Federal District Court Addresses Derivative Actions, Allows Case to Proceed

Federal District Court Addresses Derivative Actions, Allows Case to Proceed

       In January 2018, the Federal District Court for the Eastern District of Kentucky (Judge Reeves) dismissed, without prejudice, a lawsuit brought in connection with a number of family-owned business entities, it being alleged that those in control had manipulated the structure to divert to themselves nearly $75 million. The primary bases for that dismissal was the absence of demand upon those in control of the corporations and LLCs to take action. See Smith v. Tarter, 305 F.Supp.3d 733, 2018 WL 506227 (E.D. Ky. Jan. 22, 2018). HERE IS A LINK to my review of that decision.

      In what may be fairly characterized as “Round II” to this dispute, the plaintiffs have re-filed the action after taking a variety of actions including calling board meetings and submitting written demands for action. With the case now pending before Judge Caldwell, she has generally found the complaint is sufficient to proceed. C-Ville Fabricating, Inc. v. Tarter, Civ. Act. No. 5:18-CV-379-KKC, 2019 WL 1368621 (E.D. Ky. March 26, 2019).

      Judge Caldwell noted that in the prior action, it had been concluded that an individual shareholder does not have standing to bring a direct cause of action when the only injury being asserted is dimunition in the value of the corporate shares. 2019 WL 1368621, *5, citing 305 F.Supp.3d at 739. Likewise, Judge Reeves had held that the plaintiffs had not demonstrated that the futility exception applied. 2019 WL 1368621, *5, citing 305 F.Supp.3d at 742-44.

      Since then, the plaintiffs have taken a number of actions. First, they sent a round of demand letters to the current directors and managers of the various companies that “explicitly requested the Boards of the corporations and the member/managers of the LLCs to vote on the specific issue of whether to sue the Defendants - Joshua Tarter, Thomas Gregory, and QMC for their supposed misdeeds.” 2019 WL 1368621, *5.  Secondly, the plaintiffs called a meeting of the Board of Directors of Tarter Industries that passed a resolution authorizing the corporation to bring suit against the defendants. They then filed this new action. As described by Judge Caldwell, “the Plaintiffs argue that the standing deficiencies of their first complaint have been cured, pointing to the newly issued demand letters and the Tarter Industries Board resolution.” Id. *6. In response, defendants brought a number of motions to dismiss under Federal Rules of Civil Procedure 12(b)(1) and 12(b)(6).

      Initially, with respect to the plaintiffs’ assertions that they individually had standing to pursue the claims, as they had been in the initial action, those claims were dismissed.

       With respect to the direct action authorized by Tarter Industries against the defendants, they challenged the resolutions authorizing those suits on a variety of basis including who received notice and assertions of bad faith and inherent conflict of interest. Factually, it was found that the proper persons received proper notice of the meeting. The charge that one of the parties to that vote had a conflict of interest based upon the assertion that, if one of the defendants were found liable he would be required to give up his shares and shift them to her side of the family, thereby giving them control, was found to be speculative and at least at this stage of the dispute insufficient to require an abstention. On those bases, the direct suit by Tarter Industries against the defendants was allowed to proceed.

      With respect to a derivative standing, the defendants began with an assertion that the plaintiff actors “are not the ‘fair and adequate’ representatives of the other shareholders of the Tarter Companies, citing Federal Rule of Civil Procedure 23.1(a), under which a derivative proceeding “ ‘may not be maintained if it appears that the plaintiff does not fairly and adequately represent the interests of the shareholders or members who are similarly situated in enforcing the right of the corporation.’” 2019 WL 1368621, *9. The court recited the eight factors utilized in the Sixth Circuit, as set forth in Davis v. Comed, Inc., 619 F.2d 588, 593-94 (6^th Cir. 1980). Judge Caldwell would find that the claims that the plaintiffs were not “fair and adequate” representatives were unavailing and that “on balance, [ ]  the plaintiffs have adequately pleaded that they are fair and adequate representatives of the shareholders of the Tarter Companies.” Id., *10. The plaintiffs then went on to challenge the demand letters on the basis that they were sent to those who “might be Directors” this was found to be unavailing. Rather, while there was some confusion as to who might be directors and officers of various companies, a consequence of numerous failures to hold annual meetings and elect directors, the sending of demand letters to every possible recipient was the appropriate approach. An assertion that the failure to take action by the Board of Directors should be protected by the Business Judgment Rule was rejected because of an absence of a showing of any investigation.

      From there the court turned to a variety of defenses under Rule 12(b)(6) with respect to RICO, Defend Trade Secrets Act and Kentucky Uniform Trade Secret Law. A claim for misappropriation under the Defend Trade Secrets Act was upheld even as claims for aiding and abetting breach of the DSTA were dismissed on the grounds that it does not provide for aiding and abetting liability. Likewise, a claim for conspiracy to misappropriate under the DTSA was struck down on the basis that there is no claim for conspiracy to misappropriate. A direct claim under the Kentucky Uniform Trade Secrets Act was allowed to proceed while aiding and abetting and conspiracy claims thereunder were dismissed. Likewise, RICO claims were allowed to proceed. The court found that, for example, the predicate act of money laundering had taken place. In addition, a faithless servant doctrine claim was set aside, there being a lack of authority for the proposition that the Kentucky Supreme Court would adopt that doctrine when presented with the opportunity.

      For now, this lawsuit will proceed on a direct and derivative basis.