If you own part of, but you do not control, a corporation or LLC, you probably own a minority of the ownership rights in the company. The majority owners typically place themselves in control as president, board members, manager, or other roles. But what if the majority owners, or one of the managers, engages in self-dealing or takes advantage of their power? The answer is often to file what is called a shareholder derivative lawsuit (or, for an LLC, a member derivative lawsuit). This post explains what a derivative lawsuit is.
In short, a shareholder derivative lawsuit is a claim brought by one or more shareholders to enforce a legal claim that technically belongs to the corporation, but that the corporation is not pursuing.
Why would a shareholder derivative lawsuit be necessary? If an officer of the corporation has caused damage or loss to the corporation, the legal claim technically belongs to the corporation itself. After all, a corporation is a separate legal entity.
One of the clearest examples of a derivative action is a suit against the officers or directors of a corporation for mismanaging it and breaching their fiduciary obligations. An action must be brought derivatively against its officers or directors for preempting a profit on the sale of corporate property, for fraudulently dissipating the assets of the corporation, for a fraudulent withdrawal and appropriation of corporate assets, for misappropriating a corporate opportunity, for failing to obtain the necessary board or shareholder approvals prior to effecting a sale of the corporation’s assets, or generally for mismanaging the business of the corporation and thereby reducing the value of the plaintiff shareholders’ investment. In an extreme example, an officer of the company may be embezzling money from the company, and the company is doing nothing to stop it.
The common element of all the above examples is that an officer of the company is hurting the company, but the company itself is doing nothing to stop it.
In such a case, a derivative claim is the vehicle by which an owner of a minority share of the company may seek redress. In a derivative claim, the shareholder first sends a demand letter to the corporation pursuant to N.C.G.S. § 55-7-40 (or, for an LLC, pursuant to N.C.G.S. § 57D-8-01). The shareholder must explain what the company is allowing to happen, and demand that the company take legal action against the officer for his or her wrongdoing.
As one court has explained, this requirement of sending a demand letter “serves the obvious purpose of allowing the corporation the opportunity to remedy the alleged problem without resort to judicial action, or, if the problem cannot be remedied without judicial action, to allow the corporation, as the true beneficial party, the opportunity to bring suit first against the alleged wrongdoers.” Alford v. Shaw, 72 N.C. App. 537, 540, 324 S.E.2d 878, 881 (1985), rev’d, 318 N.C. 289, 349 S.E.2d 41 (1986).
There are many more requirements in a derivative lawsuit, such as having an attorney adequate to represent the corporation and jurisdictional prerequisites. Suffice it to say that a shareholder (or member) derivative lawsuit has many moving parts and requires complying with various statutes and court rules. Nevertheless, shareholder derivative claims are a powerful device for ensuring that your ownership interest in any corporation or LLC is protected, and that the company in question is not breaching the fiduciary duty it has to look after your investment.
Dye Culik PC is a Charlotte, North Carolina law firm that represents businesses, shareholders, members, partners, and entrepreneurs in all types of corporate disputes. If you have a question about a business matter, contact us to see how we can help.