Corporations and their boards frequently find themselves confronted with litigation from their own shareholders. Shareholder litigation usually involves either a shareholder demand (via a letter) or a filed complaint alleging the shareholder need not make demand in the first place (e.g. demand is “futile”). Often times, the success or failure of a shareholder’s claims simply comes down to what is (or is not) pleaded in the shareholder’s complaint or demand. This week’s blog post discusses a recent case out of federal court in the Western District of Washington where a shareholder learned this lesson the hard way.
Central Flyway Air, Inc. v. Grey Ghost International, LLC involves a “business dispute” concerning the management and assets of Grey Ghost Gear (the “Company”) (their website is here: https://greyghostgear.com/). The Company, incorporated in May 2016 by its sole shareholder, Grey Ghost International, LLC (“GGI”), manufactured and sold various lines of body armor. A couple months after its incorporation, the Company brought on another investor, Central Flyway Air, Inc. (“CFA”), who acquired 49% of the Company’s stock.
Soon after CFA’s investment, its sole owner, Jon Boychuk, became the Company’s CEO. Unfortunately, after taking over as the CEO, GGI alleged that Mr. Boychuk took “100 percent control” of all aspects of the Company, but mismanaged the Company. Vendors were not paid, purchase orders were never fulfilled, and Mr. Boychuk’s company credit card contained significant personal expenses.
These actions culminated in the lawsuit where, among other things, the Company and GGI asserted claims against CFA and Mr. Boychuk for breach of fiduciary duty, unjust enrichment, and conversion. The opinion, Central Flyway Air, Inc. v. Grey Ghost International, LLC, No. 3:20-cv-05506-BJR, 2022 WL 17976099 (W.D. Wash. Dec. 28, 2022), arose after the Company and GGI filed a motion for summary judgment on their claims.
“Derivative” Claim Dismissed
Before discussing the merits of the litany of claims made by the Company and GGI, the Court first discussed whether GGI even had standing to bring claims against CFA and Mr. Boychuk. This is the most significant analysis for purposes of this blog post because the Court’s analysis underscores the fact that these cases are frequently decided not on the merits, but on the contents of the pleadings.
A shareholder’s standing to sue is the first hurdle (and sometimes the most significant hurdle) that must be satisfied before a shareholder can proceed with its lawsuit. To have standing to sue a corporation, a shareholder “must assert more than personal economic injury resulting from a wrong to the corporation,” but instead “must be injured directly and independently of the corporation.” 2022 WL 17976099 at *4. This is the distinction between direct and derivative claims that is often so significant in shareholder litigation. Shareholders are subject to significant procedural requirements when bringing a derivative action, but these procedural requirements are absent when filing a direct action.
In this case, GGI never satisfied any of the procedural requirements necessary to assert derivative claims. Instead, GGI elected to pursue claims directly. However, all of their claims were “premised on the alleged misuse of [the Company’s] funds and misappropriation of its inventory and other assets,” which resulted in harming GGI’s investment in the Company. Id. at *5. However, “shareholders’ injuries consisting of a devaluation of their stock in a company are ‘clearly derivative because that is an injury that fell on every stockholder, majority and minority alike, and fell on each on a per share basis.’” Id. (quoting Uthe Tech. Corp. v. Aetrium Inc., 739 F. App’x 903, 905 (9th Cir. 2018)). GGI required additional, unique damage outside of harm to its stock to pursue claims against CFA and Mr. Boychuk—by failing to plead additional damage, GGI lacked standing to pursue its claims. As such, the Court dismissed all of GGI’s claims.
Pleadings Matter in Shareholder Litigation
When advising corporate boards faced with litigation from the corporation’s shareholders, the first step is often the most important: read the pleadings to determine whether the shareholder complies with necessary formalities.
If the claims asserted by the shareholder are direct, does the shareholder allege individual, unique harm?
If the claims asserted are derivative, does the shareholder comply with the procedural requirements? Does the shareholder allege harm on behalf of the company and seek damages recoverable by the company?
The answers to these questions have almost nothing to do with the merits of a shareholder’s case, but nevertheless they can spell the end for a shareholder’s lawsuit even before it gets started.
To learn more about Derivative vs. Direct Actions, please contact Beresford Booth at email@example.com or by phone at (425) 776-4100.