Closely-Held Corporations: Courts Address Distinction Between Derivative and Direct Shareholder Actions - Kansas

October 5, 2011 | Erin Herbold-Swalwell

 

This case involved a family farming corporation and a dispute among the family-member shareholders.  The trial court rendered a judgment of $1,160,737 for a sister and two brothers instead of two other brothers and the family corporation.  The sister and interveners (also shareholders) claimed that the defendants breached their fiduciary duty and engaged in self-dealing in their capacity as officers of the family farm corporation by diluting the shareholders’ interests.  The sister and the interveners further claimed that the defendants “inappropriately benefited themselves” with low equipment rental and cash rent for the land resulting in underpayment to the corporation.  The defendants argued that their siblings’ claims were barred by the applicable statute of limitations, that their siblings engaged in inequitable conduct, and that the trial court erroneously imposed the burden of proof on them as defendants.

On appeal, the issue before the court was whether the plaintiff and interveners actually had standing to bring a direct action against the officers and directors of the corporation and against the corporation itself.  The court noticed a host of “red flags” with respect to the standing issue. For instance, the defendants together never owned more than 23.5% of the outstanding stock of the corporation and, in 2005, the plaintiff became president of the corporation and she and the interveners became a majority voting block and still continued their action against the corporation. The defendants argued that the plaintiff and interveners failed to satisfy the three-prong test to bring a direct action against a corporation in Kansas.   Under that test, the plaintiff must show that the lawsuit would not:  (1) unfairly prejudice the interests of corporate creditors; (2) expose the corporation to a multiplicity of claims; and (3) impair fair distribution of recovery.

The court first discussed the distinction between direct actions and derivative actions against corporations. Generally, when a corporation is injured by the acts of those in control, the suit seeking redress for those actions belongs to the corporation and must be brought as a derivative action- one or more shareholders bringing suit on behalf of the corporation. On the other hand, direct actions are actions brought by a shareholder against those in control of a corporation for injuries affecting the individual legal rights of the shareholder. The test for whether an action is derivative or direct is who suffered the harm and who would receive the benefit of recovery or other remedy.  In Kansas, a shareholder may only litigate as an individual if the wrong to the corporation “inflicts a distinct and disproportionate injury on that shareholder.”

Kansas courts and the legislature do not recognize an exception to this rule for common-law closely-held corporations.  Indeed, the legislature has specifically prohibited special treatment for those corporations.  Furthermore, Kansas does not even recognize common-law close corporations.  Thus, there cannot be any exception for derivative claims to be brought in a derivative action.  Generally, a shareholder suit for injuries to a corporation as a result of officer or director misconduct must be brought as a derivative action and not a direct action unless the corporation is at least closely-held, if not astatutory close corporation and the plaintiffs can prove the action will not unfairly expose the corporation.  Only at that point will the courts allow a direct action.

Finally, the court addressed whether the plaintiff and interveners satisfied the three-prong test for bringing a direct action against the corporation.  Here, they did not.  The parties could not show that the lawsuit wouldn’t unfairly prejudice corporate creditors, expose the corporation to claims, and the distribution the plaintiff and interveners were asking for was not fair.  Further, the court noted that this was not a situation of minority shareholder oppression and the wrong inflicted was not distinct and disproportionate to the shareholders pursuing the claim.  The plaintiff and interveners could have filed a suit that was derivative in nature, but chose to pursue their claims through a direct action. They made the wrong choice under the law. The appellate court vacated the trial court ruling and remanded the case with instructions for dismissal.  Lightner v. Lightner, No. 104,000, No. 2011 Kan. App. LEXIS 141 (Kan. Ct. App. Sept. 23, 2011).