Derivative Shareholder Disputes; Close Corporation Disputes
Whether stockholders can sue directors of their corporation directly or whether the claim “must be pursued derivatively depends on whether the harm they claim to have suffered resulted from a breach of duty owed directly to them, or whether the harm claimed was derivative of a breach of duty owed to the corporation.” Int'l Bhd. of Elec. Workers Local No. 129 Benefit Fund v. Tucci, 476 Mass. 553, 558, 70 N.E.3d 918, 923 (2017).
It is a bedrock legal principle that only the party injured by a breach of duty has standing to sue to recover damages for that wrongdoing. When a corporate opportunity is wrongfully diverted or when in a self-dealing transaction the corporation pays too much for property or services, any harm to shareholders is derived indirectly from their ownership of the injured party, the corporation. So when a controlling stockholder takes excessive compensation or improperly takes a business opportunity that belongs to the corporation, a stockholder can only sue derivatively for the benefit of the corporation. This is so whether the corporation has only a few stockholders who work in the business or the corporation is publicly traded.
Demand Requirements for Derivative claims.
While the minority shareholder cannot sue in her own right she might be able to bring a claim on behalf of the corporation. This is called a derivative shareholder action. Only a person who is a shareholder at the time of the alleged wrongdoing, or whose shares for example were inherited from a person, who was a stockholder as the time of the alleged wrongdoing, has standing to sue.
Effective as of 2004, the Massachusetts Business Corporation statute underwent a comprehensive revision including adoption of detailed conditions for bringing a derivative shareholder suit. Massachusetts General Laws Chapter 156D §§ 7.40-7.47. The universal requirement is that the complaining shareholder of a Massachusetts corporation must make demand on the corporation to bring the claim in its own right. In the 2017 Tucci case, the Massachusetts Supreme Judicial Court outlined the requisite and mandatory procedure:
A shareholder must make a demand pursuant to G. L. c. 156D, § 7.42. The corporation then must determine whether it would be in the best interests of the corporation to take over the shareholder's claim, and the statute specifies alternative ways that the corporation may undertake to make this determination. G. L. c. 156D, § 7.44 (b). If the demand is rejected, the shareholder may commence suit, in accordance with the time requirements in § 7.42 (2).
476 Mass. at 564, 70 N.E.3d at 928.
It “is … a basic principle of corporate governance, [that] the board of directors or majority of shareholders should set the corporation's business policy, including the decision whether to pursue a lawsuit.” Halebian v. Berv, 457 Mass. 620, 626 (2010). So these decision makers must be given an opportunity to make a good faith determination of whether such a lawsuit is in the best interest of the corporation.
While the statutory procedure is detailed, a good faith, fully informed decision by a majority of independent directors or a disinterested majority of the shareholders that maintaining the derivative proceeding is not in the best interests of the corporation, bars the suit. G.L. c.156D §7.44.
This pre-suit condition is required even when the alleged wrongdoers control decisions of both the board and the stockholders. However, where there can be no informed decision by disinterested decision makers, a rejected demand is no bar to maintaining the derivative proceeding.
The statute specifies that the substantive demand requirements for a foreign corporation are to be determined by the state of incorporation. G.L. c.156D §7.47.
For Delaware corporations the substantive demand rule is different. In order to bring a derivative proceeding a shareholder of a Delaware corporation must either (1) make a pre-suit demand by presenting the allegations to the corporation's directors, requesting that they bring suit, and showing that they wrongfully refused to do so, or (2) plead facts showing that demand upon the board would have been futile. See Stone v. Ritter, 911 A.2d 362, 366–67 (Del. 2006).
And, whether brought for the benefit of a Delaware or a Massachusetts corporation, there are specific procedural rules concerning the prosecution of derivative actions that apply under both the Massachusetts Rules of Civil Procedure and the Federal Rules of Civil Procedure.
Where the company is incorporated matters.
While Massachusetts law is often similar to Delaware law and Delaware corporate governance cases are frequently cited in Massachusetts Courts, the Massachusetts business corporation statute, G.L. c. 156D, is not the same as the Delaware Corporation Law. A noteworthy Delaware vs. Massachusetts corporate law distinction is the breadth of the fiduciary duty of directors and whether certain claims can only be brought derivatively with the attendant mandatory, claim preclusive procedural hoops.
