Whether it be a shareholder oppression claim, a majority shareholder asserting a breach of fiduciary duty claim against a minority shareholder, or claims against those in control, derivative litigation is prevalent and provides a check on wrongdoing. And the necessity that each party in litigation has independent counsel advocating for their rights is well-established.
Here, we discuss when independent counsel must be engaged on behalf of the entity (encompassing corporations and limited liability companies) in derivative litigation. To do so, however, it is necessary to understand what derivative litigation is, what it entails, and the particular Rules of Professional Conduct that impact the decision to retain independent counsel on behalf of the entity.
Derivative Claims vs. Direct Claims
A derivative claim is a creation of equity in which the individual (used to describe a shareholder and member), in effect, steps into the entity’s shoes and seeks restitution on the entity’s behalf. It is important to note that the individual must have an ownership interest in the entity during the applicable time to derive standing to bring the derivative action. See Minn. R. Civ. P. 23.09 requiring the individual to be a “shareholder or member at the time of the transaction of which the plaintiff complains or that the plaintiff’s share or membership thereafter devolved on the plaintiff by operation of law.”
“Derivative suits allow [individuals] to bring suit against wrongdoers on behalf of the [entity], and force liable parties to compensate the [entity] for injuries so caused.” In re UnitedHealth Group Inc., S’holder Derivative Litig., 754 N.W.2 544, 550 (Minn. 2008) quoting Janssen v. Best & Flanagan, 662 N.W.2d 876, 882 (Minn. 2003). As a general rule, the individual may not assert a cause of action that belongs to the entity unless the entity fails to take action on its own behalf. Blohm v Kelly, 756 N.W.2d 147, 153 (Minn. Ct. App. 2009).
Derivative actions provide concerned individuals a check against abuses committed by those in control of the entity. Commonly, derivative suits allege improper actions by those in charge of the entity, including self-dealing by those in authority, entity mismanagement, or breaches of the duties of loyalty and care owed to the entity and the entity’s owners.
Direct claims, on the other hand, are those seeking redress to the individual directly. Examples of direct claims include the individual being unable to vote on a particular entity action, the denial of an individual’s right to inspect the entity’s books and records, or when only one individual has been singled out not to receive a dividend from the entity. Simply, a direct claim seeks redress for harm to that particular individual and not because of damage to the entity in which the individual holds an ownership interest.
The central inquiry in determining whether a claim is direct or derivative is “whether the complained-of injury was an injury to the [individual] directly, or to the [entity].” Blohm, 765 N.W.2d at 153. “In analyzing whether a claim is direct or derivative, [courts] look not to the theory in which the claim is couched, but instead to the injury itself.” Wessin v. Archives Corp., 592 N.W.2d 460, 464 (Minn. 1999). “Where the injury is to the [entity] and only indirectly harms the [individual], the claim must be pursued as a derivative claim.” Blohm, 765 N.W.2 at 153.
Asserting A Derivative Claim
If the claim is a derivative claim, there are procedural requirements to properly assert it. Minn. R. Civ. P. 23.09 requires that the individual’s complaint contain the following:
In a derivative action brought by one or more shareholders or members to enforce a right of a corporation or of an unincorporated association, the corporation or association having failed to enforce a right which may properly be asserted by it, the complaint shall allege that the plaintiff was a shareholder or member at the time of the transaction of which the plaintiff complains or that the plaintiff’s share or membership thereafter devolved on the plaintiff by operation of law. The complaint shall also allege with particularity the efforts, if any, made by the plaintiff to obtain the desired action from the directors or comparable authority and, if necessary, from the shareholders or members, and the reasons for the plaintiff’s failure to obtain the action or for not making the effort. The derivative action may not be maintained if it appears that the plaintiff does not fairly and adequately represent the interest of the shareholders or members similarly situated in enforcing the right of the corporation or association. The action shall not be dismissed or compromised without the approval of the court, and notice of the proposed dismissal or compromise shall be given to shareholders or members in such manner as the court directs.
Thus, to properly bring a derivative action on behalf of the entity, the individual must specifically state what efforts they made before filing the litigation to obtain the redress sought in the litigation or allege why the individual did not previously seek redress. Minnesota courts have provided guidance on these two alternative requirements.
