Monday, July 25, 2016

Direct v. Derivative under the Tennessee Business Corporation Act

In a recent decision of the Tennessee Supreme Court, Keller v. Estate of Edward Stephen McRedmond, Tennessee adopted Delaware's direct-versus-derivative litigation analysis from Tooley v. Donaldson, Lufkin, & Jenrette, Inc., 845 A.2d 1031 (Del. 2004), displacing a previously applicable test (that from Hadden v. City of Gatlinburg, 746 S.W.2d 687 (Tenn. 1988)).  Although this is certainly significant, I also find the case interesting as an example of the way that a court treats different types of claims that can arise in typical corporate governance controversies (especially in small family and other closely held businesses).  This post covers both matters briefly.

The Keller case involves a family business eventually organized as a for-profit corporation under Tennessee law ("MBI").  As is so often the case, after the children take over the business, a schism develops in the family that results in a deadlock under a pre-existing shareholders' agreement.  A court-ordered dissolution follows, and after a bidding process in which each warring side of the family bids, the trustee contracts to sell the assets of MBI to members of one of the two family factions as the higher bidder.  These acquiring family members organize their own corporation to hold the transferred MBI assets ("New MBI") and assign their rights under the MBI asset purchase agreement to New MBI

Prior to the closing, the losing bidder family member, Louie, then an officer and director of MBI who ran part of its business (its grease business), solicited customers and employees, starved the MBI grease business, diverted business opportunities from MBI's grease business to a corporation he already had established (on the MBI property) to compete with MBI in that business sector, and engaged in other behavior disloyal to MBI.  Louie's actions were alleged to have contravened a court order enforcing covenants in the MBI asset purchase agreement. They also were allegedly disloyal and constituted a breach of his fiduciary duty of loyalty to MBI.  Finally, they constituted an alleged interference with New MBI's business relations.  

Before granting relief on any of these claims, the court had to determine whether the actions were properly brought before it--namely, in this case, whether the proper plaintiffs had raised each of these claims for resolution by the court in this case (a matter earlier, but not initially, brought to the court's attention by the defendant).  Because only individual family members (the acquirors in the MBI asset purchase) were plaintiffs in the action, the court was required to focus on whether these individual plaintiffs could bring all of the legal actions identified in the complaint.  It was important, as part of this analysis, to understand whether the claims were the subject of direct or derivative actions.

After setting out the facts in some detail and describing extant standards for distinguishing direct from derivative actions, the court determined to adopt Delaware's Tooley standard to clarify the various factors involved in distinguishing direct from derivative claims and the way in which those factors are evaluated.  The court found the Hadden rule, while not vastly different in its overall coverage, less clear in application.  Both cases focus on the nature of the wrong, the party entitled to relief, and a direct injury to the plaintiff(s) independent of any corporate harm. Procedurally, "[t]he stockholder must demonstrate that the duty breached was owed to the stockholder and that he or she can prevail without showing an injury to the corporation."  Tooley, 845 A.2d at 1039.

To decide the case, the Keller court took each claim before it individually.  With respect to the violation of the trial court's order, the court found that

the Buyers were injured individually [by Louie's conduct] to the extent that they signed agreed orders and contracts regarding the purchase price of the original MBI‟s grease business assets, including its goodwill and business relationships. . . .  Protection of the status quo, so that the Buyers would receive the benefit of their bargain, was the express premise of the trial court's orders.

 With respect to the breach of fiduciary duty claim, the court concluded that

under Tooley, the Buyers' claim that Louie breached his fiduciary duty to MBI through mismanagement and self-dealing is derivative in nature and must be asserted derivatively on behalf of the corporation itself. Consequently, the Buyers do not have standing to recover individually for any harm resulting from Louie‟s breach of his fiduciary duty to the original MBI.

Query, however, whether any of Louie's actions also constituted a breach of fiduciary duty as among the shareholders of MBI as a closely held corporation.  Tennessee incorporates the Massachusetts close corporation rules from Donahue v. Rodd Electrotype Company of New England and Wilkes v. Springside Nursing Home.  That cause of action would be brought as a direct claim.  This may be a bit of a stretch in this case, and it likely wasn't adequately pleaded.  But it would be worth some thought, with the right facts to support the claim . . . .

Finally, as for the claim of intentional interference with business relations, the court found that the claim belonged to the New MBI, not the individual plaintiffs.  

[T]he Buyers did not themselves have business relations apart from their investment and involvement in [New MBI]. From our review of the Buyers' allegations, we agree with the Court of Appeals that the claim of “intentional interference with business relations” belongs to the Buyers' corporation . . . , not to the Buyers individually.

Three claims--two direct and one derivative; three separate plaintiffs--individuals and two different corporations--MBI and New MBI.  All of this seems right.

There is a lot of good doctrinal information in the Keller opinion.  But a big (yet exceedingly simple) lawyering lesson to be learned from all this is that plaintiffs' counsel must ensure that the appropriate plaintiffs are in front of the court for each of the claims made in the complaint.  And in that connection, in the context of Tennessee corporate fiduciary duty claims (where the legal action is likely to be derivative in nature), plaintiffs' counsel must pay attention to the Tooley standard in making the assessment as to the proper plaintiff.

The Keller opinion may even be worth a read for folks outside Tennessee for this reason.  Regardless, folks inside Tennessee surely should give it some attention.

http://lawprofessors.typepad.com/business_law/2016/07/direct-v-derivative-under-the-tennessee-business-corporation-act.html

Business Associations, Corporations, Delaware, Joan Heminway, Shareholders | Permalink

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