Utah Court Says Exception from Derivative Suit Requirements for Closely Held Corporations Applies to LLCs

LLC minority members who want to sue the majority members or managers for breaches of fiduciary duty are sometimes frustrated by a catch-22 – if the LLC was the injured party then the member’s complaint must be brought on behalf of the LLC as a derivative suit, but the procedural requirements for derivative suits may bar the minority member’s lawsuit. Utah has previously recognized an exception to the derivative suit requirements for closely held corporations, and recently applied that same exception to LLCs. Banyan Inv. Co. v. Evans, No. 20100899-CA, 2012 WL 5950664 (Utah Ct. App. Nov. 29, 2012).

Banyan was a 20% member of Aspen Press Company, LLC. The other five members managed the company and Banyan was not involved in its management. Banyan filed a lawsuit against the other members for breaches of their fiduciary duties and for unjust enrichment.

The defendants asked the court to dismiss Banyan’s lawsuit on the grounds that its claims were derivative and therefore could not be brought directly against the members. The defendants argued that Banyan should have filed the claims derivatively and should have complied with Rule 23A of the Utah Rules of Civil Procedure, which requires certain procedures for a derivative suit.

Rule 23A (and comparable rules from most other states) addresses the following problem. When a corporate director or LLC manager breaches its fiduciary duties, it directly harms the company. The shareholders or members are only harmed indirectly, so normally only the company would have standing to bring the lawsuit. But if those in charge of the company are themselves the wrongdoers, it’s unlikely that they’ll cause the company to sue themselves. That difficulty has led to the derivative suit, a procedural device by which a shareholder of a corporation or a member of an LLC can assert a claim on behalf of the company against a director or manager that is breaching its duties to the company.

A company’s decision to initiate a lawsuit is normally up to its management, so a derivative suit by its nature interferes with management’s authority. The rules for derivative suits therefore require, among other things, that before filing suit the complaining shareholder or member must first make demand on the company to take action against the wrongdoer, or explain why making the demand would be futile. E.g., Utah R. Civ. P. 23A.

Banyan’s lawsuit made claims for breaches of fiduciary duties directly against the other members. Its lawsuit was not a derivative suit and did not comply with Rule 23A. Banyan’s defense against the defendants’ motion to dismiss was that its suit was permitted under an exception for closely held corporations (referred to in this post as the Exception) that the Utah Supreme Court had recognized in Aurora Credit Services, Inc. v. Liberty West Development, Inc., 970 P.2d 1273, 1281 (Utah 1998) (“We therefore hold that a court may allow a minority shareholder in a closely held corporation to proceed directly against corporate officers.”).

The trial court ruled that the Aurora Credit Exception did not apply to LLCs and dismissed Banyan’s complaint. Banyan appealed. The defendants argued on appeal that the Exception does not apply to LLCs, and that even if it did apply, Banyan did not meet its requirements. Banyan Inv. Co., 2012 WL 5950664, at *4.

The Court of Appeals briskly disposed of the argument that the Exception did not apply to LLCs. The court pointed out that the Utah Supreme Court had previously decided that the corporate principles governing derivative actions apply to LLCs, and that Rule 23A governs derivative actions brought on behalf of LLCs as well as corporations. Id. (citing Angel Investors, LLC v. Garrity, 216 P.3d 944 (Utah 2009)). The court also found that the rationale for the decisions in Aurora Credit and Angel Investors was as applicable to LLCs as to corporations – the majority owners of closely held companies usually are the management, and management is usually not independent. The court concluded that “the trial court erred by dismissing Banyan’s direct claims solely on the basis of its conclusion that the [Exception] does not apply to LLCs.” Id. at *5.

The defendants also argued that Banyan could not maintain a direct action because it could not show that it was injured in a way that was distinct from any injury to the LLC. The court said no, that rule applied only to traditional direct actions by a shareholder or member, not to actions that would otherwise be derivative were it not for the Exception. Id.

The correct rule, said the court, is that for a plaintiff’s claims to come under the Exception, the plaintiff must be able to show that its injury is distinct from that suffered by the other owners: “The closely-held corporation exception applies where a minority shareholder suffers uniquely as a result of majority shareholders engaging in the type of wrongdoing that would ordinarily give rise only to a derivative claim.” Id. at *6 (emphasis added).

The court also stated that an LLC member may proceed directly under the Exception only if (i) the defendants will not be unfairly exposed to a multiplicity of actions, (ii) the interests of the LLC’s creditors will not be materially prejudiced, and (iii) the direct suit will not interfere with a fair distribution of the recovery among all interested persons. Id. (citing GLFP, Ltd. v. CL Mgmt., Ltd., 163 P.3d 636 (Utah Ct. App. 2007)).

The court held that the allegations in Banyan’s complaint satisfied these requirements and that Banyan could bring its derivative claims directly under the Exception. Id. at *7.

Comment. The Banyan court’s application of the Exception to LLCs is sensible and is consistent with the prior Utah case law. The Exception itself is a minority rule but appears to be gaining wider acceptance.

The Exception has been recommended by the American Law Institute. 2 American Law Institute, Principles of Corporate Governance: Analysis and Recommendations § 7.01(d) (1994). The American Law Institute indicates that its recommendation in § 7.01(d) is supported by decisions from nine states: Arizona, California, Georgia, Idaho, Maryland, Massachusetts, North Carolina, Ohio, and West Virginia. Id., Reporter’s Note 4, at 31-32.