One route is for the individual to make a demand on the entity’s management before filing a derivative action. The requirement to demand redress from the entity’s management is because the decision to pursue a legal claim on behalf of the entity involves “the weighing and balancing of legal, ethical, commercial, promotional, public relations, fiscal and other factors familiar to the resolution of many if not most [entity] problems.” Janssen, 662 N.W.2d at 883. This decision is best made by the entity’s management, “which is familiar with the appropriate weight to attribute to each factor given the [entity’s] product and history.” Id.
Or Minnesota law has long held that demand is unnecessary if the wrongdoers constitute a majority of those in control of the entity and it is “plain from the circumstances that [demand] would be futile.” Winter v. Farmers Educ. & Co-op. Union of Am., 107 N.W.2d 226, 234 (Minn. 1961) (“Ordinarily a demand should be made on the board of directors unless the wrongdoers constitute a majority of the board, and a demand should be made on the shareholders unless they are powerless to ratify the wrong alleged or unless the majority of their number is interested.” (emphasis added)). While Minnesota courts have held that disinterested entity management is in the best position to determine whether the entity should pursue redress, the demand futility requirement acknowledges that wrongdoers are not going to willingly have the entity pursue claims against themselves for their own wrongdoing. “The determination of demand futility is a mixed question of law and fact left to the discretion of the district court. Minnesota courts often look to the decisions of Delaware courts for guidance in this area. Delaware has developed two approaches to claims of demand futility.”
Under the first approach set forth in Aronson v. Lewis, 473 A.2d 805, 814 (Del. 1984) overruled on other grounds, a pre-suit demand may be excused when there is reasonable doubt “as to whether at the time the suit was filed a majority of the [management was] disinterested in the matter and able to act independently.” In the second prong, “the demand requirement is also excused if it is doubtful that the transaction objected to in the lawsuit resulted from the [management’s] proper exercise of business judgment. To satisfy either prong of the Aronson analysis, however, the complaint must set forth, with particularity, facts showing that a demand would have been futile.”
The business judgment rule means “that as long as the disinterested [management] made an informed decision, in good faith, without an abuse of discretion, he or she will not be liable for [entity] losses resulting from his or her decision.” Janssen, 662 N.W.2d at 882. The business judgment rule grants some deference to the decisions of management. Id. In Janssen, the Minnesota Supreme Court determined that one reason the business judgment rule is used in derivative claims is that “courts are ill-equipped to judge the wisdom of business ventures and have been reticent to replace a well-meaning decision by [management] with their own.” Id. Courts have stated they are reluctant to interfere in the inner working of an entity and, “[a]s a result, there is a ‘presumption that in making a business decision, the [management] of [an entity] acted on an informed basis, in good faith, and the honest belief that the action taken was in the best interests of the [entity].” If, however, there is a reasonable doubt that management properly applied their business judgment, then the demand requirement is excused. Professional Management Associates, Inc. v. Coss, 574 N.W.2d 107, 110 (Minn. Ct. App. 1998).
The second approach to determine whether a demand would have been futile in a derivative claim is based on Rales v. Blasband, 634 A.2d 927, 933 (Del. 1993). This analysis recognizes that the business judgment rule only applies to cases of affirmative management action. This approach determines whether the management was so conflicted that it could not have properly responded to demand. “Where there is no conscious decision by [management] to act or refrain from acting, the business judgment rule has no application.” In re Xcel Energy, Inc., 222 F.R.D. at 606. That being so if the management’s inaction “is not the product of conscious decision, the demand futility analysis considers only whether a majority of the [management] had a disqualifying interest in the matter or were otherwise unable to act independently.” Id. Basically, suppose management did not deliberately exclude themselves from deciding on the allegations. In that case, the court should only consider whether most of the management has a disqualifying (personal) interest in the matter or if they could not exercise independent judgment for other reasons. “Under the Rales analysis, the absence of a pre-suit demand is excused only if a majority of the directors had a personal interest in the disputed conduct or were unable to exercise independent judgment for some other reason.” Id.
Captioning The Case
When asserting a derivative action, although the claim is on behalf of the entity, the entity is labeled a “defendant” in the case caption. The title of “plaintiff” versus “defendant” has caused some confusion with regard to the conflict of interest analysis discussed below.
