The Oxford Dictionary defines a conundrum as “a confusing and difficult problem or question”. When considering a claim, its classification as direct rather than derivative—or vice versa—qualifies as a conundrum.
What are Direct Actions and Derivative Actions?
A direct action seeks redress for harm to a particular individual, and not as a consequence of damage to the entity that the individual holds an ownership interest in. In a derivative action, an owner of an entity causes, in effect, the entity to seek redress on the entity’s behalf. Derivative suits allow individual owners to sue wrongdoers on behalf of the entity and force the responsible party to compensate the entity for damage to the entity.
The seminal case of Tooley v. Donaldson sets forth the required analysis to distinguish between direct and derivative actions. “The analysis must be based solely on the following questions: Who suffered the alleged harm—the corporation or the suing stockholder individually—and who would receive the benefit of the recovery or other remedy?”See Tooley v. Donaldson, Lufkin, & Jenrette, Inc. 845 A.2d 1031, 1036 (Del 2004). Although the two-step analysis from Tooley is easy to state, it is “a confusing and difficult problem” in practice.
In Friet v. Gaiser, a case I argued, the Court of Appeals held that “[u]nder the Washington Limited Liability Act (WLLA) [RCW 25.15.391], a claimant may bring a derivative action to enforce the LLC’s rights, but it must be an LLC member. Although the WLLA does not specify the difference between a derivative action and a direct action, a derivative suit does not benefit the individual member, and both the cause of action and judgment belong to the company.” This means that “if stockholders are directly injured and that injury is distinct from an injury to a corporation [or LLC], the stockholders’ claims are direct, and any recovery flows to the stockholders.” See Friet v. Gaiser, 194 Wash.App. 1048, at *4 (Wash. Ct. App. 2016). Conversely if the owners are indirectly injured, and that injury is concurrent with an injury to the corporation (or LLC), the owners claims are derivative, and any recovery flows to the corporation (or the LLC).
Why Does it Matter?
As a matter of equity, courts created “derivative standing” to allow shareholders to pursue claims on behalf of a corporation. See El Paso Pipline v. Brinckerhoff, 152 A.3d 1248 (Del 2016). However, to have standing to bring such an action, the claimant must be a shareholder and that concept also applies to limited liability companies and limited partnerships.
Once a person loses, or never had, their status of a member, that person no longer has standing to sue in a derivative capacity. As a result, a proper classification of a claim as direct v. derivative in nature can be dispositive of a matter.
There are transactional means to eliminate one’s status as an owner. For example, a reverse stock split (see my post on Sound Infiniti’s reverse stock split here) or a freeze out merger can eliminate a minority owner’s status as a shareholder or member. Without the proper status as a shareholder or member, a plaintiff loses standing to sue derivatively and their case must be dismissed.
There are many ways to end litigation. Do not forget that transactional methods can be a useful tool to end litigation, too. While classifying claims as derivative or direct is a confusing and difficult problem – a conundrum – it can make all the difference.
For more information about direct or derivative actions, visit Beresford Booth – WA State Lawyers (beresfordlaw.com), reach out directly to info@beresfordlaw.com , or give me a call at (425) 776-4100.