Hostility Among Owners Blocks LLC Derivative Lawsuit

• A plaintiff seeking to bring a derivative claim on behalf of a corporation, limited liability company or limited partnership must be “suitable” and represent the interests of the business.

• A member of a limited liability company may sue individually to recover or protect the member’s individual right.  New Jersey law does not, however, permit a member to bring a claim for involuntary dissociation, or expulsion, as a direct claim.

• Courts have discretion to treat derivative claims as direct claims under New Jersey law, but may bar a derivate claim brought by a limited liability company that is antagonistic to the other owners.

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Hostility among the owners of a limited liability company is a staple in business divorce litigation, as are the derivative claims commonly asserted by the minority against the majority.  But one New Jersey court has dismissed minority derivative claims because that hostility, the court said, made the member an unsuitable derivative plaintiff.

Is this case, Cave v. Cave, from the Superior Court in Burlington County, an outlier?  Or does it merely reflect a more thorough analysis of the requirements for a derivative action.  If this decision were to be widely followed, it could change the landscape of litigation among the owners of closely held businesses.

Family Owned Business Subject of Derivative Claims

The dispute involved a family-owned business.  Lowell Cave and his daughter, Heather Cave, who together owned 52 percent of Shore Sand & Gravel, LLC sued Cave’s son, Aaron Cave, who owned the remaining 48 percent of the company and his own,  The case was initially filed in the Chancery Division seeking an injunction and claimed that Aaron was interfering with Lowell’s rights to manage the company, denying his father and sister access to business records, and was using company property without authorization.  The largely judge denied the request for an injunction, holding that the claim was essentially one seeking money damages ,and transferred it from Chancery to the Law Division.

Aaron counterclaimed, asserting that he had acted as the manager of the Shore Sand & Gravel and that he had constructed a sand washing facility that he owned individually under an agreement with his father and sister.  The counterclaim included derivative claims demands that his father and sister be expelled under the involuntary dissociation provision of the LLC statute.

The court’s decision turned on the suitability requirement of a derivative plaintiff and relied on cases that construed that requirement under federal law in class action cases.  That case, however, was a very different type of litigation than a business divorce involving a handful of members of a limited liability company or shareholders in a closely held corporation.

Derivative Claims are Actions on Behalf of the Company

The starting point for the discussion is the distinction between direct and derivative claims.  A derivative claim is an action brought by an equity holder of a corporation, limited liability company or limited partnership asserting a right that belongs to the business entity.

The recovery of a successful derivative plaintiff belongs to the business entity.  The derivative plaintiff, meanwhile, is typically entitled to a fee award because it has pursed the action for the benefit of others.

Derivative actions are common among publicly held corporations involving such disputed items as corporate waste, mergers and acquisitions on purportedly unfair terms or self-dealing by insiders.  Because the derivative claim in the context of a publicly held entity is often driven more by the class-action plaintiff’s bar than by the economic interest of any individual owner – whose stake in the successful outcome is commonly negligible – there are procedural limitations in place and a certain hostility in the court rules and applicable statutes.

These limitations on derivative actions are intended to prevent the “strike suit,” a term applied to a derivative claim in which the goal is not so much to recover a significant claim for the company or to bring about some needed change in corporate governance, but to secure a settlement motivated by the corporation’s desire to avoid litigation expenses.  In the process, the successful strike suit plaintiff secures a fee award for its counsel

Derivative claims are subject to the requirement that the plaintiff make a demand on the corporation to pursue the action, unless to do so would be futile.  N.J.S.A. 42:2C-68 provides that:

A member may maintain a derivative action to enforce a right of a limited liability company if:

1. the member first makes a demand on the other members in a member-managed limited liability company, or the managers of a manager-managed limited liability company, requesting that they cause the company to bring an action to enforce the right, and the managers or other members do not bring the action within a reasonable time; or

2. A demand under subsection a. of this section would be futile.

Court rules uniformly require that the derivative plaintiff plead that it has made demand, or that to do so would be futile.

A company that has received a demand can pursue the claim on its own or it can decide to conduct its own investigation and make a determination if the claim is worth pursuing.  It can also ignore the demand, which permits the derivative litigation to continue. Some states, such as Pennsylvania, impose stringent demand requirements on the derivative plaintiff and provide for a conclusive determination of whether the claim should be pursued by an independent committee investigating on behalf of the business entity.  If that committee decides not to pursue the claim, then it is difficult, if not impossible, for the plaintiff to proceed further.

