Shareholders in closely held corporations can bring derivative suits that would be barred to shareholders in public corporations
When family businesses are run as closely held corporations, can a shareholder bring a derivative suit more easily than could a shareholder in a public company? And does organizing a family's business into different layers of subsidiaries insulate some actions from review?
This derivative suit was brought by the 24% owner of a closely held corporation, against the wishes of that corporation's board. The suit was prompted by a bad business deal that was actually entered, not by that corporation but instead by a wholly owned subsidiary focused on a specific line of business (making this a so-called "double-derivative claim").
The trial court dismissed for lack of standing. The court of appeals reversed, concluding that the controlling Texas statute does not impose the same hurdles to bringing a derivative suit for closely held corporations.
The Texas Supreme Court agreed with the court of appeals, remanding to the trial court for the claim to move forward.
Standing: The defendants argued that the deference generally shown to corporate boards in the form of the business-judgment rule should extend to a board decision whether to pursue a claim and, thus, a shareholder lacks standing to bring a claim of which the board disapproves.
The Court acknowledged that the business-judgment rule does indeed apply to protect the general decisions of boards, even boards of closely held corporations. But it rejected the argument that this created a shield against derivative claims.
The Court rested that analysis on the statute governing derivative suits, in which it found a Legislative decision that stakeholders in closely held corporations should have more ready access to derivative suits. The specific provision is former Article 5.14(L),1 which excluded closely held corporations from some of the particular formalities of bringing such suits — including requirements that the potential derivative claims first be presented to the board and giving the board the opportunity to bring them itself. Because the Legislature carved closely held corporations out of those requirements, the Court reasoned, using the business-judgment rule to create a barrier to derivative claims would would contravene the Legislature's intent.
The Court also rejected the argument that a shareholder must plead and prove particular conduct that violates the business-judgment rule in order to have standing. It noted the longstanding concern in Texas law with carefully distinguishing between the jurisdictional concept of standing (which, among other things, cannot be waived) and the more substantive aspects of whether a particular plaintiff's claim might be legally valid. In the context of shareholder suits, the Court noted that any "confusion is understandable" because the statute (and the literature about derivative claims) often speak about the substantive aspect of a plaintiff's claim using the term "standing."
Double-derivative claims: The plaintiff here was a sharehodler in a parent corporation and sued over a busines deal entered by its wholly owned subsidiary. In doing so, the plaintiff was asserting the corporation's right to, in turn, step into the shoes of its subsidiary. This type of claim has been dubbed a double-derivative suit.
The question before the Court was whether Texas should permit such a claim.
On this issue, too, the Court's analysis proceeds from Article 5.14 of the statute, this time focuding on the article's expansion of the term "shareholder" to also "include a beneficial owner whose shares are held in a voting trust or by a nominee on the beneficial owner's behalf." Tex. Bus. Corp. Act art. 5.14(A)(2). Placing particular emphasis on the word "includes," the Court declined to treat this list as exclusive. Instead, the Court viewed this as opening the door to more general concepts of equitable or beneficial ownership, such as a shareholder's indirect interest in property held by the corporation itself. The Court thus held that Texas law does permit a double-derivative suit.
There is one notable contrast between this statutory analysis and the Court's analysis of standing: This definition in Article 5.14(A) is not, structurally, limited to closely held corporations. The same definition of "shareholder" appears, by the text, to apply to all derivative suits.2 Nonetheless, the Court tells us in footnote 14 that it does not (yet, at least) intend its holding to reach beyond the very limited context here:
We limit our holding to the situation presented in this case in which a shareholder of a closely held parent corporation asserts double-derivative standing to assert a cause of action on behalf of a wholly owned subsidiary.
What is clear is that the Court's immediate concern is with the special problems of closely held corporations. It draws support for its understanding of the word "shareholder" in Article 5.14(A) from the Legislature's decision to exempt closely held corporations from certain procedural requirements for derivative suits. ("Our holding is once again buttressed by the fact that the Legislature made the statutory standing provisions of article 5.14(B) inapplicable to closely held corporations."). And it frames the policy concerns in terms of the impact on closely held corporations: "Were we to hold otherwise, the directors of a closely held holding corporation could create a wholly owned subsidiary to circumvent the Legislature’s intent to make it easier for shareholders to assert derivative claims on behalf of closely held corporations."