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Standing Issues in Derivative Actions

Defense Update (Spring 2004)

“I sink in deep mire, where there is no standing: I am come into deep waters, where the floods overflow me.”1

In defending any action, one of the first things defense counsel must ascertain is whether the client even needs to answer. A key avenue to challenging a petition could be the plaintiff’s lack of standing to bring the particular claim or claims. While defense counsel may not give plaintiff’s standing even an initial thought in most tort or breach of contract cases, standing issues may play a large role in derivative litigation. King David’s lament in the second verse of the sixty-ninth Psalm could quickly turn into a plaintiff’s lament if the plaintiff fails to follow certain procedures before suing in the right of a corporation, or mistakes an individual action for a derivative one.

This article is intended as a primer on standing issues in derivative litigation. Specifically, this article will address the difference between individual and derivative claims, focusing on the 2001 Iowa Supreme Court decision in Rieff v. Evans (Rieff I)2; the requirements plaintiffs standing in the shoes of a business must meet before suing on the business’s behalf; the small changes the Iowa General Assembly made to those requirements effective January 1, 2003; and how those requirements differ between corporations and limited liability companies.

AUTHORITY TO ASSERT DERIVATIVE CLAIMS

The right of shareholders to sue on behalf of corporations is “unequivocally recognized” by Iowa Code section 490.740 et seq.3 Section 490A.1001 similarly unequivocally provides for a right of a member of a limited liability company to bring an action in the right of the LLC.4 Limited partners have standing to bring derivative actions on behalf of limited partnerships pursuant to Iowa Code section 487.1001.5 Finally, Iowa case law grants policyholders of a mutual company the right to bring derivative suits.6 Consequently, Iowa law answers the basic standing question—derivative suits are allowed.

Nevertheless, other considerations may “sink in deep mire” a plaintiff’s standing to bring a derivative claim. Before evaluating standing issues in derivative claims, though, it is important to understand exactly what a derivative claim is, and how it differs from an individual claim. Iowa Code section 490.740 provides that “derivative proceeding” is “a civil suit in the right of a domestic corporation or, to the extent provided in section 490.747, in the right of a foreign corporation.”7 As stated by the Iowa Supreme Court, “A derivative lawsuit is unique in that the shareholders allege the company’s directors have directly harmed it by their acts and omissions such that the company has suffered a loss. The shareholders indirectly assert their rights through the rights of the company.”8 A derivative proceeding is analogous to a “next friend” suit on behalf of an individual.9

Most derivative claims are brought against officers or directors of the corporation. After all, it is unlikely that those responsible for bringing an action on behalf of the corporation will institute a corporate action against themselves.10 That problem could be addressed by allowing shareholders to sue in their own right for harms inflicted on the corporation by its officers and directors.11 Generally, however, “shareholders have no claim for injuries to their corporations by third parties unless within the context of a derivative action.”12 This limitation on standing to bring individual shareholder actions is important for a number of reasons. Most significantly, and stated generally, limits on individual shareholder actions help avoid corporate and judicial waste. As noted by the Second Circuit Court of Appeals, “the stake of each shareholder in the likely return is usually too small to justify bringing a lawsuit,” and a large number of such suits results in a waste of resources.13 Thus, in light of 1) the need to hold officers and directors accountable, and 2) to limit individual shareholder actions, equity courts developed the shareholder derivative action.14

THE DIFFERENCE BETWEEN INDIVIDUAL AND DERIVATIVE CLAIMS

Despite the general rule that shareholders may only seek injuries to their corporations in the context of derivative proceedings, there is an exception: “[A] shareholder has an individual cause of action if the harm to the corporation also damaged the shareholder in his capacity as an individual rather than as a shareholder.”15 At first glance, the distinction appears nebulous. In the end, in the most instances the shareholder only has an injury because she is a shareholder. Digging deeper, though, the exception requires the shareholder “to show that the third-party owed him a special duty or that he suffered an injury separate and distinct from that suffered by the other shareholders.”16 (Of course, where there is a special duty, there will often by a special injury.17)

An examination of the 2001 Iowa Supreme Court decision in Rieff v. Evans aids an understanding of the demarcation between derivative and individual claims in Iowa law. In Rieff, the plaintiffs—policyholders of a mutual company—asserted five derivative claims and three class action claims against two insurance companies and numerous individuals who served as directors of the mutual company.18 According to the policyholders’ allegations, the mutual company—Allied Mutual—incorporated Allied Group, with Mutual having 100% control of Group.19 The companies shared many of the same directors.20 A series of transactions from 1985 to 1993, however, resulted in a role reversal, with Group ending up in control of Mutual.21 The policyholders alleged the transactions resulted in Mutual exchanging assets worth more than $900 million for consideration of just $126 million.22 The result was a de facto demutualization, which requires “follow[ing] strict [statutory] guidelines ensuring fairness to [the] policyholders.”23

