The Nuts and Bolts of Crafting a Derivative Case
by Tara J. Myslinski and Stephanie R. Parker
Filing a new complaint? If your client is part of a for-profit corporate entity and the dispute concerns that entity, there is a good chance that you are wondering whether some or all of your client’s potential claims are derivative or direct claims. There are plenty of ways to get tripped up in this context; it is wise to think early about all of the possible pitfalls in such a case and understand the road ahead.
In this article we discuss the steps an attorney facing this issue must take, including understanding the nature of your client’s entity at the outset of a case, determining whether your client has direct or derivative claims, and following the unique procedural and substantive rules applicable to derivative claims.
Understand the Nature of Your Client’s Entity and its Place of Formation.
The law of the state of the entity’s incorporation or registration will dictate substantive issues of law for claims concerning that entity. Procedural rules for the forum will govern procedural issues.
Issues of substantive law include whether claims are derivative or direct and whether a plaintiff has standing to pursue derivative claims against the entity. See Cannonball Fund, Ltd. v. Dutchess Capital Mgmt., LLC, 84 Mass. App. Ct. 75, 93 (2013) (quoting Harrison v. NetCentric Corp., 433 Mass. 465, 471 (2001)). The differences among the states on derivative suits can be substantial; for example, whereas under Massachusetts law a shareholder is required to make demand on directors in every case alleging derivative claims on behalf of a corporation, see G.L. c. 156D, § 7.42, a suit on behalf of a Delaware corporation may still allege futility of such demand. See Johnston v. Box, 453 Mass. 569, 578 & n. 15 (2009); Del. Ct. Ch. R. 23.1; see also 6 Del. C. §§ 18-1001 & 18-1002 (allowing any LLC member to bring derivative action).
In addition to ascertaining the state of your entity’s formation, study the entity’s governing documents for specific provisions that may apply to derivative suits. See, e.g., G.L. c. 156C, § 56.
Determine Whether Your Client has Direct or Derivative Claims, or Both.
In your complaint, you must specify whether each claim is brought directly by your client as an individual or derivatively by your client on behalf of the entity. This distinction is important because, as discussed below, you must comply with special procedural requirements for any derivative claims you assert.
In general, a derivative claim asserts a wrong done to the corporation, as opposed to any particular shareholder. As such, a derivative claim belongs to the corporation and any damages recovered on a derivative claim will go to the corporation. Examples of derivative claims include:
Wasting, mismanaging or misappropriating corporate assets, resulting in a general diminution of the value of corporate stock, assets, or cash on hand; see, e.g., Rubin v. Murray, 79 Mass. App. Ct. 64, 80 (2011);
- Engaging in acts of self-dealing and/or diverting corporate opportunities; see, e.g., Williams v. Charles, 84 Mass. App. Ct. 328, 338 (2013);
- Breach of a contractual obligation owed to the company, including breach of a non-competition provision; see, e.g., Pagounis v. Pendleton, 52 Mass. App. Ct. 270, 275 (2001); and
- Breach of a fiduciary or other duty owed by the defendant to the corporation. See, e.g., International Brotherhood of Electrical Workers Local No. 129 Benefit Fund v. Tucci, 476 Mass. 553, 558 (2017).
A direct claim, in contrast, alleges breach of a duty owed to the plaintiff as a shareholder, investor, or creditor of a corporation and seeks to remedy some harm that is distinct from that suffered by shareholders generally. IBEW, 476 Mass. at 558. As such, damages recovered on a direct claim will go directly to the plaintiff. Examples of direct claims include:
- Misrepresentation or fraud perpetrated on an individual investor in connection with his or her investment; see, e.g., Amorim Holding Financeria, S.G.P.S., S.A. v. C.P. Baker & Co., 53 F. Supp. 3d 279, 306-07 (D. Mass. 2014);
- Failure to make payments owed directly to plaintiff, such as profit distributions; see, e.g., Reeve v. Folly Hill Limited Partnership, 36 Mass. App. Ct. 90, 97 (1994);
- Dilution of one shareholder’s share value or equity while increasing the equity held by other shareholders; see, e.g., Donahue v. Rodd Electrotype Co., 367 Mass. 578, 600 n.25 (1975); and
- Breach of a fiduciary duty owed to a shareholder/member or freeze out of a shareholder/member. See id. at 579 n. 4.
In certain contexts, particularly cases involving a close corporation, the line separating direct and derivative claims can be blurred. In those contexts, good pleading practice may require alleging certain claims both individually and derivatively.
Follow the Procedural Prerequisites and Substantive Rules that Apply Uniquely to Derivative Suits.
1. As a Threshold Matter, Ensure Your Plaintiff has Standing.
Massachusetts law on a plaintiff’s standing to bring a derivative claim varies somewhat depending on the type of entity at issue. See G.L c. 156C, §§ 56-57 (LLCs); G.L c. 156D, §§ 7.40-7.47 (corporations); G.L. c. 109, §§ 56-59 (limited partnerships).
