Legal and Ethical Responsibilities in Shareholder Litigation

As the Pennsylvania federal district court stated in Miller v. American Telephone and Telegraph Co., "(a)lthough . . . any corporation involved in a stockholders' derivative action . . . is properly made a nominal defendant, it must realistically be considered to be the complainant in the action."

The usual situation in a shareholder derivative suit is that the shareholder is bringing a claim against those in control of the corporation (officers, directors and/or controlling shareholders) for damage done to the corporation through a breach of their fiduciary duties, such as looting the corporation's assets through excessive compensation. Because the defendants being accused of harming the corporation also control the corporation, the paradox almost invariably arises that the "corporation" thinks the lawsuit brought on its behalf is a very bad idea and actively opposes the effort. Because the plaintiff shareholder is required to join the corporation as a "nominal" defendant (even though it is the real plaintiff in interest), very frequently the corporation's regular counsel, paid by the corporation, undertakes the joint representation of the corporation and of the individual defendants in opposition to the plaintiff's derivative claim. Therefore, the defendants' attorney, at least theoretically, is in the awkward position of representing the corporation in trying to prevent the corporation from obtaining damages from individuals accused of looting the corporation. This situation presents a very real conflict of interest. As the United States District Court for the Northern District of Texas wrote in Clark v. Lomas & Nettleton Fin. Corp.:

In fact, the corporation is the real plaintiff and any finding of liability would redound to its benefit, not to its detriment. And, obviously, in this action any finding of liability on the part of the 'inside' directors, controlling stockholder and the controlled corporations would result in a recovery for Booth, Inc. The interests of Booth, Inc. and the other Director defendants are clearly adverse, and the representation by one law firm of Booth, Inc. and the Directors, except under very limited circumstances, would be improper under the Canons of Ethics.

Dual Representation Is Usually a Conflict of Interest

Although no Texas court has addressed the issue, many decisions in other jurisdictions have held that, in general, the same attorney may not represent both the corporation and the individual defendants accused of a serious breach of fiduciary duties to that corporation. The first case to seriously address the issue was Lewis v. Shaffer Stores Co., a New York federal district court opinion, which held:

[t]he interests of the officer, director and majority stockholder defendants in this action are clearly adverse, on the face of the complaint, to the interests of the stockholders of [the corporation] other than defendants. I have no doubt that [the attorneys] believe in good faith that there is no merit to this action. Plaintiff, of course, vigorously contends to the contrary. The court cannot and should not attempt to pass upon the merits at this stage. Under all the circumstances, including the nature of the charges, and the vigor with which they are apparently being pressed and defended, I believe that it would be wise for the corporation to retain independent counsel, who have had no previous connection with the corporation, to advise it as to the position it should take in this controversy.

In Cannon v. U.S. Acoustics Corp., the Northern District of Illinois court disqualified a law firm from representing a corporation and its board of directors in a derivative action, where the complaint alleged a misappropriation of corporate funds by the directors. The court reached its decision based upon both the conflict of interest between the corporation and its directors, and the possibility that confidences obtained from one client during the course of representation might be used to the detriment of the other. Many other courts have reached the same result. The same rule applies in a dissolution case.

Exceptions

Most courts have applied the conflict rule only in cases involving allegations of serious misconduct by the individual defendants. The Third Circuit held that where the claims against the individuals were merely negligence or mismanagement, that is, breaches of the duty of care rather than the duty of loyalty, then disqualification was not required. Also, courts do not apply the rule in derivative cases that are "patently frivolous."

Some courts have held that the early and limited representation of the individual defendants by the corporation's counsel does not present a serious conflict, such as when the corporation's attorneys file an answer or a motion to dismiss on behalf of the individual defendants but then withdraw. In Clark v. Lomas & Nettleton Fin. Corp., the court held:

There is no conflict of interest requiring disqualification in the narrow instance when one law firm represents a derivatively sued corporation and its individually sued directors and the law firm initially files a motion to dismiss on behalf of its clients, does not otherwise participate in the lawsuit, and withdraws from representation of either the corporation or the individual directors when either the motions are overruled or when it becomes necessary to participate in the defense of the corporation and the individual directors.