Direct Claims Distinguished from Derivative Claims

A direct claim, meanwhile, involves a claim of harm done to the individual shareholder, member or limited partner.  The common examples include minority oppression, including exclusion from management, access to books and records, or breach of an Operating Agreement. N.J.S.A. 42:2C-67 provides these criteria:

1. … a member may maintain a direct action against another member, a manager, or the limited liability company to enforce the member’s rights and otherwise protect the member’s interests, including rights and interests under the operating agreement or this act or arising independently of the membership relationship.

2. A member maintaining a direct action under this section shall plead and prove an actual or threatened injury that is not solely the result of an injury suffered or threatened to be suffered by the limited liability company.

The distinction between direct and derivative actions blurs very quickly in the dispute involving a closely held business.  When there are only a handful of owners directly involved in the management of the business, all are directly impacted by the alleged failure of the entity to pursue a claim, enough so that courts in New Jersey (and several other states) may disregard the distinction between direct and derivative actions.

With all of this as background, we return to the Cave family.  The Revised Uniform Limited Liability Company Act (RULLCA) as it was enacted in New Jersey does not permit individual members to sue another member seeking involuntary dissociation.  The action must be brought by the company.  (For a discussion of the grounds for involuntary dissociation, see our post here., When Can a LLC Member Be Expelled?)

Dissociation Claim Brought as a Derivative Action

Aaron’s counterclaim alleged several counterclaims as a derivative plaintiff, including claims to amend the operating agreement and for breach of fiduciary duty.  Significantly for the purpose of our discussion, he sued derivatively to involuntarily dissociate his father and sister from Shore Sand, a claim that he brought derivatively because quite obviously they were not going to approve an action to expel themselves.

Father and sister then moved to dismiss the derivative claims, arguing that Aaron was an unsuitable plaintiff because of his hostility to the other members of the limited liability company, a motion granted by the Court.

And here is where the opinion would have a broader effect.  The RULLCA is a uniform law proposed by the Uniform Law Commission, an organization that seeks to promote uniform legal standards and develops model laws for adoption by the individual states. When New Jersey adopted the RULLCA, it did not include in a right of an individual member to sue another member for dissociation.  Instead, under the version adopted in New Jersey, only the company can sue for involuntary dissociation.

It is relatively common that a minority member of a limited liability will bring a claim for dissociation as a derivative action.  This may be a claim to remove the majority or to dissociate another member when the minority cannot secure the support of the majority members.

Unsuitable Plaintiff in Closely Held Derivative Claim

The plaintiffs sought to dismiss counterclaim based on the language of New Jersey Court Rule 4:32-3, which requires that a derivative action seeking to enforce the rights of an association “unincorporated or incorporated” – a limited liability company is an unincorporated business association – “fairly represent the interests of the shareholders or members similarly situated in enforcing the right of the corporation or association.”

The judge principally relied on a decision of the federal Third Circuit Court of Appeals, Vanderbilt v. Geo-Energy, Ltd.[1], in which the court construed Federal Rule of Civil Procedure 23.1 in a derivative claim brought as a class action.  The Vanderbilt court identified a number of elements to be considered to determine whether an individual seeking to represent a class of shareholders as a derivative plaintiff was “suitable.”

The elements to consider of whether the plaintiff is “antagonistic” to the other shareholders in that case are less important that the fact that in business divorce litigation involving a handful of owners, that antagonism is baked into the dispute.  The court noted that in seeking to dissociate his father, Aaron was not aligned with the other shareholder, something one would expect in that she was a party on the other side of the litigation.

The court also noted that the existence of the derivative claim created a conflict of interest for the attorneys involved in light of the existence of other claims.

Courts Have Discretion to Treat Derivative Claims as Direct Claims

It is notable that the court makes no mention in its reasoning of the binding Appellate Division decision in Brown v. Brown,[2] holding that trial courts have the discretion to treat derivative claims as direct when equity required.  The Brown court was considering a dispute between two 50-percent owners:

We see merit … in plaintiff’s contention that it would be inequitable to allow Terri Brown and Brown and Guarino to avoid answering for their conduct by invoking rules of standing that have been developed to meet concerns not present here.

The court dismissed all of the derivative claims with prejudice.  In a subsequently filed amended answer, The derivative claims have been deleted, so it appears that the court is barring Lowell as defendant from seeking to involuntarily dissociate his father as a derivative plaintiff.

The decision does not prevent a plaintiff from seeking somewhat similar relief as an oppressed minority under the statutory provision permitting judicial dissolution of a limited liability company.  That statutory provision has been interpreted to provide a court with broad discretion, including the compelled purchase or sale of an equity interest.

It is less than clear, however, whether the statute permits a court to strip the management rights away from a member without necessarily compelling the purchase of the dissociated member’s interest, a remedy that would be available in an involuntary dissociation.

[1] 725 F.2d 204, 207 (3d Cir. 1983)

[2] 232 N.J. Super. 30 (App. Div. 1999)