[Shareholder Oppression] Direct vs. Derivative: Significant Opinion on shareh...

[Eric Fryar]

[http://www.fryarlawfirm.com/law/2011-01-13_Skyport_Opinion.pdf]
An issue that recurs with annoying frequency in our shareholder oppression cases is the argument that our shareholder oppression claims are derivative claims and that our clients therefore have no standing to assert them. This argument shows a thorough misunderstanding of the nature of an oppression claim. A shareholder oppression claim is, by definition, a claim asserted by an individual shareholder in his capacity as a shareholder for injury done to his individual interest that arise out of his share ownership. It is entirely a direct and individual claim based on the breach of duties owed directly to the shareholder.

The Texas Court of Appeals put it this way:

[A] corporate shareholder has no individual cause of action for personal damages caused solely by a wrong done to the corporation. The cause of action for injury to the property of a corporation or for impairment or destruction of its business is vested in the corporation, as distinguished from its shareholders, even though the harm may result indirectly in the loss of earnings to the shareholders. The individual shareholders have no separate and independent right of action for wrongs to the corporation that merely result in depreciation in the value of their stock.
As a result, to recover for wrongs done to the corporation, the shareholder must bring the suit derivatively in the name of the corporation so that each shareholder will be made whole if the corporation obtains compensation from the wrongdoer. However, a corporate shareholder may have an individual action for wrongs done to him where the wrongdoer violates a duty arising from a contract or otherwise and owing directly by him to the shareholder. Such a principle is not so much an exception to the general rule as it is a recognition that a shareholder may sue for violation of his individual rights regardless of whether the corporation also has a cause of action. It is the nature of the wrong, whether directed against the corporation only or against the shareholder personally, not the existence of injury, which determines who may sue. Appellate courts have also recognized an individual cause of action for “shareholder oppression” or “oppressive conduct.”

Redmon v. Griffith, 202 S.W.3d 225, 233-34 (Tex. App.--Tyler 2006, pet. denied).

A claim for shareholder oppression is thus a direct claim—not a derivative claim. Therefore, an individual shareholder necessarily has standing to assert the claim on his own behalf, does not have to comply with the procedural peculiarities of a derivative action, does not lose the right to assert the claim if the corporation goes into bankruptcy, and gets to keep all the money that a court may award on the claim.

However, there is a significant complicating factor. Very frequently, the manner in which a majority shareholder goes about oppressing a minority shareholder involves conduct also harms the corporation and also breaches fiduciary duties that are owed only to the corporation and not to the shareholder individually. University of Houston law professors Douglas Moll and Robert Ragazzo, in their excellent treatise The Law of Closely Held Corporations, describe the “classic oppression scenario” as follows:

(a) the majority uses its control over the board of directors to discharge the minority from employment and cut off access to dividends (which, as a practical matter, denies the minority any return on its investment); (b) the majority uses its shareholder voting power to remove the minority from the board of directors and otherwise cuts off all participation by the minority in the decision-making process (which may prevent the minority from being aware of misconduct by the majority); (c) the majority engages in acts of self-dealing (e.g., by paying excessive salaries or diverting business opportunities that belong to the corporation); and (d) the majority administers the coup de grace by offering to purchase the minority’s shares at a fraction of their true value. (2010 Supplement at 2-11).

Therefore, in order to prove shareholder oppression, the plaintiff must often allege conduct that sounds awfully like the pleading of a derivative claim. For example, a majority shareholder might use his power over the corporation to pay himself exorbitant bonuses, thereby leaving nothing for the minority shareholder. A majority shareholder might also take a corporate opportunity and place it in a company that he owns 100% thereby avoiding the sharing of the profits with the minority shareholder. In both instances, the majority shareholder did violate duties owed only to the corporation and thereby damaged the corporation. The corporation could certainly sue, and the minority shareholder can and should assert a derivative claim on behalf of the corporation seeking a monetary award of actual damages that were caused by the breach of fiduciary duties to the corporation. However, the minority shareholder can also point to those acts as evidencing a pattern of oppressive conduct whereby the majority shareholder has acted to enrich himself at the minority sharerholder’s expense, to diminish and violate the rights and interests that the minority shareholder has by virtue of share ownership, and otherwise to substantially frustrate the reasonable expectations of the minority shareholder. Nevertheless, a minority shareholder may not in his own capacity sue the majority shareholder seeking to recover the damages suffered by the corporation caused by the breach of fiduciary duties to the corporation. What the minority shareholder can do is to point to that same conduct as evidence of the majority shareholder’s pattern of oppressive conduct toward the minority.