At this stage of the proceedings, when the court must make a determination on whether as a matter of law the defendants should be in the lawsuit, unless it can be shown that an actual conflict exists or that certain confidences are being jeopardized, I think the client's right to select the counsel of his choice outweighs any potential conflict of interest.

Once that determination is made, or once it becomes necessary for active participation in the defense of the directors, then new counsel must be sought, because the potential for conflict has increased to the point where it outweighs the rights of the individual directors to select counsel.

However, other courts, although acknowledging that no real conflict exists at the outset of the lawsuit and that the defendants might be burdened by having to locate two different law firms from the outset, nevertheless held that even this limited joint representation was not permitted.

The district court in Clark v. Lomas & Nettleton Fin. Corp. also suggested, but did not actually consider, that it might be possible for the court to allow the corporation to waive the conflict. One rather odd Louisiana opinion recognizes the considerable authority holding that there is a conflict in dual representation when the individuals are accused of serious misconduct, but holds that disqualification is not appropriate.

Although the corporation appears as a party on both sides of the lawsuit, its true interest lies with the plaintiff shareholder; it is only nominally a defendant. Therefore, [the law firm] represents only the interests of the individual directors who have allegedly harmed the corporation, and the plaintiff's counsel actually represents the interests of the corporation, to which any recovery will be returned. [The law firm] is not representing adverse interests because the corporation has no interest as a defendant; it is merely required to be named as one.

Therefore, the court reasoned, there is no conflict because the defendants' lawyers are not really representing the corporation, which raises an interesting question of whether the corporation is paying their legal fees and why.

Legal and Ethical Responsibilities to Retain Independent Counsel

Generally, the choice of independent counsel belongs to the corporation, not to the court. However, merely requiring the defendants to associate a second law firm does not really solve the problem. If the individual defendants control the corporation, hire counsel who take their orders from the individual defendants (even if not technically representing them), and actively engage in a joint defense with the individual defendants' counsel, then the situation with the separate counsel continues the same evils that the disqualification sought to remedy. Confidential information belonging to the corporation may still be used against the best interests of the corporation, and the attorneys for the corporation are still actively opposing the interests of the corporation. Therefore, courts have been careful to exercise some supervision over the selection and conduct of the new independent counsel.

In this derivative action the officers and directors who are accused of harming the interests of the policyholders will choose counsel to represent the policyholders regarding those charges unless the court does so. The issue is equitable. We can exercise our discretion to permit the corporations to choose independent counsel to represent them, or we or the trial court can select the independent counsel. While the first alternative would respect corporate autonomy and remove the outward appearance of dual representation, it would not eliminate the substance of the problem sought to be avoided. Counsel for the corporation would be subject to the control of those accused of wrongdoing.

Some corporations attempt to address these concerns by creating a genuinely independent decision-making body before selecting separate counsel. For example, a board may form a special litigation committee made up of directors who are not named in the lawsuit and who have no financial stake in the challenged transactions. That committee can then interview potential firms, evaluate whether proposed counsel understand the nuances of shareholder litigation, and document why their selection serves the corporation's best interests. When that process is transparent and grounded in written findings, courts are more likely to respect the corporation's choice and less likely to view the appointment as a disguised effort by insiders to protect themselves.

Courts also look closely at how independent counsel actually functions once retained. It is not enough for a law firm to appear "independent" on paper if, in practice, it takes direction only from the majority owners accused of misconduct. Judges will consider whether counsel has met with minority shareholders, reviewed internal records without interference, and formed its own view about the merits of the derivative claims. Where independent counsel recommends dismissal of a case, courts generally expect a clear explanation of the investigation performed and the reasoning used, particularly in closely held businesses where minority shareholder rights are most vulnerable.

Some courts have ruled that the lawyer who has been engaging in the dual representation may continue to represent the corporation, while independent counsel is retained for the individuals. Defendants often favor this approach as it simplifies having the corporation pay the entire cost of the defense. However, most courts have required the corporation to retain new, independent counsel.