Directors of a Massachusetts corporation are fiduciaries. As fiduciaries, directors must insure that they do not sacrifice the corporation’s goal of enhancing profit and shareholder gain for their own interest or pecuniary gain. Under the Massachusetts business corporation statute G.L. c. 156D, and its predecessor G.L. c. 156B, and case law “reflecting” the Commonwealth’s “common-law principles, the general rule of Massachusetts corporate law is that a director of a Massachusetts corporation owes a fiduciary duty to the corporation itself, and not its shareholders.” Int'l Bhd. of Elec. Workers Local No. 129 Benefit Fund v. Tucci, 476 Mass. 553, 561, 70 N.E.3d 918, 926 (2017)(emphasis added). As the SJC explained in the Tucci case (a cash out merger of a public company) “there are at least two exceptions” to this general rule. Id. The first is a close corporation where stockholders owe one another a fiduciary duty that is “substantially the same duty of utmost good faith and loyalty … that partners owe to one another.” Id. This fiduciary duty adherent to closely held corporations, as a general matter, “is even stricter” than the fiduciary duty of directors owed to corporations. The second exception is “where a controlling shareholder who also is a director proposes and implements a self-interested transaction that is to the detriment of minority shareholders, a direct action by the adversely affected shareholders may proceed.” Id. at 562, citing Coggins v. New England Patriots Football Club, Inc., 397 Mass. 525, 532-533, 492 N.E.2d 1112 (1986), same case, 406 Mass. 666, 550 N.E.2d 141 (1990).
Delaware law is different. Under Delaware law directors owe a fiduciary duties of care and loyalty to the corporation and to its shareholders.
Given this separate duty owed to each of the corporation and separately to its stockholders, it is not surprising that under Delaware law there is no bright line, universal rule on whether a disgruntled stockholder must proceed with a derivative claim or can sue directly. See Tooley v. Donaldson, Lufkin & Jenrette, Inc., 845 A.2d 1031 (Del. 2004). Expressly disapproving of “the concept of ‘special injury” and the concept that a claim is necessarily derivative if it affects all stockholders equally,” id. at 1039, the Delaware Supreme Court prescribed a new rule.
In Delaware on a case by case basis the analysis whether a shareholder can sue directly or must bring a derivative action “turn[s] solely on the following questions: (1) who suffered the alleged harm (the corporation or the suing stockholders, individually; and (2) who would receive the benefit of any recovery or other remedy (the corporation or the stockholders, individually)?” Id. at 1033 (emphasis original). The Delaware Supreme Court suggests that helpful to a court’s analysis of the first prong is to:
Looking at the body of the complaint and considering the nature of the wrong alleged and the relief requested, has the plaintiff demonstrated that he or she can prevail without showing an injury to the corporation?
Id. at 1036.
The Tucci case.
In the Tucci case the plaintiff was an institutional investor who had been a shareholder of the publicly traded Massachusetts corporation EMC. Shortly after the October 2015 announcement of the merger whereby Dell Corporation would acquire EMC the institutional shareholder filed suit seeking to bring a class action on behalf of all EMC stockholders alleging that EMC’s board of directors had breached their “fiduciary duties, allegedly owed to both EMC and the shareholders.” 476 Mass. at 554. With almost two billion stockholders EMC obviously is not a closely held corporation. Nor did the Plaintiff allege that the controlling shareholder Tucci had proposed a self-interested transaction that would benefit him, as a shareholder, by picking the pockets of other shareholders. The pension fund’s squawk was that in approving the merger by which Dell acquired EMC the directors sold the corporation’s assets for an inadequate price resulting in shareholders, including the defendant Mr. Tucci, being cashed out for less than fair value. While the dollars were in the billions this was just a garden variety Massachusetts derivative shareholder claim alleging that breaching their duty to act in the best interests of the corporation the directors had failed to get a fair price for the corporation’s assets. So as a consequence of the injury to the corporation the pension fund’s theory was all of the EMC stockholders, including Mr. Tucci, had suffered a consequential, and hence indirect, injury when upon liquidation of the target EMC in exchange for their shares of stock, they got less cash than they would have received had the assets been sold at a fair price.
The plaintiff pension fund chose not to pursue its claim as a derivative claim under the statutory procedure. Looking to Delaware law the plaintiff contended that in the context of a decision to approve a merger directors owed a fiduciary duty to shareholders who in lieu of bringing a derivative action could sue the directors directly for damages challenging the fairness of the transaction that caused an injury allegedly suffered equally by all shareholders.
The SJC rejected the institutional investor’s argument it should adopt Delaware law. Both the business corporation statutes and the “corporate law principles” of Delaware and Massachusetts have some material differences. Massachusetts “continue[s] to adhere to the view that whether a claim is direct or derivative is governed by whether the harm alleged derives from the breach of a duty owed by the alleged wrongdoer—here the directors—to the shareholders or the corporation.” Int'l Bhd. of Elec. Workers Local No. 129 Benefit Fund v. Tucci, 476 Mass. 553 n., 563, 70 N.E.3d 918, 927 (2017). Holding the claim was required to have been brought as a derivative claim on behalf of the corporation the SJC affirmed the Superior Court’s dismissal of the shareholders’ claims for damages.
