United States: Suit Dismissed; Plaintiff Hoist On The Petard Of The Direct Versus Derivative Distinction

A recent decision from the Kentucky Court of Appeals reinforces the importance of understanding and properly pleading a derivative (as contrasted with a direct) action In this instance the efforts of one shareholder/director to bring a direct action against the other shareholder/director were set aside because the cause of action was in fact derivative. Gross v. Adcomm, Inc., No. 2014-CA-001031-MR, 2015 WL 8488900 (Ky. App. Dec. 11, 2015).

Sam Gross and Christopher Pearson formed Adcomm in 2001; each was a 50% shareholder and a director. Gross was appointed president while Pearson was elected vice president. In 2004 Pearson submitted to the Secretary of State documents identifying himself as the corporation's president and as well changing the corporation's registered agent to himself. In 2005, a complaint by Adcomm as the plaintiff was filed against Gross alleging financial misconduct, seeking an accounting, and seeking as well an order removing Gross from all positions with Adcomm. This suit was initiated "at the direction and upon the authority of Pearson as its 'director and vice-president.'" I guess Pearson forgot about his 2004 filing saying he was the corporation's president.

In response,

Gross moved to dismiss Adcomm's complaint for lack of standing. Specifically, Gross pointed out that no resolution from the board of directors had appointed Pearson as the president of Adcomm; authorized Adcomm to engage in litigation that was effectively against half of the directors on its own board; or authorized Adcomm to hire an attorney to prosecute its suit. Gross would later reassert this argument, or variations of it, in several other motions to dismiss Adcomm's suit or to disqualify Adcomm's counsel from prosecuting its suit over the course of the next several years of litigation that would follow. Nevertheless, on the only occasion that the circuit court made a ruling upon one of Gross's motions to this effect, the circuit court denied it without further explanation.

Slip op. at 2-3.

Various counter-claims were as well filed, and eventually the matter was referred to a master commissioner to effect an accounting. This appeal was from that master commissioner report.

On appeal, Gross argued two points, namely:

(1) Adcomm lacked standing to file suit against him so this litigation should have been dismissed at its inception; and (2) Adcomm's counsel, Jeffrey Stamper, has had a irreconcilable conflict of interest from the inception of this twelve-year-long litigation and should have been disqualified.Slip op. at 6.After classifying the various claims and counter-claims as belonging to Adcomm and its assets and noting that corporate officers and directors owe their fiduciary obligations "to the corporation, not the shareholders" (Slip op. at 6), it was observed that a corporation may initiate legal action on its behalf pursuant to to vote of a majority of the board of directors. From there the Court of Appeals characterized the question as:

Who is entitled to assert and litigate the rights of an aggrieved corporation when, as here, the party who allegedly injured the corporation is a 50% shareholder, controls half of the corporation's board of directors, and does not want the corporation to pursue litigation?

Slip op. at 7.

Pearson/Adcomm claimed that Pearson had the capacity to initiate the suit in the basis that Gross had a conflict of interest as to whether or not the suit should be brought against himself which precluded him from taking part in that determination. As Pearson was the only non-conflicted director, so went the argument, he acting unilaterally was a majority of the board and could direct the corporation. In support thereof there was cited KRS 271B.8-310(4), which precludes an interested director from voting as to whether to approve a related party transaction.

After noting that KRS § 271B.8-310 relates to the ability of a corporation to avoid a conflict of interest transaction, the Court of Appeals wrote that the statute is not mandatory and has no impact upon the decision making structure of a corporation:

Nothing in KRS 271B.8-310 alters the manner in which a corporation decides to exercise and vindicate such a right (i.e., through a majority vote of its directors at a meeting of its board). Likewise, nothing in KRS 271B.8-310 disqualifies any director—self-interested or otherwise—from voting against the corporation exercising such a right.

Slip op. at 9 (footnote omitted).

From there the Court considered an argument based upon the futility of making a demand upon the board for it to bring suit against Gross, noting that he would never endorse a suit being filed against himself. All of that may be well and good, but the Court of Appeals observed in response that "the most noticeable flaw of Adcomm's argument is that it misunderstands the posture of this case." Slip op. at 11. Rather, this was a direct action by Adcomm against Gross, not a derivative action.

With this in mind, Sahni and its interpretation of the rule regarding the "futility" of making a demand for suit upon a board of directors have no bearing upon whether Adcomm had standing to sue Gross. This is because the "futility" rule applies to derivative actions, not direct actions. And, despite Adcomm's insinuation that "Pearson" had a "position regarding [Gross's] Motion to Dismiss," Pearson did not file a derivative action against Gross on behalf of Adcomm. Rather, Adcomm purported to file a direct claim on behalf of itself, and Pearson (as reflected in his several depositions, his testimony before the master commissioner, and in Adcomm's multitude of pleadings in this matter) repeatedly stated that he was acting at all times as Adcomm's authorized representative in causing Adcomm to file the instant litigation. Further underscoring this point are the facts that (1) "Adcomm, Inc." has always been the sole individual plaintiff suing Gross during the twelve years of this litigation; and (2) Adcomm hired its own attorney to prosecute its case against Gross and to defend this appeal. Consequently, this argument also does not support that Adcomm had standing to directly sue Gross. Instead, as italicized above, it demonstrates that Adcomm does not appreciate the difference between a direct corporate action and a derivative corporate action.

Slip op. at 13 (footnote omitted).

Which brings us to the culmination of this dispute, namely:

Who is entitled to assert and litigate the rights of an aggrieved corporation when, as here, the party who allegedly injured the corporation is a 50% shareholder, controls half of the corporation's board of directors, and does not want the corporation to pursue litigation?Id.

Which was answered as follows:

[T]his action purported to be a direct corporate action. There is no resolution of Adcomm's board of directors that authorized Adcomm to file the instant litigation against Gross, or to hire and pay any attorney to prosecute it. In light of Gross's twelve years of objections to this litigation; his 50% interest in Adcomm; and his role as the second of Adcomm's two directors, it is also obvious that no such resolution would have ever been forthcoming. Absent such a resolution, Adcomm lacked authorization to file this litigation, was never properly a party to it, and its claims should have been dismissed as a matter of law.

Slip op. at 14-15.

This decision needs to be carefully considered by both attorneys and the bench when considering lawsuits by and among business entities and their constituents. The waste of corporate and other assets, as well as the time of the courts, that has followed from this 12 year journey, ultimately for no resolution, is unjustified and unjustifiable. Precise pleading of claims as either direct or derivative, and clear demonstration of authority to bring them, should be an enforced obligation, and interlocutory appeal of those determinations should as well be allowed in order to avoid the time and expense of improperly plead actions.

Originally published on Kentucky Business Entity Law

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