In Lewis v. Shaffer Stores Co., the federal district court ordered the corporation to obtain separate, independent counsel, "who have had no previous connection with the corporation," and who were to file an answer on behalf of the corporation after their own investigation of the facts. However, the court did not find the fact that independent counsel for the corporation would be selected by the same officers and directors who had been sued to "present any insuperable difficulty." The court in Messing v. FDI, Inc., faced with a similar situation, held that the corporation was required to obtain independent counsel, "unshackled by any ties to the directors," to advise it of its most favorable course of action.

In Rowen v. LeMars Mut. Ins. Co. of Iowa, the Iowa Supreme Court ordered the trial court to appoint independent counsel for the corporation. The Second Circuit acknowledged the court's power to do so. However, a Maryland court of appeals rejected this approach.

In Messing v. FDI, Inc., the federal district court declined to appoint independent counsel for the corporation as this would "prospectively pass" on the directors' willingness to comply with the court's order to associate truly independent counsel. However, the court left the door open to its future appointment of counsel if the directors requested that the court do so or if the directors failed to comply with the order. "It is the duty of the directors, in this as in other matters, to act in the corporation's best interest. If they are disqualified from acting on this or on any other matter, then it is for them, in the first instance, to devise a method to accommodate the need to continue the corporate enterprise while refraining from participating in any corporate decision in which they might have a personal interest. They act, or fail to act, at their peril."

Need to learn more about how Hopkins Centrich Law can help with your derivative suits? Contact us online or by calling (254) 249-5436 today!

Practical Considerations for Minority Shareholders

Minority owners who suspect self-dealing, excessive compensation, or other misconduct often struggle to know when concerns rise to the level of shareholder litigation. In closely held businesses, personal relationships and informal agreements can make it difficult to separate hurt feelings from true breaches of fiduciary duty. Before filing a derivative suit or an action for shareholder oppression, a minority owner should gather and review documents such as financial statements, compensation records, and board minutes to determine whether the conduct at issue harms the corporation as a whole or only affects the individual shareholder.

It is also critical for minority shareholders to understand the procedural steps that may apply under Texas law before a derivative claim can proceed. In many cases, the shareholder must first make a written demand on the board of directors, asking the corporation to pursue the claim directly. How the board responds, whether through an independent committee or otherwise, can shape the course of the dispute and the eventual remedies available. For owners of closely held corporations, this demand process can feel like going to the very people who are causing the harm, which is why advance planning with counsel is so important.

Shareholders who are considering litigation should also think through what outcomes they are realistically seeking. A derivative suit is designed to benefit the corporation, which may indirectly benefit all owners, while a direct claim for shareholder oppression can lead to remedies more tailored to the individual, such as a buyout or damages tied to lost employment. Aligning the choice of claims with business goals—whether that is staying in the company on fair terms or exiting with value preserved—can help ensure that the litigation strategy supports long-term interests rather than escalating conflict for its own sake.

The Corporation's Position in Derivative Suits

A related issue is whether the corporation, regardless of who represents it, may actively defend its management in a derivative suit. Even if the corporation and the management are represented by different lawyers, the management still controls the corporation and hires, pays, and directs the activities of the corporation's lawyer. If the management is being sued for damaging the corporation, then the management will be eager to have the corporation, through its counsel, take a position in defense of the management. The corporation, after all, is not its management, and the true interests of the corporation are not necessarily aligned with the desires of management, particularly if the management is really looting the corporation. The attorney for the corporation must be aware that the inherent conflict of interest among the management can become the attorney's conflict if the attorney is directed to conduct the litigation so as to favor the management at the expense of the true interests of the corporation. If there are outside, disinterested directors, or a disinterested litigation committee, then the corporate attorney's job is much simpler because the attorney can take direction from directors who have no personal interest in the decision, although the attorney must be aware of whether the disinterested directors are exercising their valid business judgment, fully informed and independent of domination by the self-interested directors.

In practice, this means the lawyer for the corporation must draw a clear line between defending a legitimate corporate interest and simply shielding current management from scrutiny. When the derivative claims challenge excessive compensation, self-dealing, or diversion of opportunities, the corporation typically has more to gain from a thorough airing of the facts than from a reflexive defense of insiders. Counsel who advises a closely held corporation in these situations should help the board focus on long-term value, potential impacts on minority shareholders, and the risk that an aggressive defense of management may lead to additional claims for breach of fiduciary duty.