It is well established that the entity is named as a “nominal” defendant in a derivative action, even though the derivative claims are asserted by the individual on behalf of the entity and against the wrongdoers:
It is well established that an entity on whose behalf a derivative claim is asserted is a necessary defendant in the derivative action.
Buckley v. Control Data Corp., 923 F.2d 96, 99 (8th Cir. 1991).
A number of secondary sources similarly explain that a derivative action is captioned with the entity named as a nominal defendant:
The shareholder is considered a nominal plaintiff in a particular derivative suit. The corporation then becomes the nominal defendant. However, the corporation usually gains from the recovery if ever the shareholder wins the case.
Understanding the Shareholders Derivative Suit, Lala C. Ballatan (emphasis added); also, Derivative Lawsuits, Robert J. McGaughey; Corporations in Conflict, Sa’id Vakili, Los Angeles Lawyer, March 2012.
Thus, while it is somewhat of an anomaly to be asserting claims but be named as a defendant, the entity is only a nominal defendant and is, in effect, a plaintiff asserting claims against the alleged wrongdoers. The individual asserting the derivative claims on behalf of the entity is a named plaintiff, while the management alleged wrongdoing is the true defendant. While the entity is named as a nominal defendant, the entity will recover any settlement or judgment against the management if the derivative claim is successful.
Representation of Multiple Parties
With that (basic) understanding of derivative litigation, the potential conflicts of interest involved in derivative litigation surface – conflicts of interest which the Minnesota Rules of Professional Conduct address.
Minnesota law makes clear that an entity is separate from its owners. Distinct from its owners, an entity is thus entitled to its own legal representation. In fact, an entity cannot appear pro se and must appear through an attorney in litigation. Save Our Creeks v. City of Brooklyn Park, 699 N.W.2d 307, 309 (Minn. 2005).
Rule of Professional Conduct 1.13 deals with an attorney’s representation of an entity. Rule 1.13(a) provides that a lawyer retained by the entity represents the entity, “acting through its duly authorized constituents.” As it relates to derivative litigation, Rule 1.13(f) provides:
A lawyer representing an organization may also represent any of its directors, officers, employees, members, shareholders, or other constituents, subject to the provisions of Rule 1.7. If the organization’s consent to the dual representation is required by Rule 1.7, the consent shall be given by an appropriate official of the organization other than the individual who is to be represented, or by the shareholders.
The comments to Rule 1.13 further provide the following:
The question can arise whether counsel for the organization may defend such an action. The proposition that the organization is the lawyer’s client does not alone resolve the issue. Most derivative actions are a normal incident of an organization’s affairs, to be defended by the organization’s lawyer like any other suit. However, if the claim involves serious charges of wrongdoing by those in control of the organization, a conflict may arise between the lawyer’s duty to the organization and the lawyer’s relationship with the board. In those circumstances, Rule 1.7 governs who should represent the directors and the organization.
Referenced throughout the Rules of Professional Conduct 1.13 is Rule 1.7, the Rule of Professional Conduct relating to an attorney’s conflict of interest as to current clients. Pertinent to derivative litigation in which the entity has claims against the entity’s management, Rule 1.7 (a) provides in pertinent part:
…a lawyer shall not represent a client if the representation involves a concurrent conflict of interest. A concurrent conflict of interest exists if:
the representation of one client will be directly adverse to another client; or
there is a significant risk that the representation of one or more clients will be materially limited by the lawyer’s responsibilities to another client…
The determination of whether a conflict of interest exists in a derivative action is not resolved, however, by simple, automatic rules. Instead, the inquiry requires a thoughtful balancing of competing interests and a careful review of each case’s fact pattern. That inquiry, whether by the entity’s and individual defendants’ attorney or by a court examining the propriety of the concurrent representation via a motion to disqualify, begins by considering the distinction between “serious charges of wrongdoing” and “non-serious” charges of wrongdoing as detailed in the comments to Rule of Professional Conduct 1.13.
As aptly noted by one scholar, if the allegations of wrongdoing are serious, there should be no question that an attorney cannot concurrently represent the entity and those charged with wrongdoing:
While the typical shareholder derivative action is brought against the officers and directors of a corporation, it also names the corporation as a defendant. As such, the question arises as to whether an attorney can simultaneously represent the officers and directors on one hand and the corporation on the other. If the case involves allegations of wrongdoing against the officers or directors, the answer is an emphatic no.
