Shareholder & Member Litigation — Business Associations

Delta Mills declares a $2 per share dividend and pays every shareholder except Mara, because the CEO dislikes her. Mara sues. If she wins, the money goes into her pocket. Now a second case. That same CEO secretly diverts $1 million of Delta Mills cash to a shell company he owns. Mara sues over that too.

Same shareholder. Same company. Completely different lawsuit. In the second one Mara does all the work and keeps none of the money, because the $1 million goes back to the corporation. She is only a stand-in. That fork, direct or derivative, is the whole of this topic. Get it right and everything else follows. Get it wrong and the case is dismissed before anyone reaches the merits.

Here is the route. First the fork itself, and the two-question test that decides it. Then direct actions, which are just ordinary lawsuits. Then derivative actions, which are wrapped in procedural safeguards, and those safeguards are what the exam actually tests. Then LLC members, who follow the same fork with one important difference. And a word at the end on partnerships.

Start with what the two lawsuits actually are. A direct action is a suit an owner brings in their own name to remedy an injury to themselves. A shareholder cheated out of a declared dividend. A shareholder blocked from voting. The harm landed on that owner, and any money recovered is theirs to keep.

A derivative action is stranger. The owner sues on behalf of the company, to enforce a right belonging to the company. A director loots the treasury. The corporation is the victim, but the wrongdoers are the very people who decide whether the corporation sues. So the law lets a shareholder force the issue by suing in the company's place.

Which means the shareholder is only a stand-in. The corporation is the real plaintiff, named as a nominal defendant so the judgment binds it, and every dollar recovered goes to the corporation. The reward for the shareholder is, at most, reimbursement of what the suit cost to bring.

Modern courts sort the two with a clean two-part test. Ask only this. Who suffered the alleged harm, the entity or the owner individually? And who would receive the benefit of a recovery? If both answers point to the entity, the claim is derivative. If both point to the owner personally, it is direct.

Now notice what dropped out of that analysis, because this is a trap. You no longer ask whether the shareholder suffered an injury different from, or special compared to, other shareholders. So try it. The whole board wastes corporate assets, and every single share in the company is now worth less. Every shareholder is hurt, and hurt equally. Direct or derivative?

Derivative. The harm and the recovery belong to the corporation. The falling share price is just an echo of the company's injury, not a separate personal wrong. A harm that hits every shareholder alike can still be derivative. What matters is who was hurt and who gets paid, not whether the injury was unique to one owner.

One more refinement. A single set of facts can support both theories at once. When it does, plead them separately rather than forcing a choice.

Direct actions first, because they are the simple half. A claim is direct when the owner sues to protect a right that is personally theirs. The rights that come with being an owner. The right to vote. The right to a dividend the board has already declared. The right to inspect the books and records. The right to enforce a shareholder or operating agreement. And the right to be free of oppression by those in control.

Because a direct action is an ordinary lawsuit, it skips every hoop that guards derivative suits. No demand on the board. No risk that a board committee votes the case away. The trade-off is what the owner has to prove. A direct plaintiff must show a personal injury, not merely that the company was harmed and their shares fell in sympathy. The LLC act states that gate expressly, at § 901. The injury cannot be solely the result of an injury to the company.

Now derivative actions, and it helps to know why they exist. When the wrongdoers control the board, asking the board to sue itself is pointless, so the law lets an owner sue in the entity's name instead. But that power is easy to abuse. A shareholder holding one share could drag a company into ruinous litigation, or file a weak strike suit hoping to be paid to go away.

So the law wraps the derivative action in safeguards, and they do three jobs. Confirm the plaintiff is a legitimate stand-in for the company. Give the company's own decision-makers the first chance at the claim. And keep the plaintiff from quietly selling out the other owners in a private settlement. Learn them as a checklist, because that checklist is exactly what the exam tests.

Safeguard one, standing, and it has two halves. Ownership, under § 7.41. The plaintiff must have been a shareholder when the challenged act occurred, or have received the shares by operation of law from someone who was. They must also stay a shareholder throughout the suit. That first half is the contemporaneous-ownership rule. You cannot buy stock after a wrong just so you can sue over it.

The second half is adequacy. The plaintiff must fairly and adequately represent the corporation's interests, so someone pursuing a conflicting agenda is disqualified. Note what standing does not require. There is no minimum stake. A single qualifying share is enough, so long as the owner represents the corporation fairly.

