And under North Carolina law, there is no “futility” exception to this requirement – i.e., a plaintiff cannot avoid the demand requirement by contending that under the circumstances demand on the board would be pointless. 

Furthermore, under the North Carolina derivative claim statute, even if a plaintiff makes a proper pre-suit demand, the corporation can avoid litigation if a committee comprised of independent directors – which potentially may include the directors against whom action is demanded – determines in good faith after conducting a reasonable inquiry that proceeding against the officers and directors is not in the best interest of the corporation.  See N.C. Gen. Stat. § 55-7-44.

Although the Court held that plaintiffs’ claims challenging the sale process were derivative, it reached a different conclusion with respect to plaintiffs’ claims that Flanders had failed to disclose information material to the merger. The court held that plaintiffs’ disclosure-based claims were direct rather than derivative.  But that was not the end of the inquiry.  The Business Court went on to hold that the plaintiffs had failed to state a claim for breach of fiduciary duty based on the company’s disclosures because the plaintiffs did not identify any material misrepresentations or omissions.  As a result, all of plaintiffs’ claims, both derivative and direct, were dismissed.

The Gusinsky case appears to stand for the proposition that a claim challenging the consideration received for a merger is a derivative claim, at least where there is only one class of stock involved and the target company is a public company with no controlling shareholder.  The case settled shortly after the Court’s order dismissing the claim, so there will be no review by the Court of Appeals.  So, at least for now, direct claims for breach of fiduciary duty based on the alleged inadequacy of merger consideration, which have long been a standard arrow in the quiver of plaintiffs’ class action lawyers, will not be effective in North Carolina.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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