Derivative Lawsuits by Private Company Minority Owners: Procedures for Protecting the Company from Insider Misconduct

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By definition, a minority owner in a private company does not have control over the business or the right to make decisions for the company. But minority owners do have legal recourse when the company’s majority owners – through their roles as officers, directors, or managers – engage in conduct that breaches their fiduciary duties to the company. For example, when managers negotiate contracts between the company and their family or friends on terms that are unfair to the company, the conflict of interest may breach a duty of loyalty and be actionable as self-dealing. When managers do not treat the company fairly, minority owners in the business have the right to file what is known as a derivative lawsuit to recover for the harm that the company has suffered. This post reviews the procedural requirements for derivative lawsuits, and considers the standard defenses that are presented in litigation by those in control of the company.

The Basics: The Derivative Lawsuit

Whether dealing with a corporation or a limited liability company (LLC), a lawsuit filed by a shareholder or member on behalf of the company is called a “derivative” suit. (This post will use the term “shareholder” for both entity types.) This type of suit is referred to as a derivative action because the case is being filed to protect a right that belongs to the company. In the situation above, the company is harmed directly because company assets are being wasted or misused by those in control for their own personal benefit rather than for the benefit of the company. The shareholder is harmed only indirectly by this misconduct, through a reduction in the value of his or her ownership interest.

The Texas Legislature has enacted a statutory scheme that places significant restrictions on the ability of a shareholder to bring a derivative lawsuit. These restrictions reflect the policy that the affairs of a company are managed by its directors or managers, not by its shareholders. In this regard, the company’s directors and managers are presumed to be in the best position to know what is happening in the company and to take steps to protect its interest, and that they should not be second guessed in a lawsuit every time they make a business decision for the company. See, e.g., Sneed v. Webre, 465 S.W.3d 169, 182 (Tex. 2015).

A shareholder who fails to jump through the procedural hoops that are set out in the statute will not be allowed to pursue the lawsuit, and it will be dismissed.

Hoop Number 1: The Continuous Ownership Requirement

The first hoop is called the continuous ownership requirement, and it contains two parts. First, to bring the lawsuit, the shareholder must have been a shareholder at the time of the conduct that is complained of in the lawsuit. Second, the courts require that the shareholder remain a shareholder for the duration of the suit. See, e.g., In re LoneStar Logo & Signs, LLC, 552 S.W.3d 342, 347 (Tex. App.—Austin 2018, orig. proceeding). This is a “standing” requirement, which ensures that the person who files the suit is an appropriate person to bring the case. The court cannot be sure that former shareholders will keep the company’s best interests in mind.

There is one exception to the continuous ownership rule. If the ownership “interest is ‘destroyed’ involuntarily without a valid business purpose,” then a court can (but does not have to) let the shareholder continue with the lawsuit. Id. (quoting Zauber v. Murray Sav. Ass’n, 591 S.W.2d 932, 937 (Tex. Civ. App.—Dallas 1979), writ ref’d n.r.e., 601 S.W.2d 940 (Tex. 1980) (per curiam)). The key to the exception is that the shareholder must not voluntarily give up the ownership interest, and the court may protect a shareholder whose ownership in the company was forcibly removed.

Hoop Number 2: Fair and Adequate Representation

The second hoop also concerns the standing of the shareholder who files the lawsuit. The shareholder who brings the case must demonstrate that he or she will “fairly and adequately represent[] the interests of the [company] in enforcing the rights of the [company].” Tex. Bus. Org. Code §§ 21.552(a)(2), 101.452(a)(2). This does not mean that the other shareholders have to agree with the lawsuit – a single shareholder may be able to bring the lawsuit even if every other shareholder disagrees, provided that one shareholder can fairly and adequately represent the company in the process.

Hoop Number 3: Demand Made to Control Persons

The third hoop is often the most challenging. Unless the company is closely held by a relatively small number of owners, the shareholder is required to send “a written demand” to the company “stating with particularity the act, omission, or other matter that is the subject of the claim or challenge and requesting that the [company] take suitable action.” Id. §§ 21.553(a), 101.453(a). Unless the company is suffering (or will suffer) irreparable injury, the shareholder cannot file suit until the earlier of 90 days or the receipt of a notice from the company that it has rejected taking the specific action that is called for by the shareholder’s demand letter.

A company faced with a written demand from a shareholder has two options. The company could file the suit that has been requested by the shareholder, and in that case, the shareholder is no longer involved. Or the company could reject the demand and insist that that a lawsuit is not in the company’s best interests. If the directors or managers reject the shareholder’s demand, the trial court will consider only whether the decision was made in good faith by directors (or managers) who are independent and disinterested, after conducting a reasonable inquiry. If it was, then the derivative suit will be dismissed, and the shareholder will have no further recourse.

Scrapping the Hoops: Closely Held Companies

The three procedural hoops described above make it very challenging for a shareholder or member to successfully file and prosecute a derivative lawsuit on behalf of a Texas company. Importantly, however, these requirements, do not apply to companies that are “closely held.” A closely held company is one that has fewer than 35 shareholders and is not publicly listed. If the company is “closely held,” then there is no requirement for the minority shareholder to establish continuous ownership, to prove fair and adequate representation, or to issue a written demand to control persons before filing the lawsuit. Further, a shareholder in a closely held company who files a derivative lawsuit is permitted to recover legal fees if he or she can show that the proceeding resulted in a substantial benefit to the corporation.

Removing these requirements is not the only advantage to a shareholder seeking to bring a derivative suit on behalf of a closely held company. If the court determines that “justice requires,” then the action does not even have to be brought derivatively – it can be brought as a direct action by the shareholder for the shareholder’s own benefit, and any recovery obtained as a result of the lawsuit can go directly to the minority shareholder.

Conclusion

There are a number of statutory hoops that a shareholder must jump through before pursuing a derivative lawsuit in the name of a company. Importantly, these substantial procedural hurdles do not exist for shareholders in closely held companies. The power of pursuing a derivative lawsuit free of those procedural hurdles is so significant that an investor who is considering making a minority investment in a Texas company might want to consider taking measures to ensure that, after the investment is made, the company cannot grow to include a total of more than 35 shareholders or become publicly listed without the shareholder’s express written consent.

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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