James R. Balmforth: Claims in a Business Divorce

When conflict within a privately owned company cannot be resolved through negotiation and the parties stand at the brink of filing litigation to resolve their disputes, the parties must analyze whether their claims are direct or derivative in nature. The distinction between direct and derivative claims and claim procedures may trap the unwary.

Direct Claims in a Business Divorce Case

Direct claims are those claims brought by an owner for losses suffered directly to that owner and are unique to the owner. In the personal injury context, the plaintiff is entitled to bring claims based upon their bodily injuries caused by the wrongful conduct of the defendant(s).Similarly, claims by a business owner must only be for the economic harm or equitable relief necessary to correct the wrong by the defendant(s).

Derivative claims are claims brought by an owner on behalf of or in the right of a corporation or LLC. The shareholder steps into the shoes of the company to enforce the rights of the company against the defendant(s).The owners’ claims arise because of their ownership in the company.

Stemming from these basic definitions are issues related to whether damages being sought are truly direct or damages suffered by all shareholders. If the damages claimed are suffered by all shareholders then the claim is not direct.

Derivative Claims in a Business Divorce

In Utah, the code discusses the necessary steps for a derivative claim. An LLC derivative proceeding is governed similarly under the Utah Code Annotated as well. First, a shareholder may not commence or maintain a derivative proceeding until it is established that the shareholder was an owner in the corporation at the time of the act or omission or became a shareholder through transfer by operation of law from someone who was an owner at the time of the wrongdoing. In addition, the shareholder must fairly and adequately represent the interest of the company in enforcing the rights of the company.

A shareholder may not start a derivative lawsuit until a written demand has been made upon the corporation to take suitable action to correct the wrongdoings and recover losses for the company. In addition, once a written demand is received, ninety days must expire from the date of the demand before a lawsuit may be commenced. Exceptions to this rule exist when the demand has already been rejected, the statute of limitations will expire within the ninety days, or irreparable injury to the company would result by waiting for the expiration of the ninety days. The purpose of the written demand is to give the company an opportunity to investigate the claims and take action prior to being embroiled in litigation. If the corporation does commence an inquiry even after the demand and a Complaint has been filed the court may take action to stay the derivative proceedings for a period necessary to complete such investigation.

If the parties are now prepared to file their litigation, they must also comply with the Utah Rules of Civil Procedure. The Complaint should be verified and allege that the plaintiff was a shareholder or member of the company at the time of the transaction or obtained their ownership interest by operation of law from someone who was such an owner. The Complaint must further allege with particularity the efforts made to obtain the action desired from the directors or other management authority of the company and the reasons for the plaintiff’s failure to obtain the action sought or for not making such an effort. In addition, the plaintiff must demonstrate that they fairly and adequately represent the interest of all shareholders or members similarly situated in enforcing the rights of the company.

Termination of Derivative Proceedings

A derivative proceeding may not be dismissed or compromised without approval of the court after notice. On the termination of the derivative proceedings, the court may make orders with respect to expenses incurred including attorney fees. If the court finds that the plaintiff’s derivative action has resulted in a substantial benefit to the corporation it may order the corporation to pay the plaintiff’s expenses and fees. However, if the court finds that the derivative proceeding was commenced or maintained without reasonable cause or for an improper purpose, the court may order the plaintiff to pay all defendant’s reasonable expenses and fees.

The Utah statutes have a procedure which effectively terminates the plaintiff’s derivative claim and the right to be heard before a jury or a judge if certain conditions are met. First, if the corporation investigates the matter and resolves internally the issues raised in the derivative demand the basis for the lawsuit is eliminated. The second method available to obtain early termination of the litigation is for the corporation to move the court to appoint a panel of one or more independent persons to determine whether the maintenance of the derivative proceeding is in the best interest of the corporation. The court appointed panel, like the company appointed panel, must conduct a reasonable inquiry in good faith and if it concludes that the maintenance of the derivative proceeding is not in the best interest of the corporation, the corporation may ask the court to dismiss the claim. In sum then, the plaintiff’s claim falls to the hands of either a court appointed or company appointed independent panel to determine whether or not the claim should effectively be maintained in litigation. If in fact it is determined by this panel that the maintenance of the derivative proceeding is not in the best interest of the corporation, the plaintiff then has the burden to prove by clear and convincing evidence that the panel has not acted in good faith, may not have conducted a reasonable inquiry and has drawn a conclusion that is not in the best interest of the company.

In a business divorce context, plaintiffs pushing for separation who file direct or derivative claims, effectively have two fronts to attack the wrongdoers or those from whom they would like to separate. Derivative proceedings present a procedure that may reduce the cost of litigation by use of the independent panel. The pressures of litigation may force the parties to separate hopefully by settlement rather than litigation because of the direct or derivative claims.

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