The overwhelming authority is that the corporation must remain neutral unless the derivative action directly threatens corporate interests (independent of whether it threatens corporate management).

Therefore, if disinterested directors or a disinterested special committee determine that the derivative litigation is not in the best interest of the corporation, then the corporation's attorney can and should pursue a dismissal. If the litigation threatens a legitimate corporate interest, then the corporation's attorney may defend against the derivative suit. However, the interests that justify the corporation's active participation in the defense must be interests of the corporation, not the interests of the corporation's management. If the litigation will result in exposing the corporation to liability to a third party or will result in making public confidential information, then the corporation may oppose the lawsuit or seek relief from the court necessary to protect the corporate interests. However, the fact that litigation against the management will be distracting and expensive and will otherwise inconvenience the officers and directors who are being sued should not justify active participation in the defense by the corporation.

What About When Nobody Has Authority to Hire Corporate Lawyers?

One of the thorniest issues that arises is whether information or communications between the other directors and the corporation's lawyers can be withheld from the dissident director on the grounds of attorney-client privilege. Texas has not addressed this issue head-on, but the law is clear that the right of a director of a Texas corporation to inspect the corporate books and records is absolute. Because directors of a corporation are charged with managing the business and affairs of the corporation, "it would seem to be axiomatic that the individual director cannot make his full contribution to the management of the corporate business unless given access to the corporation's books and records. The information therein contained is ordinarily requisite to the exercise of the judgment required of directors in the performance of their fiduciary duty so much so that the directors' right of inspection has been termed absolute, during their continuance in office at all reasonable times." Even before the Texas Business Corporation Act specifically conferred upon directors the right to inspect the corporate books, Texas courts held that this right existed by common law. The current BOC 3.152(a) specifically provides directors the right of inspection and a remedy for violation of that right. The director does not have to have a "proper" purpose to inspect, so long as the director's purpose is "reasonably related to his service as a director"; however, the director is not required to state his purpose or even to make a written demand.

Adverse Directors

A very difficult situation is presented to a corporation's lawyer when the dispute is between or among directors of a corporation, as often happens in oppression disputes in small closely held corporations where all the shareholders are also on the board of directors. The board of directors of a corporation is charged with its management, BOC 21.401, but the board's authority must be exercised as a group; individual directors have no authority apart from the board. When a shareholder fight involves two directors, the corporation's lawyer is faced with a real dilemma. The lawyer's duty is to the corporation, not to the individual shareholders, directors, or officers. But who is the corporation in this situation? The natural inclination is to side with the directors who represent the controlling interest and to shun the dissident director who represents a minority interest, but this can be a terrible mistake. The dissident director remains a director, is entitled to the rights and powers of a director, and the board of directors can take no action legally without notice to (and the knowledge of) the dissident director.

In closely held businesses, this tension often arises against a backdrop of long-standing personal relationships and unwritten understandings. Corporate counsel who routinely handles shareholder litigation quickly learns that ignoring a dissenting director can invite claims of oppression, breach of fiduciary duty, or even requests for a court-ordered buyout. To reduce that risk, lawyers frequently advise boards to document notice to all directors, ensure that meeting minutes reflect the participation or non-participation of each member, and avoid convening "shadow boards" that effectively exclude the minority. Taking these precautions does not eliminate conflict, but it does show that the corporation, through its board, is attempting to respect corporate governance rules rather than allowing a majority group to operate informally and unchecked.

A California appellate court decision grappled with this exact issue. Under California law, corporate directors also have an "absolute right" to inspect and copy all corporate "books, records and documents of every kind." This "absolute right" normally extends to documents otherwise subject to the attorney-client privilege.

In Tritek Telecom v. Superior Court, the California Fourth District Court of Appeal dealt with a shareholder dispute involving two equal shareholders of a closely held corporation, both of whom were directors.