Safeguard two is demand, and it is the single most tested feature of this topic. Under the MBCA, which most states and the exam follow, demand is universal, at § 7.42. No shareholder may commence a derivative proceeding until a written demand has been made on the corporation, and 90 days have passed. The exceptions are narrow. The corporation rejects the demand sooner, or waiting the full period would cause irreparable injury.

Universal means universal. There is no exception for a demand that looks futile because the board is conflicted. So test that. Ben has owned 100 shares of Orchard Foods since it was founded. Three of the five directors approved lucrative consulting contracts for their own side businesses, draining company cash. Ben wants to sue those directors. Demand on that board would plainly be hopeless. Must he make it anyway?

Yes. Under the MBCA he sends a written demand and waits 90 days, even though three of five directors are conflicted. He cannot lean on futility. The theory is that the board should get the first crack at every claim, even one that accuses the board itself, and that one demand never really hurts.

Delaware takes the older route, and a large share of big corporations are chartered there, so know it. Demand is required unless it would be futile. A plaintiff who pleads specific facts showing the board could not fairly consider a demand may skip it and sue right away.

Delaware's current futility test runs director by director. Did a majority of the board receive a material personal benefit from the challenged conduct? Do they face a substantial likelihood of liability for it? Or do they lack independence from someone who did? If enough directors are compromised, demand is excused. Same goal in both systems. Respect the board unless it cannot be trusted with the decision. The MBCA presumes a demand never hurts. Delaware lets a plaintiff prove it would be an empty ritual.

Safeguard three. Sending a demand does not guarantee a trial. Once the suit is filed, the corporation can move to dismiss, and the court must grant that motion if the right group makes the right finding. That after a reasonable inquiry, in good faith, the suit is not in the corporation's best interest.

Who is the right group? Independent directors. A majority of the board's qualified, disinterested directors, or a committee of two or more of them, or a panel the court appoints. In practice this is often a special litigation committee, a small group of independent directors who investigate the claim and recommend whether to pursue it or bury it.

The idea echoes the business judgment rule. Courts defer to a genuinely independent, informed, good-faith decision about the company's own litigation. But that deference has limits. The directors must actually be independent and the inquiry must actually be reasonable. And here is the point worth carrying. If the board was not majority-disinterested, the corporation bears the burden of proving those things, not the plaintiff.

Safeguard four, the exit, is court-controlled, and we will come back to it in the quick check. A derivative proceeding may not be discontinued or settled without the court's approval, and if a settlement would substantially affect other shareholders, the court may order that they be notified.

And then the money. Because the right enforced was the corporation's, a successful recovery goes to the corporation. The plaintiff's reward is reimbursement. A court may order the corporation to pay reasonable expenses, including attorney's fees, if the suit produced a substantial benefit. Which is Mara, in the second case. She finds the fraud, she funds the lawsuit, and the $1 million goes back into Delta Mills. Her fees are the whole of her reward.

There is a mirror image too. A plaintiff who sued without reasonable cause, or for an improper purpose, can be ordered to pay the defendants' expenses. That is the built-in deterrent against strike suits.

Now LLC members, and the good news is that it tracks the corporate model closely. Same fork. Same two-part test. Change the label from shareholder to member. A member sues directly to enforce their own rights, subject to that § 901 gate. A member sues derivatively to enforce a right of the LLC, with any recovery going to the LLC.

The one difference worth committing to memory is demand. Under § 902, a member may maintain a derivative action in two situations. First, the member demands that whoever runs the company bring the action, and they fail to do so within a reasonable time. Or second, such a demand would be futile.

Two things in that sentence. The demand goes to whoever actually runs the company. Managers if it is manager-managed, the other members if it is member-managed. And unlike the corporate universal-demand rule, the LLC act keeps the futility escape hatch. So try it. Riverbend Cafes is a manager-managed LLC. Manager Dana signs a lease on the LLC's behalf with a building Dana secretly owns, at inflated rent that drains the company. Member Pilar wants to sue.

Pilar's demand would go to the managers. But Dana is a manager and the wrongdoer, and Dana controls that decision. So Pilar may be able to plead that demand would be futile and sue without making one. That is an option the corporate rule would have denied her. Compare Ben, who had to demand and wait 90 days on facts just as hopeless. Same conflict, two different answers, because one is a corporation and one is an LLC.