With respect to any entity in Massachusetts, however, to have standing to bring a derivative claim, a plaintiff must have been a shareholder (or member or partner) at the time of the alleged misconduct and must continue to be a shareholder throughout the entirety of the derivative litigation. G.L. c. 156D, § 7.41; see Billings v. GTFM, LLC, 449 Mass. 281, 289-96 (2007) (involuntary loss of ownership interest during pendency of litigation deprived plaintiff of standing to press derivative claims); see also Kolancian v. Snowden, 532 F. Supp. 2d 260, 262-263 (D. Mass. 2008) (“a narrow exception to this rule arises where the [event causing the loss of the plaintiff’s ownership interest] itself is the subject of a claim of fraud. . . [t]o establish that a merger was fraudulent, a plaintiff must plead with particularity that it was undertaken ‘merely to eliminate derivative claims’”) (quotation omitted). If your client is concerned that, during the pendency of the case, the defendant may eliminate your client’s interest, preliminary injunctive relief to halt that transaction may be necessary. See IBEW, 476 Mass. at 564 n.15.
If your client controls the entity by owning a majority of its shares or serving as its manager or president, your client may be able to bring a direct suit against a wrongdoer. But if the company is owned 50/50 and your client is one of the 50% owners seeking to sue the other 50% owner in the company’s name, the analysis is different. Although Massachusetts has yet to issue a clear decision on this issue, other jurisdictions uniformly hold that a 50% owner may not bring suit against another 50% owner in the company’s name without following derivative procedures. See, e.g., Swart v. Pawar, No. 1:14-cv-10, ECF #162 (N.D.W.Va. Nov. 19, 2015); Barry v. Curtin, 993 F. Supp. 2d 347, 352-53 (E.D.N.Y. 2014); Crouse v. Mineo, 189 N.C. App. 232, 238-39 (2008).
If the entity is a limited liability company, G.L. c. 156C, § 56 imposes additional constraints on a plaintiff’s standing. It requires that a plaintiff alleging a derivative claim be either: (1) a member authorized to sue by the vote of members owning more than 50% of the unreturned contributions to the LLC; or (2) a manager of the LLC authorized to sue by a vote of a majority of the managers. In either case, the vote of any member or manager who has an interest in the outcome of the suit that is adverse to the LLC’s interest must be excluded. Given this statutory rigor, unless the LLC’s operating documents state otherwise, a minority member, or single manager in a multi-manager LLC, would have to secure a favorable vote to obtain a non-interested majority in order to have standing to sue on behalf of the LLC. Compare G.L. c. 156D, § 7.41 (any shareholder holding stock at the time of wrongdoing may commence a derivative proceeding so long as they “fairly and adequately” represent the interests of the corporation).
2. Comply with Procedural Rules for Derivative Claims in Massachusetts State or Federal Court.
State and federal rules of civil procedure impose special pleading requirements on derivative claims. Specifically, in addition to any substantive law governed by the entity’s state of formation, Massachusetts Rule of Civil Procedure 23.1 requires that the derivative complaint:
- Be verified;
- Allege that the plaintiff was a shareholder or member at the time of the transaction at issue, or that the plaintiff’s share or membership thereafter devolved on him by operation of law from someone who was a shareholder or member at the time; and
- Allege with particularity the efforts made by the plaintiff to obtain the action he or she desires from the directors or comparable authority and the reasons for his failure to obtain the action.
The requirements of Federal Rule of Civil Procedure 23.1 are similar, but add that the plaintiff must plead that “the action is not a collusive one to confer jurisdiction that the court would otherwise lack.” The requirements of the Massachusetts Rule can be waived if a defendant proceeds to trial without addressing these issues, see Diamond v. Pappathanasi, 78 Mass. App. Ct. 77, 89 (2010) (involving a general partnership), but there is no analogous case law concerning the Federal Rule.
You also must name the company as a nominal defendant in any derivative action when filing suit in Massachusetts state or federal court, regardless of the state of formation of the entity. See Fusco v. Rocky Mountain I Investments Ltd. P’ship, 42 Mass. App. Ct. 441, 447 (1997); Gabriel v. Preble, 396 F.3d 10, 14-15 (1st Cir. 2005).
3. Properly Apply Substantive Law on Demand Requirements Prior to Filing a Derivative Suit.
The most frequently litigated issue of substantive law in derivative cases is demand/demand futility. Massachusetts substantive law imposes hurdles additional to the procedural requirement of Mass. R. Civ. P. 23.1.
A plaintiff intending to bring a derivative claim on behalf of a Massachusetts corporation must first demand that the corporation pursue the claim. G.L. c. 156D, § 7.42. “The rationale behind the demand requirement is that, as a basic principle of corporate governance, the board of directors or majority of shareholders should set the corporation’s business policy, including the decision whether to pursue a lawsuit.” Harhen v. Brown, 431 Mass. 838, 844 (2010). The procedure for making demand is detailed and is set forth in G.L. c. 156D, §§ 7.40, et seq. Massachusetts is a universal demand state, which means that demand must be made even if the plaintiff believes it would be futile due to a board’s interest or lack of independence. See Johnston, 453 Mass. at 578 n.15.
