Prof. Larry Ribstein has posted Reforming Limited Liability Company Fiduciary Litigation on SSRN. He presented this paper at last week’s LLCs at 20 symposium at Suffolk. Here’s the abstract:
Derivative suits are designed for publicly held corporations. In limited liability companies, the remedy creates significant costs and complications. These costs are unnecessary because more appropriate remedies member-authorized and direct suits are available. The application of the derivative remedy to LLCs is an example of lawmakers applying rules across business entities without adequately thinking through which rules belong in a coherent business association statute.
I’m not sure that I agree. If nothing else, minority-member lawsuits are likely to get labeled at "entity" lawsuits, rather than direct, individual lawsuits.
(Note: Pennsylvania law (15 Pa.C.S. § 8992) permits derivative actions in limited liability companies.)
There are plenty of issues in an LLC that cannot be addressed appropriately by direct action. More importantly, retaining derivative actions answers two questions that have frustrated and confused a number of lawyers and judges: do individual members of an LLC have standing to sue when the majority of LLC members engage in tortious or intentional conduct, and, if so, what remedies are available?
Answering that question by reference only to contract law is usually impossible, because the vast majority of the LLC operating agreement have no provision for what should happen in the event of a breach, they just generally affirm the principle of majority rule. Viewed literally, most LLC operating agreements permit, by silence, the majority members to frustrate the reasonable expectations of the minority members and freeze them out of the business.
Courts are supposed to avoid absurd and unjust results, and most will not allow an operating agreement to cheat a minority member merely because of the absence of a "don’t cheat" provision.
How do courts do then? There are a variety of options, including the common law proposition that "bad faith conduct" constitutes a breach of contract, regardless of whether the conduct specifically breaches the text of the agreement. But each one of those options relies heavily on discretion, resulting in inconsistent outcomes across similar cases before different judges.
I think the bigger question is: what’s the harm of allowing a derivative action? A lawsuit is a lawsuit, and I fail to see how a derivative lawsuit in an LLC will result in any more discovery, costs, or anything else. In the context of an LLC, it’s largely a different style of pleading.
Indeed, even if there is a harm, the
American Law Institute’s Principles of Corporate Governance
(2-7 § 7.01) says, in the case of a closely held corporation, the court in its discretion may treat an action raising derivative claims as a direct action, exempt it from those restrictions and defenses applicable only to derivative actions, and order an individual recovery, if it finds that to do so will not (i) unfairly expose the corporation or the defendants to a multiplicity of actions, (ii) materially prejudice the interests of creditors of the corporation, or (iii) interfere with a fair distribution of the recovery among all interested persons.
That, in essence, can make all derivative actions direct if the court is so inclined, creating an escape hatch for situations in which derivative actions are inappropriate. No corollary exception exists to permit derivative recovery where direct is inappropriate; that’s why it needs to be there by statute.