You represent a minority shareholder of a closely held corporation and the company is having an off year. The majority shareholder is the sole member of the board and serves in every officer position. She draws significant compensation. Without a business justification, she unilaterally decides to double her salary and have the company pay the mortgage on her vacation home. Your client is the only other shareholder and likely the only person hurt by the majority shareholder’s self-declared raise. Although the minority shareholder suffers a clear injury, characterizing the injury as direct or derivative can have a significant impact on the outcome of the litigation.
Until recently, minority shareholders in closely-held companies could assert claims for breach of fiduciary duty and corporate waste directly against the majority owner. If the claimant was successful, a court could order the majority shareholder to disgorge the spoils of her behavior and pay them to the minority shareholder. This type of direct recovery is no longer permissible. Since 2014, Pennsylvania courts have made clear that claims arising from breach of the duties owed to a corporation, even a closely held one, belong to the corporation and must be asserted on a derivative basis. This requirement creates procedural and substantive complexities when compared to direct claims. Bringing such claims requires strategic and creative analysis and careful attention to detail.
Without a shareholder’s agreement, minority shareholders are largely at the mercy of the majority shareholder. Minority shareholders have no formal ability to direct how the company spends money, compensates employees or hires vendors. Some majority owners use their power to disadvantage the minority shareholder by excessively compensating themselves or causing the corporation to contract with vendors affiliated with the majority on unfair terms. Although the minority shareholder is the party ultimately damaged by this behavior, the Pennsylvania Business Corporation Law (BCL) makes clear that “the duty of the board of directors … is solely to the business corporation … and may not be enforced directly by a shareholder.” To obtain redress for the majority shareholder’s misconduct, the minority shareholder is therefore required to assert their claims on a derivative basis on behalf of the corporation.
Notwithstanding the language of the BCL, Pennsylvania courts previously allowed minority shareholders to directly assert claims arising from a majority owner’s breach of the duties owed to the company and without the need for the formality of a derivative action. The impetus for this flexibility was dicta contained in a footnote in a case not involving a closely held corporation. In Cuker v. Mikalauskas, 692 A.2d 1042, 1049, n. 5 (Pa. 1997), the Supreme Court relied heavily on the American Law Institute’s “Principles of Corporate Governance: Analysis and Recommendations” (ALI Principals) and offered its resounding endorsement of the publication generally. It emphasized the interlocking character of the provisions of the ALI Principals and invited the lower courts to apply them to the extent consistent with Pennsylvania law.
Pennsylvania trial courts accepted the court’s invitation in the context of closely held corporations. Section 7.01(d) of the ALI Principals recognizes that the traditional justifications for requiring derivative claims may be less persuasive in the closely held company setting and gives courts discretion to relax the requirement in certain circumstances:
In the case of a closely held corporation, the court in its discretion may treat an action raising derivative claims as a direct action, exempt it from those restrictions and defenses applicable only to derivative actions, and order an individual recovery, if it finds that to do so will not unfairly expose the corporation or the defendants to a multiplicity of actions, materially prejudice the interests of creditors of the corporation, or interfere with a fair distribution of the recovery among all interested persons.
Trial courts, notably the First Judicial District’s commerce program, adopted both the substantive and procedural aspects of Section 7.01(d). They allowed individual recovery to plaintiff shareholders, rather than to the corporation. Adoption of Section 7.01(d) also gave the courts discretion to reduce the procedural hurdles attendant to a derivative suit, such as the requirement that the minority shareholder formally demand that the corporation’s board sue the majority shareholder prior to the minority shareholder filing suit.
In 2014, the Superior Court reversed this trend when it expressly rejected application of the substantive aspects 7.01(d) as inconsistent with Pennsylvania law in Hill v. Ofalt, 85 A.3d 540, 556 (Pa. Super. Ct. 2014). Although the Superior Court left open the possibility that the Supreme Court might adopt the procedural aspects of Section 7.01(d), it rejected the notion that trial courts may “simply ignore the corporate form and … treat an action raising derivative claims as a direct action and order an individual recovery.”
The post-Hill regime requires attorneys representing minority shareholders to look for opportunities to assert direct claims in lieu of derivative claims. The same facts that support a derivative claim may also be the basis of a direct claim. This is particularly common when the minority shareholder is involved in the operation of the business. For example, claims arising from the wrongful termination of a minority shareholder’s employment may form the basis of a direct claim on behalf of the minority shareholder, as well as a derivative claim against the majority shareholder for the breach of duty of care owed to the company.
Shareholder oppression claims are direct claims and may provide a viable method for a minority shareholder to obtain an individual recovery. Pennsylvania has long recognized that a majority shareholder has a quasi-fiduciary duty not to use their power in such a way as to exclude the minority shareholder from the “benefits accruing from the enterprise.” Carefully structured, a shareholder oppression claim can often address the same conduct that a court might otherwise classify as giving rise to a derivative claim. A claim that a majority shareholder increased their compensation to a level that leaves no profits available to be distributed to shareholders is likely a direct shareholder oppression claim. It may also be a derivative claim if the compensation is excessive by objective measure.
Fraud claims against majority shareholders may also be asserted directly if they arise from a misrepresentation made to the minority shareholder. The misrepresentation, however, must not be related to malfeasance in relation to the company. For example, misrepresenting the financial status of the business to induce a minority shareholder to invest additional capital that is subsequently lost is likely a direct claim. Falsely representing the terms of the majority shareholder’s excessive compensation is likely derivative because it is so closely related to the breach of the majority’s duty owed to the company itself.
When developing claims, keep in mind that counsel’s labeling of claims in pleadings as direct or derivative is not dispositive. Courts look to the substance of the allegations to determine the nature of the wrong.
The distinction between direct and derivative claims presents a variety of challenges in the context of closely held business disputes. Recognizing the issue at that outset of the litigation and developing theories for asserting direct claims is critical to the successful representation of the minority shareholder.
Edward S. Robson is the managing shareholder of Robson & Robson and focuses his practice on litigation arising from commercial transactions, disputes among business owners, unfair competition and mergers and acquisitions. He has written and taught on a variety of topics affecting closely held businesses. He can be reached at 610-825-3009 or firstname.lastname@example.org.