The five derivative claims asserted by the plaintiffs were: breach of fiduciary duty, waste of corporate assets, improper transfer of control; intentional interference with business advantage and contracts; and equitable relief.24 The three direct class action claims were: de fact conversion, breach of fiduciary duty, and intentional interference with advantageous business and contractual relationships.25

As is evident, the derivative and individual claims overlapped in some respects, underscoring the nebulous nature of the distinction between derivative and individual shareholder/policyholder claims. The defendants in Rieff I, in fact, “suggested that the class claims were really derivative claims in sheep’s clothing.”26 The Iowa Supreme Court agreed with that assessment regarding the policyholders’ intentional interference class claims, which the policyholders also asserted as a derivative claim. With respect to that claim, the Court stated:

If the directors of a mutual corporation interfere with its ability to conduct business and enter into contracts, this injures the corporation directly, and only indirectly, the policyholders. This is akin to a corporate waste claim, which is a classic derivative injury. Under such a scenario, there is no special, individual injury distinct from the corporation’s. Moreover, this claim was correctly brought derivatively . . . .27

The Court allowed the other two direct claims to go forward, however. The Court allowed the de facto conversion claim because under Iowa Code chapter 515G requires certain steps for a mutual company to demutualize, including notice and a vote on that decision.28 If the approved demutualization takes place, the policyholders are due a payout, such as stock offers or dividends.29 This payout the policyholders alleged they were due “was never something the corporation was entitled to.”30 Consequently, the mutual company suffered no injury as the result of the de facto demutualization, and the policyholders were the only injured parties.31

The direct breach of fiduciary claim, which was also brought as a derivative claim, was a closer call than the direct conversion claim. The plaintiffs argued the applicability of the special injury exception, stating that the transfer of the surplus of Mutual to Group deprived them of the benefit of the surplus through “reduced premiums or a declared dividend.”32 It is difficult to distinguish that claim from a loss of corporate assets due to director malfeasance, which may reduce a shareholder’s dividend but is really a direct injury to the corporation and only an incidental injury to the shareholder. Nevertheless, the Rieff I Court held there was “enough separateness” between the class action and derivative breach of fiduciary claims to get past the motion to dismiss stage.33 This was due to the “unusual circumstances of the fact pattern alleged.”34 The lesson to take, though, is that under normal circumstances a breach of fiduciary duty claim will be derivative rather than individual.35 Moreover, it is possible after the commencement of discovery, facts could have developed that would have led the court to determine the derivative and class action breach of fiduciary duty claims were in reality the same claim.36

Despite the example provided by Rieff I, distinguishing between derivative and individual claims remains difficult. One resource recommends asking two essential questions, a restatement of the special injury and special duty exceptions: “The basic tests are: (1) Who suffered the most immediate and direct injury? If the corporation, the suit is derivative. (2) To whom did the defendant’s duty run? If the corporation, the suit is derivative.”37

RESTRICTIONS ON STANDING TO BRING DERIVATIVE SUITS

While Iowa law may unequivocally recognize the right to bring a suit in the right of a corporation or LLC, the right is not unconditional. Litigation is costly and is obviously not always the best use of company resources.38 Businesses, through their officers and directors (or members or managers, or general partners), must have significant control over the decision whether to institute a legal action. Consequently, even though derivative litigation addresses a need to hold officers and directors accountable,39 restrictions on standing to sue in the right of a company are important. As stated by the Second Circuit Court of Appeals:

Since any judgment runs to the corporation, shareholder plaintiffs at best realize an appreciation in the value of their shares. The real incentive to bring derivative actions is usually not the hope of return to the corporation but the hope of handsome fees to be recovered by plaintiffs’ counsel. . . .

