Before Taking Action to Protect a Business...

A Few Things to Consider 

Let’s say you have an ownership interest in Company ‘XYZ’.

The company’s leadership has opted not to pursue an action you know to be vital to ensuring ‘XYZ’s future success. You’ve implored management as well as the board of directors to “do the right thing” but they simply won’t listen. They’re failing in their fiduciary duty to you, the other shareholders as well as endangering the future of the company itself. What do you do?

One possible answer to this question is to file a derivative lawsuit.

Essentially, these are legal actions brought by a shareholder on behalf of the company and its shareholders against a third party. That third party can be another company in the case of, say, patent infringement, or an individual officer of the company in cases of corporate theft or even just intractable disputes between business partners.

Though they’re mostly known as an oft-used tool of high-profile activist shareholders seeking to force proxy fights with major public companies, the truth is derivative actions make up a great deal of B2B litigation and partnership disputes. Any time you’re trying to force a company to act in what you see to be both its own and its shareholders’ best interest, you’ll most likely go this route.

But, don’t go running down to the courthouse and trying to file a Pro Se complaint to clear everything up and to make management and/or your wayward partner fall in-line. There are some important specifics you should know before doing anything—and it may be a good idea to assess how certain you are that you’re in the right.

Plaintiffs must clear a number of hurdles to have these cases heard and any early misstep can prove costly. These hurdles include:

  • Business Judgement Rule—Courts operate under the presumption that officers and boards are making informed decisions in good faith and are reluctant to get in the middle of “business decisions”. As a result, you’re required to first demand (unsuccessfully) that leadership take action before bringing the matter to the courts and then show how your action further satisfies the rule.

    Another route is to claim futility which comes up in cases of a very few shareholders—often partnerships—where one or more partners may be engaging in illegal behavior and are unlikely to take action against themselves.
     
  • It’s Your Party—In order to take this action, you’re going to need to be ready to open up your own wallet for the case. Whatever their reasoning is, the company and the board have already declined to take any action, so they’re not likely to pony up the cash at this point. Also, the spoils of any victory will be shared with any similarly situated shareholders.
     
  • Sign and Verify—Even if you’ve hired a lawyer to file the suit on your behalf, you’re going to have to verify the complaint. Failure to sign off on the statement of facts will get your case thrown out immediately, leaving you on the hook for defendants court fees.

After satisfying these preliminary hoops, the State of Tennessee has specific procedures outlined which plaintiff’s must follow for taking action against various types of business entities including Partnerships; For-Profit Corporations; Non-Profit Corporations; LLCs, etc.

Despite the procedural difficulty, however, sometimes these actions present the only recourse available to shareholders seeking to protect their interest in a company, as well as the health of that company itself.  As always, the best bet is to talk with your lawyer and make sure they’re checking all these boxes on your behalf.