A third non-shareholder director apparently aligned with one of the shareholders, thus giving that shareholder effective control. The controlling shareholder then proceeded to lock out the other shareholder, stop paying his salary, and misappropriate assets. The ousted shareholder sued the other two directors and the corporation, alleging various causes of action and seeking the return of the shareholder's investment. Initially, the corporation's lawyer represented both the corporation and the individuals in the litigation. The trial court correctly disqualified the corporation's lawyer from the dual representation and required new and separate counsel for both the corporation and the individual defendants.

Thereafter, the plaintiff sought to inspect the documents and communications generated by the corporation's attorney during the time of the dual representation. The defendants resisted the inspection on the grounds of attorney-client privilege. The trial court ordered the inspection. The appellate court reversed, holding that the plaintiff shareholder/director had no right to inspect attorney-client privileged documents that were generated in defense of the plaintiff's lawsuit filed against the corporation.

In reaching its conclusion the Court of Appeal acknowledged that the director's rights to access to corporate records are absolute, but then paradoxically noted that there are exceptions to this absoluteness. One California Court of Appeal had previously noted hypothetically that a director's absolute right of inspection might be denied where a disgruntled director announces his or her intention to violate fiduciary duties to the corporation, such as by using inspection rights to learn trade secrets to compete with the corporation. That court had held that the director was entitled to inspection but had ruled that section 1603(a) of the California Corporations Code, which provides that a court may enforce the right of inspection "with just and proper conditions," permits a court to grant a corporation a protective order denying or limiting a director's inspection, but only if the corporation demonstrates by an evidentiary showing that the protective order is necessary to prevent a tort from being committed against the corporation by the director. The Tritek court also cited La Jolla Cove Motel and Hotel Apts. Inc. v. Superior Court for the proposition that corporate counsel has no duty to disclose privileged information to a dissident director with which the corporation has a dispute.

In Tritek, the court held that the dissident director's "absolute right" to access corporate records did not extend to privileged communications generated in defense of each suit that the director had filed against the corporation because the interests of the director were adverse to those of the corporation and because such access would violate the privilege between the controlling shareholder and the corporation's lawyer during the time that the corporation's lawyer represented the individual shareholder.

The court's reasoning is very troubling on a number of levels. First, the court fails to consider whether the attorney-client privilege ever existed in the first place. A communication is subject to the attorney-client privilege only if the communication is made with the expectation of confidentiality. Cal. Evid. Code § 952. The attorney-client privilege may be held jointly by two or more persons, and the assertion or waiver by one of the joint holders does not affect the others. Cal. Evid. Code § 912. The very nature of the corporation is that it is controlled and managed by its board of directors. The directors exercise their power and authority over the corporation only as a group, not individually. Therefore, while the corporation is the holder of the attorney-client privilege with its corporate counsel, the privilege is exercised by and through the directors, and no one director has any more claim to access privileged communications than any other. Therefore, communications between a corporation and its corporate counsel cannot be made with the expectation that they will be kept confidential from any member of the board of directors. Therefore, as to the sitting members of the board of directors, the question arises: what attorney-client privilege can be asserted against them? One previous California case held that meetings with corporate counsel by one group of shareholders in a closely held corporation could be withheld from another group of shareholders on the grounds of attorney-client privilege, where the evidence showed that the meeting had served a corporate purpose. However, that court neatly sidestepped the difficult issue posed by the fact that one of the dissident group of shareholders was also a director by noting that the lawsuit had been brought in the director's capacity as a shareholder, not a director.