Dual representation of the corporation and individual defendants in a derivative proceeding which asserts a claim of serious wrongdoing by those in control of the corporation is considered improper because a potential conflict of with the individual defendants.
Corporations in Conflict, Sa’id Vakili, Los Angeles Lawyer, March 2012 (citing 13 Fletcher, Cyclopedia of Corporations § 6025 and Developments in the Law – Conflicts of Interest in the Legal Profession, 94 Harv. L. Rev. 1244, 1339-40 (1981)).
The Minnesota Court of Appeals has similarly proclaimed its stance when the same attorney represents both the entity and those charged with wrongdoing, requiring a said attorney to testify at trial:
The trial court compelled two members of that firm to testify as to communications between themselves and Blesi [individual charged with wrongdoing] on the theory that by representing both the majority shareholder and the corporation, the lawyers were in a conflict of interest position and had a duty to advise Mr. Evans, the minority shareholder, of their advice regarding corporate matters. Therefore, their conversations with Blesi were not privileged.
Evans v. Blesi, 345 N.W.2d 775, 780-81 (Minn. Ct. App. 1984) (emphasis added).
On the other hand, if the allegations of wrongdoing are not “serious” or are obviously or patently frivolous, having joint counsel represent the entity and those charged with wrongdoing at the outset of a derivative case have obvious benefits. This arrangement is cost-effective and convenient for the entity and its management. It also permits all the defendants to easily share information, present a united defense to the claims, and coordinate their strategy at the early stages of the litigation.
The issue, thus, pivots on the determination of whether the charges of wrongdoing are “serious” or obviously or patently frivolous. At the outset of a derivative action, and certainly, before any motion to dismiss or disqualify, counsel for the entity should investigate the substance of the claims asserted. If the preliminary investigation unveils no evidence of “serious” wrongdoing, joint representation of the entity and the entity’s management charged with wrongdoing is proper. But if the preliminary investigation reveals the potential for merit to serious charges of wrongdoing, independent counsel should be retained for the entity and those charged with wrongdoing. Retaining separate counsel for the entity and those charged with wrongdoing avoids the appearance of a conflict. It avoids the litigation expense should the individual’s counsel pursue a motion to disqualify, which would require the court to determine whether the charges of wrongdoing are “serious” or obviously or patently frivolous. As a result, counsel should proceed with extreme caution and undertake a thorough investigation into the claims alleged when determining whether the concurrent representation of the entity and the individual management charged with wrongdoing is permissible.
Based on the above, when there are charges of fraud, unethical or illegal conduct, breaches of fiduciary duty, or usurpation of entity opportunities, to name a few “serious” charges of wrongdoing commonly asserted in derivative actions, against the entity’s management, counsel should not concurrently represent the entity and those charged of wrongdoing. Here, the entity is better served by independent representation: there is no appearance of impropriety; there is no conflict to be raised by the individual to the court, and independent representation for the entity may help resolve the matter early and cost-effectively. Avoiding the appearance of conflicted representation by an attorney also ensures that the attorney acts with high ethical standards and retains his or her credibility with the court.
Derivative suits present complex legal and ethical questions, including questions about conflicts of interest. Understanding the differences between direct and derivative claims is necessary to examine whether the concurrent representation of the entity and the entity’s management is permitted if a derivative claim is asserted. Counsel must be cautious and thorough in investigating the viability of the claims and whether the derivative claims asserted represent “serious” charges of wrongdoing. If they do, independent counsel is necessary for the entity and the individuals comprising the entity’s management charged with wrongdoing.
Because of the growing number of derivative actions asserted in Minnesota, the law on conflicts of interest in this setting will also probably be expanded and further defined by Minnesota’s appellate courts. Counsel should continue to conduct their thorough analysis and investigation based on the Rules of Professional Conduct regarding the propriety of undertaking concurrent representation or continuing concurrent representation when derivative claims are asserted. Ensuring compliance with the Rules of Professional Conduct and ensuring that the entity is properly represented must be front and center throughout this analysis. At no time should conflicted representation be undertaken.