However, there is a danger in authorizing lawyers to bring actions on behalf of unconsulted groups. Derivative suits may be brought for their nuisance value, the threat of protracted discovery and litigation forcing settlement and payment of fees even where the underlying suit has modest merit. Such suits may be harmful to shareholders because the costs offset the recovery.40

Addressing derivative actions on behalf of corporations first—shareholders must meet certain statutorily imposed obligations before bringing an action on behalf of a corporation. First, they must have been a “shareholder of the corporation at the time of the act or omission complained of.”41 Second, they must be “[f]airly and adequately represent[ing] the interests of the corporation in enforcing the right of the corporation.”42 Third, they must have made “[a] written demand . . . upon the corporation to take suitable action.”43 Finally, the corporation must have notified the shareholder that the corporation has rejected the demand, “[n]inety days have expired from the date the demand was made,” or “irreparable injury to the corporation would result by waiting for the expiration of the ninety-day period.”44 If a shareholder fails to follow these steps, a derivative complaint is subject to attack in a motion to dismiss. All of these obligations were essentially also part of the Code prior to the 2002 amendments.45 One difference is the addition of the ninety-day period corporations have to respond absent a showing of irreparable injury. The previous Code provision merely stated the shareholder could due if the demand was “ignored.”46 Additionally, the previous Code provision allowed a complainant to state the reasons why if a complainant chose not to make a demand.47 The new Code provision thus provides greater specificity—refusal, ninety days, or irreparable injury—and expressly disallows the ability of a shareholder to sue without making a demand, even if the demand would be obviously futile.

These specific requirements do not need to be met if the action is brought in the right of a foreign corporation.48 Instead, the laws of the jurisdiction of incorporation are applicable,49 though many jurisdictions impose similar requirements.

Even if a shareholder has met the requirements to institute a derivative proceeding, the court may stay the proceeding for whatever time period the court deems appropriate “[i]f the corporation commences an inquiry into the allegations made in the demand or complaint.”50 Moreover, court approval is required for a discontinuance or settlement of a derivative suit.51 These statutory requirements were additionally part of the Code prior to the 2002 amendments.52

Significantly, though a shareholder may have met all of the requirements of bringing a derivative suit, the Iowa Code provides a further protection to officers and directors (and, nominally, the corporation) from having to defend against such suits. The added protection was part of the 2002 amendments, effective January 1, 2003, and thus not available to the Rieff I defendants. New Iowa Code section 470.744 provides that if a statutorily specified group “has determined in good faith after conducting a reasonable inquiry upon which its conclusions are based that the maintenance of the derivative proceeding is not in the best interests of the corporation,” then the court must dismiss the suit.53 That group may be any one of the following:

• “A majority . . . of independent directors present at a meeting of the board of directors if the independent directors constitute a quorum.”54
• “A majority . . . of a committee consisting of two or more independent directors appointed by majority vote of independent directors present at a meeting of the board of directors, whether or not such independent directors constitute a quorum.”55
• A court-appointed panel of one or more independent persons, appointed on motion by the corporation.56

The corporation has the burden of proving the requirements—determination in good faith, reasonable inquiry—for dismissal on this basis have been met where the majority of directors are not independent.57 The plaintiff has the burden of proving the requirements have not been met where a majority of the directors are independent, or in the case of a court-appointed panel.58 Significantly, that the petition names a director as a defendant in the proceeding does not “by itself” mean that the director is not independent.59 Additionally, that a director has been nominated by defendant directors or that a director approved of the act the petition challenges likewise do not by themselves make a director not independent.60

There are a couple of other things worth noting from the Iowa Code regarding derivative actions. First, derivative actions are suits in equity.61 As a result, there is no right to a jury trial in derivative proceedings.62 Second, Iowa Code section 490.746 allows a court to award attorney fees to the plaintiff if the court finds “finds that the proceeding has resulted in a substantial benefit to the corporation,” and to the defendants if the court “finds that the proceeding was commenced or maintained without reasonable cause or for an improper purpose.”63

DERIVATIVE CLAIMS UNDER THE LIMITED LIABILITY COMPANY CHAPTER

Limited liability company members may also bring a derivative action on behalf of their LLC. As noted above,64 Iowa Code section 490A.1001 expressly grants them that right.