Three more LLC provisions round it out. There is § 903, the proper plaintiff. They must be a member when the suit is filed. And either have been one when the wrong occurred, or have become one by operation of law. Then § 905, which lets the LLC appoint an independent committee much like the corporate one. And § 906, which sends any recovery to the company, with reasonable expenses available to a successful plaintiff.

Finally, partnerships mostly avoid this machinery altogether. Because every partner already has direct access to the firm's affairs and books, a partner may simply sue directly, against the partnership or another partner, to enforce the partner's rights. There is no true derivative suit in the general partnership act. So on the exam, the word derivative almost always signals a corporation or an LLC.

A word on authorities, because this episode named no cases, and that was deliberate. This topic is unstarred, which means the exam may hand you the governing statute, an MBCA or LLC act excerpt. It tests whether you can spot the issue and apply it, not the memorized citation. Read any provided text slowly, because the small words are where the answer hides.

If you keep only three things, keep these. The two-part question, who was harmed and who would be paid, because it decides everything downstream. Universal demand under the MBCA, 90 days, no futility excuse. And the fact that the entity keeps the recovery while the plaintiff recovers only expenses.

Now the traps. One. Calling a claim direct just because the plaintiff's shares lost value. A drop in share price caused by harm to the company is derivative. Two. Reaching for the old special-injury test. The modern test asks who was harmed and who is paid, so a harm shared by every shareholder can still be derivative.

Three. Forgetting universal demand under the MBCA. There is no futility excuse for corporations. Demand and wait 90 days, even against an obviously conflicted board. Four. Importing that rule into LLCs. The LLC act keeps futility, and there the demand runs to managers or members depending on how the company is managed.

Five. Assuming the plaintiff pockets the recovery. In a derivative suit the entity is paid, and the plaintiff recovers only expenses and fees. Six. Overlooking contemporaneous ownership. Someone who bought in after the wrong generally cannot bring the claim. And seven. Letting a derivative case settle privately. Settlement and dismissal both require court approval.

Time for the quick check. This one comes straight from the BARGO question bank.

In a pending derivative suit, the plaintiff shareholder and the defendant directors quietly reach a private deal. The directors will pay the plaintiff's attorney a comfortable fee, the plaintiff will dismiss all claims with prejudice, and the corporation itself will receive nothing. They file a joint stipulation asking the clerk to dismiss, without notifying the other shareholders or seeking any judicial review of the terms.

How should the court treat that dismissal? Option one. It takes effect automatically once both parties stipulate to it. Option two. It is valid, because the plaintiff controls his own claim. Option three. The court must approve any settlement, and the shareholders may need notice. Pause here if you want a moment.

The answer is option three. A derivative proceeding may not be settled or dismissed without the court's approval, and if the deal would substantially affect other shareholders, the court may order that they be notified. That safeguard is aimed squarely at this maneuver, where the plaintiff takes a private payoff and drops claims belonging to the whole corporation.

Options one and two make the same mistake. They assume the plaintiff can end the case on his own. He sued on the corporation's behalf, and he cannot privately trade away the corporation's claim.

That is the strike suit those safeguards were built to stop. There are thirty-plus more questions on this topic alone.

Five things to take away. One. Ask two questions. Who suffered the harm, and who would keep a recovery? Both point to the entity, it is derivative. Both point to the owner, it is direct. Two. Ignore special injury. A harm felt by every shareholder alike can still be derivative, and a falling share price is an echo of the company's loss.

Three. For derivative suits run the checklist. Standing, including contemporaneous ownership. Demand. Board dismissal by independent directors. And court-approved exit. Four. Under the MBCA demand is universal, 90 days, no futility. Under the LLC act futility survives. Five. The entity keeps the recovery, and the plaintiff recovers expenses and fees.

Which brings us back to Mara. In the first case she keeps every dollar. In the second she keeps none of it, and she is the one who did the work. Nothing about the wrongdoer changed. What changed is whose right was injured. Ask that first, every time. Next time, Liability and Veil-Piercing.

Practice this topic with more than 2,900 exam-style questions, free to start, at nextgenbargo.com. This episode is for education and exam preparation only, not legal advice, and we are not affiliated with or endorsed by the NCBE or any bar examining authority.