By LaCrecia Perkins and Ladd Hirsch

A look back at Business Divorce developments during Texas 2018 reflects a continuing negative trend for private company shareholders[1] who have claims for misconduct against the company’s control group (e.g., majority owners, officers, managers, and/or directors).  The rocky road for Texas shareholders began in 2014 with the Supreme Court’s Ritchie v. Rupe decision,[2] which eliminated the remedy previously available to minority shareholders of securing a court-ordered buyout of their ownership interest upon proof that majority owners had engaged in oppressive conduct.  The slope became even steeper in late 2018 with an appellate court decision requiring dismissal of shareholder derivative lawsuits if the shareholder cannot meet the “Continuous Ownership Rule.”  See In re LoneStar Logo & Signs, LLC.[3]

What are shareholder derivative lawsuits, how does the Continuous Ownership Rule apply to claims in these cases, and do private company shareholders continue to have the right to pursue valid claims for wrongdoing against the company’s majority owners, officers, managers, and directors?  This post answers those questions, and the upshot is that the best advice for shareholders is to file their derivative lawsuit as soon as possible.  While winning the race to the courthouse provides no guaranty that the lawsuit will be permitted to continue through trial, under the current Texas law, having a derivative lawsuit on file gives the shareholder the best possible legal and equitable arguments for maintaining the lawsuit to judgment.

The Shareholder Derivative Lawsuit

A derivative lawsuit is one in which a shareholder files suit on behalf of the company for injuries the business has sustained, and the lawsuit is filed because the control group has failed to take action to protect the company.  The shareholder therefore files the lawsuit in the company’s name in a representative capacity.  In most cases, shareholders file these claims contending that members of the control group engaged in self-dealing conduct that hurt the company.  Therefore, in these derivative lawsuits, the shareholder is alleging that the company’s officers, managers, and/or directors breached their fiduciary duties to the company.

The procedural requirements for filing a shareholder derivative action are steep, but Texas law relaxes these standards for shareholders in closely-held companies (less than 35 shareholders), making it easier for them to file a derivative suit when controlling persons engage in improper conduct.  See Tex. Bus. Orgs. Code §§ 101.451-.463 (2017).  For example, under this section of the TBOC, shareholders are not required to make any demands on the company before filing suit.  In addition, in a normal shareholder derivative lawsuit, any recovery obtained in the case must be paid to the company.  However, shareholders in closely-held companies under this statute can request that the judgment be paid directly to the derivative plaintiff shareholders “if justice requires.”  Finally, shareholders in derivative lawsuits can recover their legal fees from the defendants if the court determines that the suit provided the company with a substantial benefit.

The Continuous Ownership Rule—Barrier to Suit  

The general rule in Texas and in most states is that the shareholder’s ownership status must be maintained throughout the derivative lawsuit.  The specific requirement is that the shareholder must have held the shares: (i) at the time the alleged injury took place; (ii) at the time the suit was filed; and (iii) throughout the lawsuit.  If the shareholder loses his or her interest in the company at any point, whether voluntarily or involuntarily, that deprives the shareholder of the right to file or continue the lawsuit.

There was some thought after the Ritchie v. Rupe case that all standing requirements in filing derivative actions for shareholders in closely-held Texas companies were eliminated by the TBOC provisions that apply to these companies.  The LoneStar case last year removed that doubt and enforced the Continuous Ownership Rule resulting in the dismissal of the shareholder’s derivative lawsuit.  The appellate court in LoneStar specifically held that a former member of a closely-held Texas LLC lacked standing to file a derivative lawsuit, despite the fact that the shareholder had been a member of the LLC when the claims accrued.  The Continuous Ownership Rule was invoked by the defendant officers after the shareholder lost ownership of his stock in the company as the result of a merger.  The appellate court reasoned that in derivative litigation, the plaintiff must have an ownership interest in the company and, therefore, a stake in the outcome of the lawsuit.  Thus, when the shareholder no longer had any ownership interest in the company, the court concluded that he no longer had standing to pursue his claims on a derivative basis on the company’s behalf.

The shareholder in LoneStar lost his ownership interest in the company before he had filed the derivative lawsuit.  Nevertheless, the timing of the shareholder’s loss of ownership is not generally seen as a factor in cases from Texas and other jurisdictions.  These cases hold that even if the shareholder has filed the derivative suit, the court will not permit the shareholder to continue to prosecute derivative claims for the company if his/her ownership interest in the company has been removed while the lawsuit is pending.

An Important Exception to the Continuous Ownership Rule

While all seemed bleak for shareholders pursuing derivative claims after LoneStar, the court did identify an equitable exception to the Continuous Ownership Rule upheld by Texas courts.  Under this exception, even if a shareholder has lost his/her status as a shareholder, e.g., via a merger or a forced buyout of the shares, the Continuous Ownership Rule will not bar the former shareholder from filing or proceeding a derivative lawsuit if the shareholder can establish that: (i) the shareholder’s interest in the company was destroyed “involuntarily” and (ii) the loss of the shares was accomplished “with no valid business purpose.”  These two terms have not yet been defined by Texas case law leaving this as a legal gray area that will continue to develop.

After LoneStar, the take-aways for private company shareholders who want to file or maintain a derivative lawsuit against the company’s control persons are as follows:

  • Don’t sell, transfer, or otherwise voluntarily give up ownership of the ownership interest in the company at any point before a final judgment has been entered in the case;
  • File the derivative lawsuit as soon as possible, which should help in seeking resist dismissal of the pending lawsuit and in establishing that any later loss of the ownership interest was involuntary and without a valid business purpose; and
  • If the owners fire the shareholder and immediately exercise a buy-sell agreement to obtain the ownership interest from the shareholder for a low-ball price, the shareholder should consider securing a valuation of the company to help establish that there was no valid business purpose for the involuntary loss of the shares.

There is one Texas appellate court case upholding the equitable exception to the Continuous Ownership Rule, which remanded the case to the trial court to determine whether the exception applied, which would permit the shareholder to proceed with the derivative lawsuit.  See Zauber v. Murray.[4]  According to the appellate court in Zauber: “If no valid business purpose exists, a court of equity will consider the destruction of a stockholder’s status a nullity and allow him to proceed with the suit in the name of the corporation.”

Conclusion

The guidance for private company shareholders after last year’s LoneStar decision is simply this: hold onto your shares at all times if you can.  After LoneStar, shareholders are at risk of being barred from filing a derivative lawsuit or having the lawsuit dismissed if they lose their ownership interest at any point.  If shareholders do lose their shares, they will be left to argue an equitable exception to the Continuous Ownership Rule—that their shares were taken “involuntarily” and “with no valid business purpose.”

To best position themselves to make this equitable argument opposing the Continuous Ownership Rule, shareholders are advised to file their derivative lawsuit as soon as valid claims arise against the company’s control group.  First, it will be more compelling to argue that the defendants have “no business purpose” in securing the shares after the lawsuit has been filed.  Second, defendants look more self-serving in seeking dismissal of the derivative lawsuit after obtaining the shares from the plaintiff on an involuntary basis.  The exception to the Continuous Ownership Rule may be the only lifeline available to shareholders in maintaining a derivative lawsuit after they have lost their shares, so let the race to the courthouse begin.

[1] In this Post as a shorthand reference, the use of the term shareholders is intended to also include LLC members of private companies.

[2] See 443 S.W.3d 856 (Tex. 2014).

[3] 552 S.W.3d 342 (Tex. App.—Austin 2018).

[4] See 591 S.W.2d 932 (Tex. Civ. App.—Dallas 1979).