Limitations in a Derivative Action Lawsuit

Notice Is to Disinterested Directors Only

When does the corporation (which presumably would be charged with knowledge of all the activities of its officers and directors) receive notice of a breach of fiduciary duty? In International Bankers Life Ins. Co. v. Holloway, the Supreme Court held that notice to the corporation for purposes of the statute of limitations is notice to its disinterested officers and directors rather than notice to the wrongdoers of their own conduct. This holding was considered at length by the Austin Court of Appeals in Allen v. Wilkerson. In Allen, a creditor of a defunct corporation sought to enforce a cause of action belonging to the corporation against one of its former directors for misappropriation of corporate assets. The former director defended on the grounds that limitations had run on the cause of action. The Court held: "In order for limitations to run against a corporation’s right of action against one of its own directors, two things must concur: (1) notice (2) to a disinterested majority of its board of directors." The Allen Court affirmed a judgment for the creditor because there was sufficient evidence that the corporation had never had a disinterested majority on its board of directors after its cause of action arose; therefore, limitations never ran. Thus, under the doctrine of adverse domination, if a disinterested majority of directors does not exist, then limitations never begins to run. This doctrine of adverse domination has been clearly recognized as controlling Texas law in recent federal decisions.

Proving Absence of Disinterested Majority

The disinterestedness of officers and directors of a corporation is a fact issue. "In short, interestedness or disinterestedness does not turn on any technical form of legal status; it is a substantial fact question." However, the plaintiff shareholder does have the burden of proof that a majority of the board are not disinterested.

Shareholder’s Knowledge Is Irrelevant

In a shareholders' derivative action, however, while the corporation might not legally have had notice of the wrong-doing, the shareholder initiating the suit might have had knowledge of the wrongdoing outside the limitations period. No Texas case has addressed the application of the tolling of limitations in the context of derivative actions, but the reasoning of the controlling authorities leads to the conclusion that prior notice of the claims to individual shareholders does not necessarily bar the derivative action. This conclusion is based, first, on the important principle that derivative claims belong exclusively to the corporation and not to the shareholders initiating the action. The shareholders of a corporation are not agents of the company, and their knowledge is not imputed to the corporation. A shareholder has no power to act for or to bind the corporation. An individual shareholder cannot settle, release or ratify a wrong done to the corporation by a director.

Under the Texas law of adverse domination, notice to the shareholders should be immaterial for purposes of limitations: “And where, as here, the management of a corporation's affairs are de facto under the domination and control of the adversary of such cause of action, or the corporation is de facto powerless to sue on such cause of action because of the lack of a disinterested majority of its board, mere notice to shareholders does not start running of limitations against the corporate cause of action.” This principle is accepted in other jurisdictions.

The argument that the doctrine of adverse domination should not apply when the shareholder could have earlier prosecuted the claim by a derivative action was made by the former director in Allen v. Wilkerson and was rejected by the court: “Whatever right Chester Lankford [a shareholder and director] might have somehow perfected to bring a shareholders derivative suit for recovery on a corporate cause of action, he himself could neither have expressly released such cause of action, nor have sued directly on the cause of action, which belonged to the corporation and was under the control of its board of directors.” Some other jurisdictions have applied the adverse domination doctrine in a way that might preclude its application in derivative suits. Texas follows what has been termed the "majority test" theory of adverse domination in which adverse domination tolls the statute of limitations when a majority of the board of directors are adverse to the cause of action. The competing theory, which has been adopted by some jurisdictions, is called the "complete domination test." The leading case on this theory is International Rys. v. United Fruit Co., a case out of the Second Circuit. This theory requires proof that the corporation is in the "full, complete and exclusive control" of the defendants and requires that the plaintiffs to "negate the possibility that an informed stockholder or director could have induced the corporation to sue." Under the "complete domination test," adverse domination would generally not apply in a derivative case, but that test is simply not the law in Texas.

Furthermore, there is no policy reason for requiring shareholders to use the same diligence in enforcing corporate claims that the law imposes on officers and directors. A shareholder has no duty to protect the corporation or to institute a derivative action. A shareholder is free to act in his own self interest. Furthermore, the shareholder's right to bring a derivative suit is far from unfettered. The rules of procedure governing derivative actions are "designed to prevent shareholders from interfering with legitimate discretion in corporate governance.“

A corporation that is dominated by dishonest officers and directors is considered by the law to be under a "disability" similar to that of a minor or mentally incompetent party. A shareholder who brings a derivative action to assert a cause of action for the corporation is the same representative capacity as a guardian or parent who brings an action as "next friend" on behalf of a minor or incompetent. “The cause of action which such a plaintiff brings before the court is not his own but the corporations. It is the real party in interest and he is allowed to act in protection of its interest somewhat as a "next friend" might do for an individual, because it is disabled from protecting itself.” Texas law is clear that the knowledge or lack of diligence by one who brings an action in a representative capacity does not affect tolling of limitations. In a suit brought by the next friend for a minor, the minor and not the next friend is the real plaintiff. The Supreme Court has held that the capability of a parent to bring a suit within the two year limitations period does not affect the tolling of limitations on the claim of a minor. In Hopkins v. Spring Ind. Sch. Dist., the knowledge of the accident by the mother who brought suit as next friend for her daughter did not affect the tolling of limitations. In Simpson v. City of Abilene, claims brought by the father as next friend for his son were not barred by limitations even though the father's individual claims arising from the same accident were barred by limitations. Similarly, the corporation's rights in connection with a claim asserted in its behalf in a stockholders’ derivative suit are the same as if the corporation sued directly. Liken v. Shaffer, “Where a claim is asserted in behalf of a corporation in a stockholders derivative action in order for matters to be a bar to the claim, they must be such matters as relate to the corporation itself, and the conduct of a particular stockholder is not material.”

The only reported Texas authority which reaches an inconsistent result is Alice Roofing & Sheet Metal Works, Inc. v. Halleman. In that case, a cause of action brought by the new owners of a corporation against the former owners was held to be time-barred. The court reasoned that a change in ownership did not re-start the limitations clock after it has run. The court did not consider whether the running of the limitations clock had been tolled for any period of time. This case has been held not to be applicable to a claim of adverse domination. “Alice Roofing did not involve the adverse domination rule.... Although the adverse domination rule might have been relevant, nothing in the opinion indicates that appellants argued adverse domination before either the trial court or the court of appeals." The unreported Texas case of Gibney v. Culver, likewise reaches an inconsistent result on the facts, but without mention or consideration of the doctrine of adverse domination.