Based on our personal experience handling Business Divorce matters for both majority owners and substantial minority investors in private companies, we have learned firsthand that there are two sides to every story and every Business Divorce matter is unique. But, we continue to be surprised by instances of outlandish behavior and self-serving conduct by majority owners that are reported to us by minority partners in the business.
Examples of Abuse of Power by Majority Owners
The following are just a few examples of the type of abusive conduct by majority owners that we have confronted on behalf of minority partners.
In one instance, the majority owner siphoned off more than $1.2 million from the company to build a “corporate retreat center.” What the majority owner actually built, however, was a lake house that he used solely for himself and his family.
Another majority owner directed the company to reimburse his cost in building a new deck above the pool at his home so that he could entertain clients. But the company’s clients were rarely, if ever, invited to use the new pool deck at the majority owner’s home.
In another memorable case, the majority owner required the company to pay for a diamond ring he purchased for his new fiancé. The majority owner contended that the ring’s cost would be paid “in kind” to the company from materials that he supplied from another business.
Much more commonplace is for majority owners to include family members on the company payroll even when they provide little or no service to the business. This allows the majority owner’s family members to receive free or low cost health insurance from the company.
The Derivative Claim as a Remedy for Abusive Conduct by Majority Owners
The foregoing examples of self-dealing conduct by majority owners violated their fiduciary duties to the company. Minority investors who seek legal recourse in response to the improper actions of majority owners, however, have found that their legal options have been constrained in recent years. Since the Texas Supreme Court’s decision in June 2014 in Ritchie v. Rupe, minority shareholders have faced an uphill legal climb in confronting majority owners.
The Rupe decision effectively eliminated the claim for minority shareholder oppression as a legal remedy, which had been the primary claim that minority shareholders relied when responding legally to oppressive conduct by majority owners. Fortunately for minority partners, the Rupe case did not deprive them of all legal recourse against majority owners who engage in self-dealing conduct. The surviving legal vehicle still available to minority owners to challenge improper actions by majority owners is the shareholder derivative claim. As a result, derivative claims filed by private company minority shareholders against officers and directors have increased substantially in the post-Rupe era.
The remainder of this post discusses the shareholder derivative claim that remains available to minority owners (and LLC members) when the majority owners of a private, closely-held Texas company engage in abusive conduct that is harmful to the company.
What Gives Rise to a Shareholder Derivative Claim?
The common thread running through the examples cited above is self-dealing conduct – behavior that financially benefited the majority owners themselves, or their family members, without providing any economic benefit to the company.
When majority owners harm the company by putting their own self-interest ahead of what is best for the company, they breach their fiduciary duty of loyalty. This breach of fiduciary duty by the majority owners authorizes the minority shareholders to bring a derivative claim in the name of the company. In the derivative action, the minority shareholders seek recovery for the harm that the company has suffered as a result of the majority owners’ wrongdoing.
Texas Law Provides a Straightforward Path for Minority Investors to Sue
The Texas Business Organizations Code governs the actions of businesses in Texas, and spells out what happens when companies and their owners act improperly. When the majority owner of a closely-held company (those with less than 35 shareholders) engages in abusive conduct, the statues lay out the path for minority shareholders to bring a derivative lawsuit. See Tex. Bus. Org. Code §§ 153.401-.405.
Texas is unusual when compared to other states in this context, because it has created very few procedural barriers to prevent minority owners from filing derivative suits, which speeds up the process. Some highlights of the Texas closely-held company derivative statute are:
There is no need for the derivative plaintiff to make a demand for payment or request for relief from the majority owner before suit is filed, which is a typical requirement in most states before a lawsuit is permitted to go forward.
Derivative plaintiffs can request the court to order that the amount awarded in the lawsuit be paid to them “when justice so requires” rather than having the recovery go to the company. That changes the ordinary rule in derivative cases, which requires that the funds recovered in the lawsuit to be paid to the company.
Derivative plaintiffs who are shareholders can recover their attorneys’ fees from the defendant if the court finds that the case provided the company with a substantial benefit. Further, the benefit that is obtained for the company in the lawsuit does not have to be financial, i.e., requiring the company to begin holding regular corporate governance meetings could be a substantial benefit.
When To Let the Arrow Fly
A simple misstep by a majority owner does not provide the basis for any legal action. But when majority owners engage in self-dealing conduct that harms the company, Texas law authorizes shareholders in closely-held companies to file a derivative action. This derivative action is filed in the name of the company, and it permits the minority shareholder to obtain a full recovery that may be paid directly to the shareholder, along with reimbursement of all of the legal fees the shareholder incurred in the lawsuit. Thus, the remedy of a shareholder derivative lawsuit remains a sharp arrow available to minority shareholders when majority owners abuse their authority to the company’s detriment.