Even absent section 490A.1001, it is likely members of LLCs would have standing to bring derivative actions. One of the main issues the Rieff I Court addressed was whether enactment of section 490.740 abrogated the common law right of policyholders to bring derivative suits, with section 490.740 exclusively providing that right in all corporate contexts.65 Because section 490.740 only acknowledges shareholder derivative suits, the defendants argued policyholders of mutual companies lacked standing to sue in the right of their company.66 The Court rejected that argument, holding section 490.740 did not overrule the recognition in earlier case law of the right of policyholders to bring derivative claims.67 The Court noted that chapter 490, under section 490.1701(2), does not apply to “‘a corporation organized on the mutual plan under chapter 491.’”68 Consequently, section 490.740 could not have abrogated policyholder derivative suits because section 490.740 has no application to mutual companies and does not otherwise “purport to be the exclusive provider of derivative remedy for every corporate context.”69 Additionally, the United States Supreme Court and many state courts have expressly provided for or assumed policyholder derivative standing and “no court . . . has expressly said this right is unavailable to policyholders absent controlling statutory direction.”70

The Rieff I Court also, quoting earlier case law, stated policy reasons for allowing derivative suits:

“[W]e have long recognized the right and obligation of the courts to vindicate wrongs done to corporations by others, whether they be officers, directors or strangers. . . . We have also permitted derivative actions. The derivative action is a unique judicial device by which those who hold the public franchise may seek redress in behalf of the corporation for wrongs done to it. Although the right to seek derivative relief is subject to abuse, it is essential as a means to permit correction of intracorporate wrongs.”71

Moreover, “[u]sually the wrongdoing officers . . . possess the control which enables them to suppress any effort by the corporate entity to remedy such wrongs.”72 Equity thus supports derivative proceedings.73 It is hard to imagine the Court would not consider that policy rationale applicable in the context of LLCs as well.

The basic requirements a member must meet before instituting a claim in the right of the LLC are substantially the same as the requirements the law imposes on shareholders of a corporation. The plaintiff must have been a member at the time the act complained of occurred, must be fairly and adequately representing the members’ interests, must have made a demand on the LLC to sue in its own right, and the LLC must have refused to bring the action or failed to respond to the demand after “adequate time.”74 Additionally, the LLC must be manager-managed or member-managed by the plaintiff member lacks the “authority to cause the [LLC] to sue in its own right under the provisions of the articles of organization or an operating agreement.”75

There are a few distinctions between the LLC derivative actions statute and the corporate derivative actions statute. There is nothing in the LLC statute about irreparable injury exception to waiting period. However, in a practical sense, that may be inconsequential. “Adequate time” is certainly more flexible than “ninety days,” and is more analogous to the previous allowance of a shareholder derivative suit if the demand was “ignored.” “Adequate time” may be much shorter than ninety days, especially where the plaintiff can show irreparable injury if there is further delay. In that sense, the “adequate time” requirement impliedly provides for an “irreparable injury” showing, allowing the plaintiff to sue sooner than normally allowed.

Additionally, there nothing in the LLC statute about staying proceedings while the company investigates whether to bring the claim.

There is finally nothing in LLC statute about required dismissal (though with LLC, there is nothing corresponding to “independent” directors).

The extent these distinctions hold any practical significance is, at this point, speculative. There are no Iowa appellate cases interpreting the LLC derivative action statute.

BASIC CONSIDERATIONS

In summary, the following are some basic questions defense counsel should ask themselves when asked to defend a derivative suit:

• Is the plaintiff a shareholder or member of the company on whom the plaintiff purports to act?
• Was the shareholder or member a shareholder or member at the time the act complained of occurred?
• Can the shareholder or member be said to be representing the interests of the company?
• Did the shareholder or member make a demand on the company to bring a suit on its own behalf?
• If so, did the company refuse to do so, or, if the company is corporation, has at least ninety days past since the shareholder or member made the demand?
  

If the answer to any of those questions is “no,” then the plaintiff’s petition is subject to attack for lack of standing, and defense counsel should proceed with a motion to dismiss or a motion for summary judgment.

If the plaintiff has surpassed all of these hurdles to suing in the right of the corporation or LLC, the plaintiff will have avoided “sink[ing] in deep mire, where there is no standing.”

