Challenges in Bringing Shareholder Claims

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We have previously written about intra-corporate disputes, i.e., disputes between shareholders in a corporation or other entity, such as an LLC, over the management of the entity. [1]  In Barefoot v. Barefoot, et al., 2022 NCBC 5 (Feb. 2, 2022), the North Carolina Business Court discussed the law on both derivative claims (shareholder claims brought on behalf of the entity) and direct claims (shareholder claims brought on behalf of the individual shareholder).  All the claims brought by the plaintiff, in that case, were dismissed, and the case highlights the difficulties that an individual shareholder may encounter in attempting to bring claims as a shareholder based on alleged mismanagement of the entity by other shareholders.

          The plaintiff in the case, Brett Barefoot, held a 10.6% minority interest in an LLC known as Robert & Sons (the “LLC”).  His three brothers, Quint, Heath, and Keith, also each held a 10.6% minority interest in the LLC.  Their mother, Iris, held a 57.6% majority interest through a trust and was the sole manager of the LLC.

          Relations among the family soured, leading Brett to file his lawsuit.  Brett attempted to allege both derivative claims and direct claims. 

Derivative Claims

          A derivative claim is one brought on behalf of the entity, for injuries to the entity.  Brett asserted derivative claims on behalf of the entity for constructive fraud, fraud, negligent misrepresentation, and breach of contract.  Unfortunately, Brett failed to make a proper pre-suit demand as required under N.C.G.S. § 57D-8-01(a)(2), and the Court, therefore, found that he lacked standing to pursue any derivative claims on behalf of the LLC, and dismissed those claims.

The Pre-Suit Demand Requirement

          N.C.G.S. § 57D-8-01(a)(2) provides that prior to asserting a derivative claim, an LLC member must have made a written demand on the LLC to take suitable action, and either (i) the LLC notified the member that the member’s demand was rejected; (ii) ninety days have expired from the date the demand was made; or (iii) the LLC would suffer irreparable injury by waiting for the expiration of the ninety-day period.

          In this case, Brett had not made a pre-suit demand at all.  He alleged that the filing of an application and order extending the time to file a Complaint qualified as a pre-suit demand, but the Court rejected this argument.  He also sent a letter requesting discussion on the same day that he filed the application and order, but that was not a pre-suit demand, and ninety days did not elapse before he filed a lawsuit. 

          In addition, the letter was sent to only three of the five members of the LLC, rather than to the LLC itself, as required. [2] Finally, Brett was unable to show that the LLC would have suffered any irreparable injury by waiting for the expiration of the ninety day response period.  For all these reasons, Brett lacked standing to pursue the derivative claims, and the Court dismissed those claims.

Direct Claims

          Brett also attempted to allege direct claims on his own behalf against his brother Quint for breach of fiduciary duty, constructive fraud, constructive trust, embezzlement and fraud.  But in North Carolina, shareholders of entities generally may not bring individual actions to recover what they consider to be their share of the damages suffered by the corporation for mismanagement.  There are two exceptions to this rule:  (1) the “special duty” exception and (2) the “separate injury” exception.

Special Duty

          Under the special duty exception, the duty that allegedly was breached must be one that the alleged wrongdoer owed directly to the shareholder as an individual, separate and distinct from any duty that the wrongdoer owed to the entity - - for example, breach of a fiduciary duty that was owed to the member individually.  Brett tried to argue that his brother owed him fiduciary duties here, based on the fraternal relationship and on the fact that the brother was a trustee of unrelated trusts of which Brett or his children were beneficiaries.  However, a sibling relationship without more is insufficient to support a fiduciary relationship, and a trustee owes fiduciary duties only with regard to management and administration of the trust, not as to all matters. 

Intra-Corporate Fiduciary Duties

          Moreover, in the corporate context, directors generally owe fiduciary duties to the corporation, rather than to individual shareholders, such that when directors’ fiduciary duties are breached, a shareholder may sue the offending director in a derivative action.  This same reasoning applies in the LLC context.  Managers of an LLC usually owe fiduciary duty to the LLC, not to the LLC’s individual members. 

          However, unlike a corporation, an LLC is primarily a creature of contract, and the operating agreement for the LLC governs its internal affairs and the rights, duties, and obligations of LLC members in relation to each other, the entity, and interest owners.  We have seen operating agreements that extend fiduciary duties of LLC members to each other.  The operating agreement in this case, however, did not.  The members of the entity could have provided in the operating agreement that the managers and members owed a fiduciary duty to both the company and the members, but they did not do so in this case, and accordingly, any claim for breach of fiduciary duty was a derivative claim, rather than a direct, individual claim.

Majority Member Fiduciary Duties

          The other thing to note in this context is that although members of an LLC generally do not owe a fiduciary duty to each other or to the company, majority members do owe a fiduciary duty to minority members.  Similarly, in the corporate context, the majority stockholder of the corporation owes fiduciary duties to minority stockholders.  While our Supreme Court has never held that a minority stockholder owes fiduciary duties to other stockholders, it also has never held that a minority stockholder cannot ever owe fiduciary duties to other stockholders. 

          Delaware courts have found fiduciary duties for holders of less than a majority of a corporation’s share when the minority member is a “controlling stockholder,” i.e., the minority member actually controls the corporate conduct at issue.  For example, if a minority shareholder had actual control over a company’s board of directors, that shareholder might have a fiduciary duty.  However, actual control exists only when the allegedly controlling stockholder exercises such formidable voting and managerial power that he effectively has majority voting control.  The stockholder’s power must be so potent that independent directors cannot freely exercise their judgment because they fear retribution.

          In this case, there was no showing that the brother, Quint, who owned only a 10.6% interest, exercised actual domination and control over the LLC.  The Complaint had conclusory allegations about control, but contained few details to explain exactly how Quint controlled the LLC and the siblings’ mother, and how Quint engaged in the alleged wrongdoing.  Those allegations did not suffice to show the “formidable” managerial control over the company, and therefore the allegations did not show that Quint, holder of only a 10.6% interest, was a de facto majority interest holder.  As a minority member, without more, Quint did not owe Brett, or any other member of the LLC, a fiduciary duty.  Brett therefore lacked standing to pursue his individual, direct claims against Quint because he failed to plead facts showing that Quint owed him a fiduciary duty or some other special duty, and as a result the Court granted a motion to dismiss those claims.

Practice Pointers

          If you represent a shareholder who believes that others are mismanaging the entity, first consider whether your potential claims are derivative or direct.

          If the claims are derivative, you will most likely need to comply with the written pre-suit demand requirement, so you should review the applicable statute (§ 570-8-01(a)(2) for LLCS) and case law.

          If the claims are direct, you will need to be able to fit them in one of the exceptions to the general rule that shareholders cannot sue directly for injuries to the entity.  You will need to show either that (1) the defendant owed your client a “special duty,” i.e., a duty owed directly to your client individually, or that (2) the injury to your client was “separate and distinct” from any injury to the entity.

 

 


[1] See A Primer on Intra-Corporate Disputes, May 10, 2021

[2] There is a similar requirement for derivative actions in the corporate context,  N.C.G.S. § 55-7-42.

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About the Author

Alan M. Ruley

Alan Ruley is a seasoned civil trial and appellate lawyer. He represents clients in a wide variety of disputes in federal court, state court, and the North Carolina Business Court, focusing primarily on business litigation, intellectual property, insurance coverage and recovery, banking and employment.
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