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

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By definition, a minority shareholder in a private company does not have control of the company or the right to make decisions for the company. But minority owners have legal recourse when the majority owners of the company – through their roles as officers, directors or managers – engage in conduct that breaches their fiduciary duties to the company. For example, when executives negotiate contracts between the company and their family or friends on terms that are unfair to the company, the conflict of interest may violate a duty of loyalty and be subject to prosecution as an act of ‘initiated. When the executives do not treat the company fairly, the minority owners of the company have the right to sue derivative lawsuits to repair the harm suffered by the company. This article reviews the procedural requirements for derivative suits and examines the standard defenses presented in litigation by those who control the business.

The basics: the derivative process

Whether it’s a corporation or a limited liability company (LLC), a lawsuit brought by a shareholder or member on behalf of the company is called a “derivative” lawsuit. (This article will use the term “shareholder” for both types of entities.) This type of lawsuit is called a derivative action because the case is filed to protect a right that belongs to the company. In the above situation, the company is harmed directly because the assets of the company are wasted or misused by those who control it for their own personal benefit rather than the benefit of the company. The shareholder is only indirectly harmed by this fault, by a reduction in the value of his participation.

The Texas Legislature has enacted a statutory regime that imposes significant restrictions on a shareholder’s ability to bring a derivative lawsuit. These restrictions reflect the policy that the affairs of a company are managed by its directors or managers, and not by its shareholders. In this regard, the directors and officers of the company are presumed to be in the best position to know what is going on in the company and to take measures to protect its interests, and that they should not be second guessed in a lawsuit every time they make a business decision for the company. See, for example, Sneed v. Webre465 SW3d 169, 182 (Texas 2015).

A shareholder who fails to complete the procedural steps required by law will not be permitted to pursue the lawsuit and the lawsuit will be dismissed.

Circle Number 1: The Continuing Ownership Requirement

The first circle is called the continuous ownership requirement and has two parts. First, to bring the lawsuit, the shareholder must have been a shareholder at the time of the behavior complained of in the lawsuit. Second, the courts require the shareholder to remain a shareholder for the duration of the lawsuit. See, for example, In re LoneStar Logo & Signs, LLC, 552 SW3d 342, 347 (Tex. App.—Austin 2018, original proceeding). This is a “permanence” requirement, which ensures that the person filing the complaint is an appropriate person to bring the matter. The court cannot be sure that the former shareholders will keep the best interests of the company in mind.

There is an exception to the continuous ownership rule. If the ownership “interest is ‘destroyed’ unintentionally for no valid business purpose”, then a court may (but is not required to) let the shareholder pursue the suit. Identifier. (quoting Zauber versus Murray Sav. Ass’n, 591 SW2d 932, 937 (Tex. Civ. App.—Dallas 1979), writ ref’d nre, 601 SW2d 940 (Tex. 1980) (by curiam)). The key to the exception is that the shareholder must not voluntarily relinquish the stake, and the court can protect a shareholder whose ownership of the company has been forcibly removed.

Circle number 2: Fair and adequate representation

The second hoop also concerns the quality of the shareholder who brings the action. The shareholder bringing the action must demonstrate that he “will fairly and adequately represent[] the interests of the [company] in the application of the rights of [company].” Texas Bus. Org. Code §§ 21.552(a)(2), 101.452(a)(2). This does not mean that the other shareholders must agree to the lawsuit – a single shareholder may be able to bring the lawsuit even if all the other shareholders do not agree, provided that a shareholder can represent fairly and adequately society in the process.

Circle number 3: Request Made to control people

The third hoop is often the most difficult. Unless the company is closely owned by a relatively small number of owners, the shareholder is required to send “a written request” to the company “stating precisely the act, omission or other fact which makes the object of the claim or dispute and requesting that the [company] take appropriate action. » Identifier. §§ 21.553(a), 101.453(a). Unless the corporation suffers (or suffers) irreparable harm, the shareholder may not bring an action until the earlier of the 90 days or receipt of notice from the corporation that it has refused to take action. specific action requested by the letter of formal notice from the shareholder. .

A company faced with a written request from a shareholder has two options. The company could bring the lawsuit that was requested by the shareholder, and in this case, the shareholder is no longer involved. Or the company could deny the claim and insist that a lawsuit is not in the company’s best interest. If the directors or managers reject the shareholder’s request, the court of first instance will only consider whether the decision was taken in good faith by independent and disinterested directors (or managers), after having carried out a reasonable investigation. If so, the derivative suit will be dismissed and the shareholder will have no further recourse.

Dropping Hoops: Closed Societies

The three procedural circles described above make it very difficult for a shareholder or member to successfully file and pursue a derivative lawsuit on behalf of a Texas corporation. But above all, these requirements, do not apply to “closed” companies. A private company is a company that has fewer than 35 shareholders and is not listed on a stock exchange. If the company is “closely owned”, the minority shareholder is not required to establish continuing ownership, prove fair and adequate representation, or issue a written request to control persons before suing. justice. In addition, a private company shareholder who brings a derivative action is entitled to recover legal costs if he can demonstrate that the proceeding resulted in a substantial benefit to the company.

The removal of these requirements is not the only advantage for a shareholder seeking to bring a derivative action on behalf of a private company. If the court determines that “justice requires it”, then the action need not even be brought derivatively – it can be brought as a direct action by the shareholder for his 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 hurdles a shareholder must clear before bringing a derivative lawsuit on behalf of a corporation. It is important to note that these substantial procedural obstacles do not exist for shareholders of private companies. The power to bring a derivative lawsuit without these procedural hurdles is so important that an investor considering making a minority investment in a Texas company might consider taking steps to ensure that once the investment is made , the company cannot grow to a total of more than 35 shareholders or become listed on the stock exchange without the express written consent of the shareholder.


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