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.
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