A plaintiff may only initiate a derivative action once the corporation has either (i) refused a demand to bring suit; or (ii) ignored the demand for at least 90 days (or 120 days if the decision regarding whether to pursue the claims is submitted to the shareholders for a vote). A derivative plaintiff may file suit before expiration of the waiting period if the plaintiff can show that irreparable injury would result by waiting for the period to expire. G.L. c. 156D, § 7.42.
If your client’s demand is refused and she disagrees with the corporation’s decision, you should carefully study G.L. c. 156D, § 7.44 and be prepared to challenge the refusal in your complaint and in your opposition to the inevitable motion to dismiss. In this context, the “business judgment rule” precludes the suit if the corporation can show that it determined in good faith and after reasonable inquiry that the suit would not be in the best interests of the corporation. G.L. c. 156D, § 7.44(a). Although challenging a director vote to refuse a demand is difficult because of the protections of the business judgment rule, Judge Kaplan of the Superior Court’s Business Litigation Session recently denied a motion to dismiss derivative claims in just that context. See Brining v. Donovan, No. 1684-CV-3422-BLS1 (Mass. Super. Ct. Sept. 14, 2017). The court questioned the directors’ independence given their close ties with the alleged wrongdoer and also found reasonable doubt as to whether the board conducted its investigation in good faith because its conclusion in the face of glaring financial improprieties was “so different from what an independent Board would be expected to do.” Id.
Limited Liability Companies
In contrast to corporation derivative suits, the futility exception is still alive in the context of LLC derivative suits, but must be well-pleaded to satisfy Mass. R. Civ. P. 23.1. See Billings, 449 Mass. at 289-90 n.19; see also Harhen, 431 Mass. at 844 (futility exception is pled by alleging that “a majority of [members] are alleged to have participated in wrongdoing, or are otherwise interested” and adopting definition of “interested” director as stated in ALI’s Principles of Corporate Governance, §§ 1.15 & 1.23); Diamond, 78 Mass. App. Ct. at 89 (“to satisfy rule 23.1, a complaint in a derivative action must plead with particularity either the presuit demand the plaintiff has made or the reasons why making such demand would have been futile”).
Limited partners alleging damage to the partnership must make demand upon the general partner or allege the reasons that doing so would be futile. G.L. c. 109, § 58.
4. Follow Procedural and Substantive Rules at the Conclusion of a Derivative Case.
A derivative proceeding filed in Massachusetts may not be discontinued or settled without court approval. Mass. R. Civ. P. 23.1; G.L. c. 156D, § 7.45.
As discussed above, damages recovered on a derivative claim will go to the entity. The Massachusetts Appeals Court recently noted that there may be some irony, particularly in the context of a close corporation, if this rule results in the wrongdoer benefiting from a share in the recovery. See Beninati v. Borghi, 90 Mass. App. Ct. 566, 567, n.11 (2016). This irony can be mitigated by the trial judge, who is “free to take the equities into account in fashioning any remedy under c. 93A.” Id. In an effort to remedy that type of unfair result, on remand to the Business Litigation Session in Beninati, Judge Sanders recently reduced a G.L. c. 93A damages award by a wrongdoer’s percentage of ownership interest in the company and directed that the company “shall not permit” any distribution of the damages to the wrongdoer. Beninati v. Borghi, Nos. 1284-cv-1985-BLS2, 1384-cv-1772-BLS2 (Mass. Super. Ct. June 30, 2017). An appeal of that decision is currently pending.
Massachusetts law authorizes the court to award attorneys’ fees and costs to the plaintiff upon conclusion of a case if the court finds that the proceeding has resulted in a “substantial benefit to the corporation.” G.L. c. 156D, § 7.46; see also Beninati , 90 Mass. App. Ct. at 568 (affirming denial of fee application in part because time records failed to make that distinction). The court may award the defendant its fees and costs if the court finds that the proceeding was commenced or maintained without reasonable cause or for an improper purpose. G.L. c. 156C, § 57 contains parallel fee-shifting provisions for derivative claims in the Massachusetts LLC context. Because Massachusetts law is not clear on the issue of whether an award of attorneys’ fees in derivative litigation is procedural or substantive, be sure to also understand the law of the entity’s formation state on this issue at the outset of your case.
Tara J. Myslinski is a partner in the business litigation boutique O’Connor Carnathan & Mack LLC based in Burlington. She focuses her practice in complex commercial and corporate litigation, frequently involving small-business shareholder disputes, complex contractual disputes, trade secret and non-compete litigation, and internal pre-litigation investigations.
Stephanie R. Parker is an associate in the business litigation boutique O’Connor, Carnathan & Mack LLC, based in Burlington, MA. Ms. Parker graduated from Northeastern University School of Law in May 2013. Prior to joining OCM, Ms. Parker worked as a judicial intern for The Honorable Patti B. Saris at the U.S. District Court for the District of Massachusetts.