The Current View On Direct vs. Derivative

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When a member or shareholder of a company or corporation sustains a loss, is that member’s loss directly compensable by a direct suit?  Or does the member have to bring a derivative suit on behalf of the corporation?  While it may sound like an easy question, the inquiry involved to arrive at the answer can be confusing.  Recently, the Third District Court of Appeals in Florida shed some light on the analysis.

In Dinuro Investments, LLC v. Camacho et al., 2014 WL 3290609, —So.3d— (Fla. 3d DCA July 9, 2014), the plaintiff and the two defendants established an LLC to develop real property.  The defendants subsequently entered into a few transactions that left the plaintiff with no ownership interest and the LLC with no viable assets.  The plaintiff filed a direct suit against the defendants, which was dismissed.  The trial court determined that the claims were derivative, not direct and, therefore, the plaintiff lacked standing in its individual capacity.  The decision was appealed.

The Court of Appeals explained that there is a lack of clarity in Florida case law regarding what standard to apply when determining whether a suit is direct or derivative.  It further explained that currently there are three approaches relied on to make the determination: (1) the “direct harm” test, (2) the “special injury” test, and (3) the “duty owed” test.  Under the direct harm test, the court will examine whether the harm from the alleged wrongdoing flows first to the company and only damages the shareholders or members due to the loss in value of their respective ownership interest in the company, or whether the harm flows “directly” to the shareholder or member in a way that is not secondary to the company’s loss.  Under this test, a shareholder can only bring a direct suit if the damages are unrelated to the damages sustained by the company and if the company would have no right to recover in its own action.

Under the special injury test, the court will compare the individual plaintiff’s alleged injury to those injuries suffered by the other members or shareholders of the company and then determine whether the plaintiff’s injury is separate and distinct from other members or shareholders.  The court will require a plaintiff to demonstrate that he has sustained a loss that is substantially different from those losses sustained by other shareholders or members before he can maintain an individual or direct.

Finally, under the duty owed test, the court simply examines the statutory and contractual terms to determine whether the duty at issue was owed to the individual member or shareholder by a particular manager or member, or whether those duties were owed to the company generally.  The “duty owed” approach allows for the greatest freedom of contract, as parties can actively decide whether and when to allow direct suit between members for various categories of conduct.

The court in Dinuro found that Florida law, as it currently stands, embraces none of these tests individually, but utilizes all three to determine whether an action can be brought directly.  It therefore examined the “nearly fifty years of apparently divergent case law on this point” and determined that an action may be brought directly only if (1) there is a direct harm to the shareholder or member such that the alleged injury does not flow subsequently from an initial harm to the company and (2) there is a special injury to the shareholder or member that is separate and distinct from those sustained by the other shareholders or members.  Dinuro however also found that there is an exception and the member or shareholder does not need to satisfy this two-prong test when there is a separate duty owed by the defendant(s) to the individual plaintiff under contractual or statutory mandates.  In other words, if the plaintiff has not satisfied the two-prong test (direct harm and special injury) or demonstrated a contractual or statutory exception, the action must be maintained derivatively on behalf of the corporation or company.

While Dinuro clarified the test to be applied in making the direct vs. derivative determination, application of the facts will still not be as black and white.

Topics:  Derivative Suit, Shareholder Activism, Shareholder Litigation, Shareholders

Published In: Business Organization Updates, Civil Procedure Updates, General Business Updates

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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