TEXAS SUPREME COURT TACKLES SHAREHOLDER DERIVATIVE CLAIMS IN CLOSELY HELD CORPORATIONS

Last summer in Ritchie v. Rupe, when the Supreme Court of Texas killed off the cause of action for “minority shareholder oppression,” it pointed to shareholder derivative claims as an alternative that shareholders in closely held corporations might pursue. Now, in Sneed v. Webre, the Court has articulated several important principles with respect to such derivative cases:

• The “business judgment rule” applies as a defense to derivative claims involving closely held corporations, just as it does in other cases;
• The courts cannot create by implication prerequisites or requirements for a derivative suit involving a closely held corporation that the Legislature has expressly removed by statute; and
• Texas “recognizes the availability of double-derivative standing for shareholders of a closely held parent corporation to assert a derivative action on behalf of a wholly-owned subsidiary. 

The statutory framework for shareholder derivative actions in Texas was for years found in § 5.14 of the Texas Business Corporation Act. In 2010, those principles were migrated to §§ 21.551–.563 of the Business Organizations Code. Because “a corporation should be run by its board of directors, not a disgruntled shareholder or the courts,” the TBCA (and now the TBOC) included a number of threshold requirements before a “disgruntled shareholder” could pursue a derivative claim on behalf of a corporation—e.g., a demand must first be made to the board that the corporation itself pursue the claim in question, and an opportunity must be provided for an independent and disinterested evaluation of the proposed claim that can lead to dismissal of the putative derivative suit if pursuing it is not in the corporation’s best interest. With respect to closely held corporations, however—those with fewer than 35 shareholders and not traded or quoted on a national exchange or market—the Legislature elected to remove most of those threshold requirements and procedures. “Remarkably,” the Court observed, “the Legislature even removed the requirement that a [derivative] shareholder … fairly and adequately represents the interests of the corporation in enforcing the right of the corporation.” And it is that statutory context that largely governed the outcome of this case.

At the outset, the parties wrangled over the applicability to closely held corporations of the “business judgment rule”—i.e., that corporate fiduciaries like directors and officers will not be liable and their decisions will not be second-guessed by the courts if made “within the exercise of their discretion and judgment in the development or prosecution of the enterprise in which their interests are involved.” The derivative plaintiff in Sneed contended the rule had no place at all in claims involving closely held corporations; the defendants and corporations countered that the rule applied not only to the merits of the claims, but also stood as a barrier to the case proceeding at all, unless the derivative plaintiff could prove the board’s refusal to pursue the claims at issue was, itself, outside their protected “business judgment.” The Supreme Court rejected both arguments. The Court first held that nothing in the statutory scheme altered the viability of the business judgment rule as a defense and, therefore, “The business judgment rule continues to apply to the merits of a derivative proceeding, whether brought on behalf of a closely held corporation or any other corporation ….” On the other hand, because the Legislature had by statute stripped the threshold requirements of demand and independent review from derivative cases involving closely held corporations, the Court held such constraints could not be re-imposed by the judiciary by way of requiring that the derivative plaintiff first prove the board’s refusal to bring the proposed claims went “beyond unsound business judgment.” “[B]y removing the demand requirement, the Legislature gave shareholders of closely held corporations the right to pursue corporate causes of action derivatively without interference from the board of directors,” and further, “the Legislature removed the ability for disinterested and independent directors or a special investigation committee to decide whether continuing the derivative proceeding is in the best interest of the corporation.”

In addition to its principal ruling, the Court also held that, because shareholders of a corporation are “beneficial” or “equitable” owners of its assets, a shareholder of a parent corporation has standing to pursue a “double-derivative” claim on behalf of its wholly owned subsidiary. Finally, the Court noted in passing the provision of former TBCA § 5.14(L) (now, TBOC §21.563(c)), which authorizes a court to treat a derivative proceeding involving a closely held corporation like a direct action and allow the plaintiff shareholder to recover directly, rather than having any award paid to the corporation. The Court then observed, as have certain courts of appeals, that even in that situation, “the proceeding still must be derivative.” Like the courts of appeals before it, however, the Supreme Court did not explain what that meant in practical effect, other than to say that the right to such treatment was not “absolute.”