You represent a minority
shareholder of a closely-held corporation and the company is having an off
year. The majority shareholder is the sole member of the board and serves in
every officer position. She draws significant compensation. Without a business
justification, she decides to double her salary and have the company pay the
mortgage on her vacation home. Your client is the only other shareholder and likely
the only person hurt by the majority shareholder’s self-declared raise. Although
the minority shareholder suffers a clear injury, characterizing the injury as
direct or derivative can have a significant impact on the outcome of the
litigation.
Until recently, minority
shareholders in closely-held companies could assert claims for breach of
fiduciary duty and corporate waste directly against the majority owner. If the
claimant was successful, a court could order the majority shareholder to
disgorge the spoils of her behavior and pay them to the minority shareholder.
This type of direct recovery is no longer permissible. Since 2014, Pennsylvania courts have made clear
that claims arising from breach of the duties owed to a corporation, even a
closely-held one, belong to the corporation and must be asserted on a derivative
basis. This requirement creates procedural and substantive complexities when
compared to direct claims. Bringing such claims requires strategic and creative
analysis and careful attention to detail.
Without a shareholder’s
agreement, minority shareholders are largely at the mercy of the majority
shareholder. Minority shareholders have no formal ability to direct how the
company spends money, compensates employees or hires vendors. Some majority
owners use their power to disadvantage the minority shareholder by excessively
compensating themselves or causing the corporation to contract with vendors
affiliated with the majority on unfair terms. Although the minority shareholder
is the party ultimately damaged by this behavior, the Pennsylvania Business
Corporation Law (“BCL”) makes clear that “[t]he duty of the board of
directors … is solely to the business corporation … and may not be enforced
directly by a shareholder.” To obtain redress for the majority shareholder’s
misconduct, the minority shareholder is therefore required to assert their
claims on a derivative basis on behalf of the corporation.
In this regime, attorneys representing minority shareholders
are required to look for opportunities to assert direct claims in lieu of
derivative claims. The same facts that
support a derivative claim may also be the basis of a direct claim. This is particularly common when the minority
shareholder is involved in the operation of the business. For example, claims arising from the wrongful
termination of a minority shareholder’s employment may form the basis of a
direct claim on behalf of the minority shareholder, as well as a derivative
claim against the majority shareholder for the breach of duty of care owed to
the company.
Shareholder oppression claims are direct claims and may
provide a viable method for a minority shareholder to obtain an individual
recovery. Pennsylvania has long
recognized that a majority shareholder has a quasi-fiduciary duty not to use
their power in such a way as to exclude the minority shareholder from the
“benefits accruing from the enterprise.” Carefully structured, a shareholder
oppression claim can often address the same conduct that a court might
otherwise classify as giving rise to a derivative claim. A claim that a majority
shareholder increased their compensation to a level that leaves no profits
available to be distributed to shareholders is likely a direct shareholder
oppression claim. It may also be a derivative claim if the compensation is
excessive by objective measure.
Fraud claims against majority shareholders may also be
asserted directly if they arise from a misrepresentation made to the minority
shareholder. The misrepresentation, however, must not be related to malfeasance
in relation to the company. For example, misrepresenting the financial status
of the business to induce a minority shareholder to invest additional capital
that is subsequently lost is likely a direct claim. Falsely representing the
terms of the majority shareholder’s excessive compensation is likely derivative
because it is so closely related to the breach of the majority’s duty owed to
the company itself.
When developing claims, keep in mind that counsel’s labeling
of claims in pleadings as direct or derivative is not dispositive. Courts look to the substance of the
allegations to determine the nature of the wrong.
The distinction between direct and derivative claims presents
a variety of challenges in the context of closely-held business disputes. Recognizing the issue at that outset of the
litigation and developing theories for asserting direct claims is critical to
the successful representation of the minority shareholder.
Reprinted with permission from the
February 28, 2018 issue of The Legal Intelligencer.
© 2018 ALM Media Properties, LLC.
Further duplication without permission is prohibited. All rights reserved.
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