The Interplay Between Shareholder Oppression Suits and Derivative Actions in Closely Held Corporations

 

by Hunter Schoen, Issue Editor

Introduction

In any corporation, minority shareholders are vulnerable to the decisions of majority shareholders. Majority shareholders can deny minority shareholders participation or financial rights, such as refusal to pay them dividends. In addition to this vulnerability, closely held corporations pose unique risks to minority shareholders because of the lack of marketability of their shares.[1] Unlike a typical corporation, there is no readily available market where minority shareholders of a closely held corporation can sell their shares.[2] Because of this lack of marketability, traditionally, the only remedy provided to minority shareholders was judicial dissolution under the Louisiana Business Corporation Law (“LBCL”). The LBCL, however, provided only meager protection to minority shareholders because courts were reluctant to enforce the remedy.[3] The Louisiana Business Corporation Act changed this lack of protection for minority shareholders.

On January 1, 2015, the Louisiana Legislature replaced the LBCL with the Louisiana Business Corporation Act (“LBCA”).[4] Among the rights and remedies created by the LBCA, the new statutory regime provides an alternative to judicial dissolution for minority shareholders in a closely held corporation—shareholder oppression suits.[5] Due to the relative youth of the LBCA, an attorney may not appreciate the interplay between a shareholder oppression suit and a derivative action—an action filed by a shareholder to challenge the actions of a corporation—and the consequences of filing one before the other. To adequately represent the interests of a minority shareholder, an attorney should be acutely aware of the interplay between the two.

 

Shareholder Oppression Suits vs. Derivative Actions

In a shareholder oppression suit, the shareholder withdraws from the corporation and receives compensation for the value of his or her shares. The LBCA provides, “If a corporation engages in oppression of a shareholder, the shareholder may withdraw from the corporation and require the corporation to buy all of the shareholder’s shares at their fair value.”[6] Under the LBCA, “oppression” is defined as when a corporation fails “to deal fairly and in good faith with the shareholder.”[7] Often, an act or omission by a corporation that constitutes oppression—making it an appropriate basis for a shareholder oppression suit—may also be the basis of a derivative action.

A derivative action asserts a right on behalf of the corporation.[8] An example of a derivative action is a suit filed for breach of fiduciary duty, such as misappropriation of corporate funds for personal expenses.[9] Although closely related, an important distinction between a shareholder oppression suit and a derivative proceeding is that an oppression suit is brought on behalf of a withdrawing shareholder and a derivative proceeding is brought on behalf of the corporation.[10] This distinction has significant procedural implications, namely the issue of standing, as well as substantive effects.

 

The Effects of Filing One Before the Other

To have standing to bring a derivative action, a shareholder must be “a shareholder of the corporation at the time of the act or omission complained of” and must “fairly and adequately represent[] the interest of the corporation in enforcing the right of the corporation.”[11] In a successful shareholder oppression suit, however, a shareholder withdraws from the corporation and thus loses standing to bring a derivative action, as the shareholder no longer adequately represents the interest of the corporation.[12] Therefore, before filing a shareholder oppression suit, a shareholder should assert all potential derivative actions.

In addition to the procedural implication of standing, a shareholder should file a derivative action first because a derivative action can potentially increase the fair value of a corporation’s stock. The derivative action can increase stock value in two ways: first, a corporation may be compensated through the litigation, thus increasing the fair value of each share; and second, a stayed derivative action is valued as an asset of the corporation.[13] Although any pending derivative actions are stayed upon the filing of a shareholder oppression suit,[14] the judge will nonetheless have to address the issues presented in the derivative action as they relate to the fair value of the corporation’s shares.[15] Given these effects, ideally a shareholder should file a derivative action before the institution of a shareholder oppression suit and have the action recognized as an asset. As judges and attorneys interact with the novel portions of the LCBA, however, this scenario will not always be the case.

What happens in the event an attorney does not file an applicable derivative action before filing a shareholder oppression suit, or a previously filed derivative action is not recognized as an asset? In these instances, a shareholder is not entirely out of luck. In a shareholder oppression suit, the litigation is largely based upon the fair value of the shares, not the withdrawal itself.[16] Expert testimony from a certified valuation analyst or an accredited business valuator can be used to determine the fair value of the shares. When valuing the shares of a closely held corporation for a buyout, fair value is calculated through investment value.[17] In valuing the shares based upon investment value, industry standards require the valuator to adjust the corporation’s books to account for misappropriated funds.[18] This valuation will effectively litigate the issues that would have been brought in the derivative action. Nevertheless, a derivative action should be filed before a shareholder oppression suit because it could be valued as an asset or addressed in a different manner by the judge on a case-by-case basis.[19]

 

Conclusion

With little to no jurisprudence stemming from the LBCA regarding shareholder oppression suits, an attorney may not realize the value of filing a derivative action before a shareholder oppression suit. When a derivative action is not asserted first, the relevant issues sought to be remedied in the action may be determined when valuing the stock. If the expert testimony is unconvincing or a judge does not interpret the expert testimony in the shareholder’s favor, the fair value of the stock may be lower than if a corporation’s harmful conduct was first challenged in a derivative action. Asserting derivative actions before filing a shareholder oppression suit will require the judge to address the pending litigation and formally bring to light issues that will affect the value of the stock before the shareholder oppression suit commences.

 

[1] Douglas K. Moll, Shareholder Oppression and the New Louisiana Business Corporation Act, 60 Loy. L. Rev. 461, 467 (2014).

[2] Id.

[3] See, e.g., Glenn G. Morris & Wendell H. Holmes, Business Organizations § 40.11, in Louisiana Civil Law Treatise (4th ed. 2013 & Supp. 2016).

[4] La. Rev. Stat. § 12:1-101 through 1-1704 (2017).

[5] Id. § 12:1-1435. Before the LBCA, the only remedy for an oppressed shareholder was involuntary dissolution under the LBCL. This drastic measure was frowned-upon by the courts and was rarely granted. Effectively, minority shareholders had no remedy in instances of shareholder oppression. See Morris & Holmes, supra note 3, § 22.08.

[6] La. Rev. Stat. § 12:1-1435A.

[7] Id. § 12:1-1435B.

[8] See id. § 12:1-741.

[9] See Moll, supra note 1, at 502.

[10] Compare La. Rev. Stat. § 12:1-1435A, with La. Rev. Stat. § 12:1-741.

[11] La. Rev. Stat. § 12:1-741A.

[12] See Maison Orleans P’ship in Commendam v. Stewart, 167 So.3d 1 (La. Ct. App. 2014) (holding that under the LBCL, petitioner gave up all rights to assert any claims, including derivative ones, when petitioning for dissolution).

[13] See Steven G. Durio et al., Louisiana Business Corporation Act is A Game Changer: A Discussion of Remedies and the Valuation Standard, 63 La. B.J. 396, 398 (2016).

[14] La. Rev. Stat. § 12:1-1437.

[15] Moll, supra note 1, at 505.

[16] See La. Rev. Stat. § 12:1-1436A(1).

[17] See, e.g., Blake v. Blake Agency, Inc., 486 N.Y.S.2d 341, 347 (N.Y. App. Div. 1985) (defining investment value as the earnings of the corporation).

[18] See, e.g., Raskin v. Walter Karl, Inc., 514 N.Y.S.2d 120, 121 (N.Y. App. Div. 1987). The adjustment of the books means that the valuator will add back the value of the misappropriated funds.

[19] Durio et al., supra note 13, at 398 (“While the LBCA is largely silent on handling such pending litigation, foreign jurisprudence indicates that these determinations will continue to occur on a case-by-case basis; Louisiana will likely follow this trend.”).

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