Closely-Held Shareholder Derivative Actions are Alive and Well in Texas

Originally published by Drew York.

After 30 years of running his family-owned business, Hillbilly Oil Co., Jed Clampett decided to retire in 2013. The board of directors elects Jethro Bodine as Hillbilly’s President and Elly May as Vice President. Both Jethro and Elly May sit on the company’s board of directors. Soon after taking over, Jethro is presented with a proposed lease for the company’s land in Oklahoma. The operator offers Hillbilly Oil above-market bonus payment and royalty. Jethro turns it down though, thinking the company is better off drilling the land itself while oil prices continue to rise. Soon after Hillbilly begins drilling oil prices tank, causing the company to lose $5 million. Jed can’t believe to learn that Jethro rejected the proposed lease, and soon learns that Jethro bought the drilling equipment from a company that he has a 50% interest in and paid double market price, but never disclosed his interest to the other board members. He decides to file a derivative lawsuit against Jethro. Jethro responds to the lawsuit claiming the “business judgment rule” protects him from any liability and that Jed’s lawsuit also fails because he did not make a demand on the corporation. Is Jethro right?

Explaining Closely-Held Corporations and Shareholder Derivative Actions

A closesly-held corporation has fewer than thirty-five shareholders and its shares are not listed on a national securities exchange. Typically the shareholders of closely-held corporations are family members, but that is not a requirement to make the corporation “closely-held.” A shareholder derivative action involves a corporation’s shareholder bringing suit on behalf of the corporation against its officers or directors.

The Business Judgment Rule

The business judgment rule comes up in two contexts. First, it protects officers and directors from a shareholder’s derivative lawsuit for acts that are within the honest exercise of their business judgment and discretion. In other words, officers and directors are protected from liability for past actions that are “negligent, unwise, inexpedient, or imprudent.” Second, the business judgment rule applies to the board of directors’ decision of whether to pursue the corporation’s cause of action against the officers or directors.

The Texas Supreme Court recently held that while the business judgment rule applies to the merits of the shareholder’s lawsuit – that is, the shareholder must prove that the officer or director’s past action was fraudulent, oppressive, or an abuse of power – a shareholder in a closely-held corporation is not required to make a pre-suit demand on the corporation. Thus, unlike a shareholder of a publicly traded corporation, a shareholder of a closely-held corporation does not have to prove that the corporation violated the second instance of the business judgment rule: that the corporation’s board of directors acted fraudulently, oppressive, or abused its power in deciding not to pursue a lawsuit against one of its officers or directors for alleged mismanagement.

Tilting the Scales in Your Favor

Because Hillbilly Oil is a closely-held company, Jethro loses his argument that Jed failed to make a pre-suit demand on the corporation. And because Jethro engaged in a transaction in which he had a conflict of interest without disclosing that conflict to Hillbilly’s board, his “business judgment rule” defense likely fails as well. Minority shareholders in closely-held corporations like Jed should exercise their rights to bring derivative actions when the corporation’s officers and directors engage in abusive or oppressive activities.

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