Shareholder oppression is an equitable remedy. If the shareholder proves a pattern of oppressive conduct, the shareholder is not necessarily entitled to economic damages caused by that conduct. Rather, the court is required to fashion an equitable remedy designed to address the harm suffered by the minority shareholder’s rights and interests arising from share ownership. The most common remedy is a judicially-ordered buy out of the plaintiff’s shares at a fair price as determined by the court. There is absolutely nothing inconsistent about claiming, as a result of the majority shareholder’s misappropriation of corporate assets, that the corporation, on the one hand, is entitled to an award of actual damages for the amount of the misappropriated assets and that the minority shareholder, on the other hand, is entitled to have the majority shareholder buy the minority shares. The plaintiff could assert both claims in the same lawsuit, and we frequently do this. The only issue that must be addressed by the simultaneous assertion of the derivative claim and the oppression claim is whether the plaintiff should be awarded a pro rata share of the derivative claim damages or whether that amount should be reflected in the fair value of the shares.

Sometimes, the minority shareholder will not be able to assert the derivative claim. The corporation may be in bankruptcy, in which case the derivative claims are controlled by the bankruptcy estate. Or the derivative claims may have already been released or barred by res judicata. Or the defendants may be successful in blocking the derivative claims through various procedural maneuvers, such as appointment of a special committee. In those instances, the shareholder only has his direct claim for shareholder oppression, but the shareholder may still offer into evidence certain oppressive conduct of the defendant even though that same conduct would also give rise to a no-longer-assertable derivative claim—so long as the shareholder does not seek to recover the damages that would have been awarded under the derivative claim. The issue that faces the court in such an instance is not one of standing but one of evidence. So long as the plaintiff is only using conduct that breaches duties to the corporation as evidence of oppressive conduct toward the minority shareholder, he is not asserting a derivative claim. The issue is not whether the shareholder has standing to offer such evidence, but whether the specific conduct the shareholder seeks to prove is relevant to a claim of oppressing the minority shareholder.

A very significant decision was recently handed down in one of Fryar Law Firm’s cases that addressed these very issues. The United States Bankruptcy Court for the Southern District of Texas (Judge Bohm) issued a 108-page opinion on January 13, 2011, resolving exactly the direct vs. derivative issues described here. In re Skyport Global Communications, Inc., No. 08-36737, 2011 WL 111427 (Bankr. S.D. Tex. 2011). In that case, Fryar Law Firm filed a lengthy and complex oppression and fraud lawsuit in state court in Houston, Texas on behalf of four different groups of shareholders. The corporation had previously been through bankruptcy, and the majority shareholder had received releases of all derivative claims as part of the reorganization. Therefore, the plaintiffs could only assert whatever individual, direct claims survived the bankruptcy. The various defendants removed the case to federal bankruptcy court and asserted that all of plaintiff’s claims were derivative and moved to dismiss the lawsuit with prejudice in its entirety. The Court rejected that argument and acknowledged that many states have adopted the position stated here that oppression claims are inherently direct. However, Delaware law governed the claims in this case, and the Delaware courts had not ruled on that issue. Therefore, in an exhaustive and pain-staking analysis, Judge Bohm’s opinion applies the Delaware test for derivative claims to each factual component of each of the plaintiffs’ claims. The Court did hold that certain of the allegations made would support only claims that were either derivative claims or were otherwise barred by the bankruptcy confirmation order. These claims were dismissed with prejudice. However, the Court found that the majority of plaintiffs’ claims for oppression and fraud were direct claims under Delaware law, and the Court ordered these claims to be remanded to the state court to proceed to trial.

--
Posted By Eric Fryar to Shareholder Oppression at 2/19/2011 03:27:00 PM