The Delaware courts have also addressed this issue, and their conclusions have been markedly different from that reached in the Tritek case. Under Delaware law, when a corporation employs legal counsel, each of the members of the board of directors has a status co-equal with the corporation as "client." "The issue is not whether the documents are privileged or whether plaintiffs have shown sufficient cause to override the privilege. Rather, the issue is whether the directors, collectively, were the client at the time the legal advice was given. Defendants offer no basis on which to find otherwise, and I am aware of none. The directors are all responsible for the proper management of the corporation, and it seems consistent with their joint obligations that they be treated as the 'joint client' when legal advice is rendered to the corporation through one of its officers or directors." Therefore, communications with corporate counsel during a director's tenure on the board cannot be privileged as to that director because, as a matter of law, such communications could not legally have been intended to be kept confidential from that director. "Absent a governance agreement to the contrary, each director is entitled to receive the same information furnished to his or her fellow board members." In fact, Delaware corporate law is clear that attorney-client communications to which a director should have had access during tenure continue to be available after that person ceases to be a director. In Kirby v. Kirby, the Delaware Chancellor held that, as to attorney-client communications that occurred during the tenure of former directors, it is not possible for any privilege to have been created for those communications, and therefore, there is no basis for the invocation of the attorney-client privilege at a later date. Independently, under Delaware corporate law, the corporation is prohibited from asserting the attorney-client privilege as to information to which a director is entitled. A corporation may not "assert the privilege to deny a director access to legal advice furnished to the board during the director's tenure."

Perhaps more troubling are the explicit reasons for the Tritek court's holding: that the plaintiff is adverse to the corporation and that access to privileged communications would violate a privilege held independently by the controlling shareholder. The opinion does not give great detail about the exact procedural posture of the case and the exact causes of action asserted by the plaintiff. If the plaintiff asserted a cause of action against the controlling shareholder for breach of fiduciary duties as a result of misappropriation of corporate assets, then this claim must almost certainly have been brought as a derivative claim, in which case the plaintiff would have been asserting claims on behalf of the corporation rather than against it. In almost every lawsuit between a controlling shareholder and a non-controlling shareholder for wrongdoing by the controlling shareholder, the law governing standing and capacity will almost always require that some of the claims be brought against the corporation. This very often results in the strange situation in which a plaintiff is both suing and representing the interests of the corporation in the same lawsuit. Courts, however, generally view the situation as a matter of substance over form. The true dispute is between the shareholders, and regardless of how the complaint is stated, the gravamen of the complaint is the manner in which the controlling shareholder has exercised power over the corporation. There is absolutely no reason for a court to assume that the party that controls the corporation is therefore acting in the interests of the corporation. If the claims made by the plaintiff in Tritek are true, then the plaintiff was acting on behalf of the corporation, and the controlling shareholder was adverse to the corporation.

There can be little justification for protecting the confidentiality of communications between the corporation's lawyer and the controlling shareholder/director as against another director when the very act of establishing the attorney-client relationship between the corporation's lawyer and the controlling shareholder was a breach of both of their duties to the corporation. "[A]s attorneys for [a] corporation, counsel's first duty is to [the corporation]." "These cases make clear that corporate counsel's direct duty is to the client corporation, not to the shareholders individually, even though the legal advice rendered to the corporation may affect the shareholders." A corporation's attorney is not permitted, either during or after that engagement, to represent any shareholder or director against the corporation (or the other shareholders when that would entail acting contrary to the attorney's prior representation of the interests of all the shareholders). Moreover, a corporation is not permitted to defend a derivative action on the merits, and the corporation's lawyer has a duty to refrain from taking part in any controversies or factional differences among shareholders as to control of the corporation, so that the lawyer can advise the corporation without bias or prejudice. As for the controlling shareholder who elected to use the corporation's lawyer to defend claims brought against that shareholder personally based on an individual breach of duties to the corporation and to the other shareholder, the controlling shareholder has misappropriated corporate assets (the services and independence of the corporation's lawyer, not to mention the fees incurred by the corporation) for individual benefit and has directed the corporation's lawyer to violate duties to the corporation and to cause the corporation to take a position that it is not legally permitted to take. It is very difficult to understand why the Tritek court believed that this was a valid exercise of the attorney-client privilege worthy of the court's protection, and the opinion does not address the issue.

Of course, if a dispute arises between two groups of shareholders or between the corporation and one of its directors, the corporation may very easily preserve the attorney-client privilege and the integrity and confidentiality of the legal advice from the corporation's lawyer by establishing an independent litigation committee to consult with corporate counsel. As the Chancellor held in Moore Business Forms, Inc. v. Cordant Holdings Corp.:

Holdings had alternative means to enable its directors (other than Mr. Rogers) to receive confidential attorney advice not discoverable by Moore. Holdings could have bargained for such protections in the Stockholders Agreement. Alternatively, and independent of the Stockholders Agreement, the Holdings board could have acted, pursuant to 8 Del. C. § 141(c) and openly with the knowledge of Moore and Rogers, to appoint a special committee empowered to address in confidence those same matters. Under either scenario the special committee would have been free to retain separate legal counsel, and its communications with that counsel would have been properly protected from disclosure to Moore and its director designee. Neither approach was followed here.

