Alabama Supreme Court Defines Scope of Nonprofit Derivative Actions

Last month the Alabama Supreme Court decided, in a case of first impression for the state, that the Alabama Nonprofit Corporation Act permits derivative suits against board members' ultra vires acts, but does not allow derivative suits against third parties on behalf of the corporation.  In business corporation law, derivative suits are attempts by shareholders to substitute their judgment for that of directors when directors are unable to exercise independent judgment in pursuit of a claim on behalf of the corporation.  The classic example, of course, is when directors engage in self-dealing.  Its unlikely that directors will cause the corporation to sue themselves for self-dealing.  When shareholders are successful, they may sue the directors or any third party on behalf of the corporation.  In self-dealing cases, directors bear a heavy “entire fairness” burden to preclude shareholder derivative actions.  Entire fairness is to corporate governance law what strict scrutiny is to constitutional law.

In Ex parte Caribe Resort Condo Association Board of Directors, the Court ruled that the legislature’s decision to adopt all of the Model Nonprofit Business Corporation Act except subchapter D, relating to derivative actions, indicates that the legislature rejected a “general” right of derivative actions.  The Model Act, in Sections 7.40 – 7.48 allows nonprofit derivative actions with standing and demand requirements analogous to those applicable to for-profit corporations.  Thirty-seven states have adopted the Model Act, but only 7 have adopted it in its entirety.  

Although Alabama declined to adopt the Model Act's derivative action provisions, it specifically allows derivative suits against directors acting ultra vires, according to the Court.  Since directors usually act without authority when violating fiduciary duties, Alabama law necessarily allows nonprofit members to sue directors for the usual fiduciary violations typically asserted derivatively.  But because Alabama does not allow derivative suits generally, as is the case under the Model Act, members may not bring suits against third parties on behalf of the corporation.

Thus, the members in Ex parte Caribe were allowed to proceed derivatively against a director for the corporation's conflict-of-interest transaction with the director's wholly owned LLC, but they were not allowed to proceed derivatively against the LLC.  The Alabama Supreme Court relied on a similar holding by the Texas Supreme Court.   

darryll k. jones