The New Hampshire Supreme Court has recently changed the rules applicable to lawsuits filed by minority shareholders against directors, officers and majority shareholders in closely held corporations in this State. The change removes significant restrictions that until now governed the filing of so-called derivative actions and allows minority shareholders to recover direct damages against the majority rather than having the monies returned to the corporate coffers. As a result, suits by minority shareholders may well increase. Shareholders, directors, and officers in closely held corporate entities should be aware of these changes.
Prior to the Court’s February 2005 decision in Durham v. Durham, a minority shareholder in a closely held corporation who wished to challenge the actions of the board of directors, officers, or majority shareholders was required to file suit in a “derivative” action brought in the name of the corporation. Suits of this nature usually focus on claims of corporate mismanagement and breach of fiduciary duty by officers, directors and majority shareholders. While the issue of what suits must be filed by shareholders derivatively, as opposed to individually, is complicated, in general, if the suit involves matters that would affect all shareholders equally (for example, corporate mismanagement, as opposed to alleged fraud in the sale of stock to a particular shareholder), the action was required to be filed in the name of the corporation. The purpose of requiring the suit to be filed derivatively was to: (1) prevent a multiplicity of suits against the corporation by a series of unhappy shareholders; (2) protect corporate creditors by putting the funds back into the entity; (3) protect the interest of all shareholders by increasing the value of their shares instead of allowing recovery to one shareholder; and (4) compensating the injured shareholder by increasing the value of his or her shares. Derivative suits have strict pre-suit requirements that must be met before the suit can be filed, including a demand on the board giving it a chance to file the suit and a 90 day waiting period for the board to act. If the board has independent members who can evaluate the issue and determines not to act, a derivative suit generally cannot be filed. In addition, there are requirements that the shareholder “fairly and adequately” represent the interests of all shareholders. Perhaps most important to the complaining shareholder in derivative actions, any recovery belongs to the corporation, not the shareholder bringing suit. Most minority shareholders view this as simply supplying more chickens to the henhouse guarded by the fox. These pre-suit requirements have traditionally been significant hurdles to the filing of suits by minority shareholders.
The Durham case involved a typical set of facts in suits by minority shareholders in closely held or family corporations. Four family members owned the Sunset Ranch Camp in Orford, New Hampshire, which was in the business of renting cottages, with the complaining minority shareholder owning 40 per cent of the company and his brothers and sister owning the remainder of stock. The shareholders were also all of the officers and directors of the company. Roland Durham complained that the majority had rented cottages without returning rentals to the entity, had unlawfully made distributions to themselves, had illegally cut trees on the property, wasting corporate assets, and had failed to maintain insurance. When Durham sued, the Superior Court dismissed the action, requiring that the demand be made on the corporation as a derivative suit.
The Supreme Court reversed. Although recognizing past decisions requiring derivative suits in this situation and affirming the policy behind those decisions, the Court reasoned that in cases where a suit involves “two individuals or sets of shareholders, one who is in control and the other who is not” and all of the shareholders are involved in the suit, the rigid requirements of derivative actions are not necessary and may in fact, undermine the principles those suits were designed to serve. The Court thus allowed Roland Durham to pursue the action in his own behalf and to recover any damages for himself so that the recovery was not “under the control of the wrongdoers.” The Court did not adopt a blanket rule for all cases but instead stated that in closely held companies and in situations where all the shareholders are before the court, trial courts have discretion to ignore the derivative requirements and to allow direct actions, provided that doing so will not unfairly expose the corporation to multiple lawsuits, prejudice creditors or interfere with a fair distribution of the recovery to interested parties.
Suits like that in Durham challenging actions by the majority in closely held corporations are the every-day fare of corporate governance disputes, whether to challenge the level of salaries for officers, the expenditures of the corporation, the failure to pay dividends or unfair treatment of the minority shareholders. Durham leaves officers, directors and majority shareholders in closely held corporations with far less certainty about the rules for suits challenging their conduct and certainly makes it easier to challenge majority action. For example, what standards will a court apply to determine whether the interests of corporate creditors are affected by a suit? How will the courts assess whether the minority shareholders interests differ from those of the majority? Or how will the courts assess whether the minority shareholder is entitled to recover personally from the majority? While the exact parameters of the decision may have to play out in the courts, majority owners of closely held entities should be aware that they can be sued more easily and that the rules governing such suits have far less predictability. As a result, majority owners of closely held businesses would do well to heed the warning of the sergeant at the beginning of each episode of the former television show Hill Street Blues: “Be Careful Out There.”