Of course, this approach assumes that there are independent directors and that the corporation (as apart from the shareholders involved in the lawsuit) has some legitimate, independent reason for legal advice. This alternative would not have been possible in the Tritek case, where there were only two shareholders, no independent directors, and no reason for the corporation or the corporation's lawyer to be actively involved in defending one or the other shareholder.

Legal and Ethical Responsibilities When Representing the Shareholders in a Derivative Action

Attorneys representing plaintiff shareholders in litigation must also be aware of potential conflicts of interest because these attorneys will owe duties both to their individual client and to the corporation on whose behalf the lawsuit was brought. These interests are not always perfectly aligned.

Joining Individual and Derivative Claims 

Very frequently, the shareholder will have individual claims, such as shareholder oppression, that arise out of or relate to the transactions and occurrences that gave rise to the derivative claims and that are properly brought in the same lawsuit. At a very theoretical level, there is some conflict of interest inherent in the simultaneous pursuit of individual and derivative claims.

In bringing the derivative claims on behalf of the corporation, the plaintiff and counsel are acting in a representative capacity and owe the corporation fiduciary duties of loyalty. If the plaintiff shareholder is also suing on individual claims, then that plaintiff and counsel might be tempted to devote greater resources and attention to the individual claims or to favor the individual claims in settlement negotiations. Courts have recognized that the conflict between a plaintiff's derivative and individual claims is more "theoretical than real." In assessing this "theoretical" conflict, courts look beyond the "surface duality" and determine whether an actual conflict exists.

Legal and Ethical Responsibilities When Representing the Shareholders in a Derivative Action

Attorneys representing plaintiff shareholders in litigation must also be aware of potential conflicts of interest because these attorneys will owe duties both to their individual client and to the corporation on whose behalf the lawsuit was brought. These interests are not always perfectly aligned.

Notwithstanding this theoretical possibility of a conflict (and bearing in mind that the court must pass on the fairness and adequacy of the settlement), courts have almost universally held that it is permissible for a plaintiff shareholder to join individual and derivative claims. Nor does it matter that the derivative and individual claims arise from the same facts.

Frequently Asked Questions

When Should a Minority Shareholder Consider Filing a Derivative Suit?

A minority owner should consider a derivative suit when the alleged misconduct harms the corporation itself rather than only reducing that owner's personal income or influence. Examples include diversion of corporate opportunities, misuse of company funds for personal expenses, or paying insiders compensation that bears no relationship to the business's performance. Before taking that step, it is advisable to review corporate records, request an explanation from management when appropriate, and discuss whether a written demand on the board is required under Texas procedure. This preparation helps clarify whether a derivative claim is the right tool or whether a direct oppression claim would be more effective.

How Do Courts Evaluate Whether Counsel in a Derivative Case Has a Conflict of Interest?

Courts look beyond labels to examine who counsel actually represents, how fees are being paid, and whether confidential corporate information could be used to favor one side over the other. When one firm purports to speak for both the corporation and the individuals accused of misconduct, judges ask whether their interests diverge and whether any group of disinterested directors is providing independent direction. If there is a substantial risk that loyalty to one client will compromise duties owed to another, courts have broad discretion to order disqualification or require the retention of independent counsel.

What Remedies Are Available in Shareholder Litigation Beyond Money Damages?

Shareholder disputes do not always end with a simple award of damages. In appropriate cases, courts can order changes to corporate governance, require an accounting, or approve settlements that revise compensation structures and related-party contracts. In closely held businesses, a court may consider equitable remedies such as a buyout of a minority owner's shares or, in extreme situations, dissolution of the company. The precise remedy depends on whether the claims are derivative or direct, the nature of the misconduct proved, and the practical impact of different outcomes on the ongoing business and all of its owners.