General principles for all corporations and closely held corporations.
Directors of a Massachusetts corporation owe a duty of reasonable care and a paramount duty of loyalty to the company. Demoulas v. Demoulas Super Markets, Inc., 424 Mass. 501, 528-29 (1997). In the exercise of their fiduciary responsibilities the directors are charged with acting in good faith and must exercise reasonable intelligence in conducting the affairs of the corporation. Sagalyn v. Meekins, Packard & Wheat, Inc.,290 Mass. 434, 438 (1935). Directors “are bound to act with absolute fidelity and must place their duties to the corporation above every other financial or business obligation . . .. They cannot be permitted to serve two masters whose interests are antagonistic.” Demoulas, 424 Mass. at 528. Directors must subordinate their personal pecuniary interests to their paramount duty to the corporation. It is improper for directors and officers to promote their own interests in a manner harmful to the corporation. Geller v. Allied-Lyons PLC, 42 Mass. App. Ct. 120, 122 (1997).
Likewise controlling stockholders in a close corporation owe other stockholders an even “stricter” fiduciary duty of utmost good faith and loyalty that partners owe one another. Donahue v. Rodd Electrotype Co. of New England, 367 Mass. 578 (1975). A close corporation is generally defined as having a small number of shareholders, no ready market for its stock, and substantial majority shareholder participation in the management, direction and operations of the corporation. Harrison v. NetCentric Corp., 433 Mass. 465, 469 n.6 (2001).
Majority shareholders in a close corporation cannot use oppressive devices, including withholding of dividends, to “freeze out” the minority interests. Donohue, 367 Mass. at 588-89.
One example of improper conduct by a director or a controlling shareholder in a close corporation is when he or she improperly takes advantage of a business opportunity. This is the so-called corporate opportunity doctrine. It is fundamentally unfair for a director or senior executive of a company to take advantage of a business opportunity for his own profit when under the circumstances he or she should first present the opportunity to the company. This is particularly so when the director or executive becomes aware of a potential opportunity either in performing the function of director or executive or through the use of corporate information or property. Demoulas, 424 Mass. at 528-530. If the company rejects the opportunity, after full disclosure of all material facts, the director or executive may pursue the opportunity for her own account. The decision to reject the opportunity must be made by disinterested directors or, if need be, by disinterested shareholders. If the decision makers are not disinterested, then in any subsequent litigation, “the burden is on those who [have] benefit[ed] from the [new] venture to prove that the decision was fair to the corporation.” Demoulas, 424 Mass. at 531. These same principles apply equally to any “self dealing” transaction between the director or executive, on the one hand, and the corporation.
Statute of Limitations Considerations
When a director or executive takes a business opportunity rightfully belonging to the corporation the legal wrong is in the nature of a tort action for conversion and subject to a three-year statute of limitations. Demoulas, 424 Mass. at 517. When a director or executive improperly takes excessive compensation, the wrong to the corporation is for money had and received, a legal wrong sounding in contract and subject to a six year period of limitations. Von Arnim v. American Tube Works, 188 Mass. 515, 517-520 (1905).
Where the injured party is the corporation and the wrongdoers control all decisions, the corporation cannot protect its interests and bring suit within the applicable period of limitations. In addition, the minority stockholders may not learn of the wrongdoing until the passage of many years.
It is fundamentally unfair for a wrongdoer to evade liability when he covers up his wrongdoing whether by active concealment or by standing mute and silent in the face of a fiduciary duty to fall on his sword and disclose his wrongdoing. Under certain circumstances the law will prevent injustice from a rigid time bar calculated from three or six years from the date of the wrongdoing. This is particularly appropriate where the wrongdoer controls the injured party.
In the Demoulas case, the plaintiffs filed suit in April 1990 and successfully attacked self-dealing transactions in 1975, 1979, 1981 and at diverse other times. Where a defendant conceals the operative facts of the legal wrong, the doctrine of fraudulent concealment tolls or delays the statute of limitations from running. Demoulas, 424 Mass. at 517-18. In addition a director’s silence and failure as a fiduciary to disclose those operative facts can constitute fraudulent concealment. That a derivative plaintiff might have discovered the wrongdoing if he had been more diligent does not bar the case on statute of limitations grounds. Puritan Medical Center v. Cashman, 413 Mass. 167, 172 (1992).
In a derivative suit a successful plaintiff is generally entitled to recover attorney’s fees.
See specimen complaints:
Specimen 1
Specimen 2
Specimen 3