___________________________

1 Psalm 69:2 (KJV).
2 630 N.W.2d (Iowa 2001).
3 Rieff v. Evans, 630 N.W.2d 278, 283 (Iowa 2001) (Rieff I).
4 See IOWA CODE § 490A.1001 (2003) (“A member may bring an action in the right of the limited liability company to recover a judgment in its favor if all of the following conditions are met . . . .”).
5 See Id. § 487.1001. This article only specifically addresses shareholder, policyholder, and member derivative actions. However, many of the same principles discussed will also apply to suits in the right of limited partnerships
6 Rieff I, 630 N.W.2d at 287.
7 IOWA CODE § 490.740(1) (2003).
8 Weltzin v. Nail, 618 N.W.2d 293, 295 (Iowa 2000).
9 Rieff I, 630 N.W.2d at 288 (citing Koster v. (American) Lumbermens Mut. Cas. Co., 330 U.S. 518, 522-23 (1947)).
10 WILLIAM A. KLEIN ET AL, AGENCY, PARTNERSHIPS, AND LIMITED LIABILITY ENTITIES 334 (2001).
11 CHARLES R.T. O’KELLEY & ROBERT B. THOMPSON, CORPORATIONS AND OTHER BUSINESS ASSOCIATIONS 395 (3d ed. 1999).
12 Engstrand v. West Des Moines State Bank, 516 N.W.2d 797, 799 (Iowa 1994).
13 Joy v. North, 692 F.2d 880, 886-87 (2d Cir. 1982).
14 O’KELLEY, supra note 11, at 395.
15 Engstrand, 516 N.W.2d at 799.
16 Rieff I, 630 N.W.2d at 293-94 (emphasis added).
17 See id. at 294 (“We have recognized that when a special duty is present, the shareholders suffer a harm not suffered by the corporation itself . . . .”).
18 Id. at 281-83.
19 Id. at 282.
20 Id.
21 Id.
22 Id. at 283.
23 Id. “Demutualization occurs when a private mutual company converts to a publicly held stock company.” Id.
24 Id.
25 Id.
26 Id. at 292.
27 Id. at 295 (citing Whalen v. Connelly, 545 N.W.2d 284, 292 (Iowa 1996); Economy Roofing & Insulating Co. v. Zumaris, 538 N.W.2d 641, 652 (Iowa 1995)) (citations omitted from text).
28 Id. at 294 (citing IOWA CODE § 515G.4, .6).
29 Id. (citing IOWA CODE § 515G.3).
30 Id.
31 Id.
32 Id.
33 Id. at 295.
34 Id.
35 See id. (“We . . . recognize that a breach of fiduciary duty is generally recognized as a derivative claim.” (citing Weltzin v. Nail, 618 N.W.2d 293, 299 (Iowa 2000); Cunningham v. Kartridg Pak Co., 332 N.W.2d 881, 883 (Iowa 1983))).
36 Cf. id. (“[T]his claim is somewhat entwined with . . . the derivative claim . . . .”).
37 See KLEIN, supra note 10, at 334.
38 O’KELLEY, supra note 11, at 395.
39 See supra note 10 and accompanying text.
40 Joy v. North, 692 F.2d 880, 886-87 (2d Cir. 1982).
41 § 490.741(1).
42 Id. § 490.741(2).
43 Id. § 490.742(1).
44 Id. § 490.742(2).
45 See IOWA CODE § 490.740 (2001).
46 Id. § 490.740(2).
47 Id.
48 § 490.747.
49 Id.
50 § 490.743.
51 § 490.745.
52 See IOWA CODE § 490.740(2)-(3) (2001).
53 § 490.744(1). Section 490.744(1) opens: “A derivative proceeding shall be dismissed by the court on motion by the corporation if . . . .” Id. (emphasis added).
54 § 490.744(2)(a).
55 § 490.744(2)(b).
56 § 490.744(6).
57 § 490.744(5).
58 Id. § 490.744(5)-(6).
59 Id. § 490.744(2).
60 Id. § 490.744(1), (3).
61 Rieff v. Evans, No. 136/02-0727 (Iowa Dec. 17, 2003) (Rieff II) (citing Weltzin v. Nail, 618 N.W.2d 293, 297 (Iowa 2000).
62 Id.
63 Iowa Code § 490.746.
64 See supra note 4 and accompanying text.
65 Rieff I, 630 N.W.2d at 286.
66 Id.
67 Id. at 287. The main earlier cases recognizing a policyholder’s right to sue derivatively were Rowen v. LeMars Mut. Ins. Co., 230 N.W.2d 905 (Iowa 1975) (Rowen I) and Rowen v. LeMars Mut. Ins. Co., 282 N.W.2d 639 (Iowa 1979) (Rowen II). See id. (“We feel our past cases, especially our Rowen jurisprudence, provide [the necessary] authority.”).
68 Id. at 286-87 (citing Iowa Code § 490.1702(2) (2003)) (emphasis in original).
69 Id. at 287.
70 Id. at 287-88.
71 Id. at 286 (quoting Rowen v. LeMars Mut. Ins. Co., 230 N.W.2d 905, 916 (Iowa 1975)) (alteration and ellipsis in original; emphasis added).
72 Id. at 288.
73 Id.
74 § 490A.1001.
75 Id.