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Supreme Court of Tennessee Adopts New Standard for Determining Whether a Claim is Direct or Derivative

Generally speaking, a shareholder of a corporation or a member of an LLC has no individual right against a third party for an injury done to the corporation or LLC. While injuries done to corporations and LLCs most always have a direct monetary impact on owners, still, such claims belong to the corporation or LLC. Thus, they must be filed on behalf of the corporation or LLC. As well, any recovery must be paid to the corporation or LLC.

In Tennessee, claims filed on behalf of a corporation or LLC are called “derivative lawsuits,” “derivative claims” or “shareholder derivative lawsuits.” “Direct claims” belong directly to shareholders (or LLC members), and can be filed in the name of the injured shareholders or LLC members. Any recovery or relief in a direct claim will go to the shareholder or LLC member who brought the claim.

A shareholder who brings a lawsuit in his or her own name had better be careful. That is because, if the claim brought by the shareholder should have been brought on behalf of the corporation as a derivative claim, it will be dismissed on the basis that the shareholder does not have standing. (The same analysis applies to claims brought by LLC members.)

For many cases, distinguishing between a claim that must be filed as a derivative claim versus a claim that may be filed by a shareholder or member in his, her or its own name and right is pretty easy. For example, if an officer or owner of a corporation or LLC breaches his or her fiduciary duties by misappropriating monies or business opportunities of the corporation or LLC, a shareholder or member would have to sue that officer or owner in a derivative lawsuit.

If a shareholder’s or member’s claim arises from the fact that he or she was deprived of voting rights; was not allowed to inspect books or records; or, sold his or her interest to another member based on a misrepresentation, that shareholder or LLC member, under Tennessee law, can bring a direct action against the corporation or LLC or against the person or entity who made the misrepresentation.

In some cases, it is not so easy to determine whether a claim is a derivative claim, which must be asserted in a derivative lawsuit to avoid dismissal or, on the other hand, whether the claim is a direct claim.

In a recent decision of the Supreme Court of Tennessee in a case involving a shareholder dispute, it adopted a new standard for determining whether a claim is derivative or direct. The case is Keller v. Estate of McRedmond. For Tennessee lawyers who handle shareholder and LLC cases, it is a must read.

In Keller, the Supreme Court of Tennessee adopted the approach laid out by the Delaware Supreme Court in what is known as the Tooley case. To determine whether a claim is a direct claim or a derivative claim under Tooley, the court must ask two questions: (1) who suffered the alleged harm — the stockholder who filed the lawsuit or the corporation; and, (2) who would receive the benefit of any recovery — the stockholder or the corporation?

In Keller, stockholders had filed a direct claim against an individual by filing a lawsuit in their own names that asserted several different causes of action. The Supreme Court held that the causes of action asserted by those stockholders for breach of fiduciary duty and interference with business relations were derivative claims. Thus, it held that the trial court had erred in not dismissing those claims for lack of standing. However, the cause of action brought by the shareholders for contempt of an order entered by the trial court was held to be a direct claim of the shareholders as it affected them directly; involved conduct which occurred in the lawsuit to which the corporation was not a party; and, involved violation of a court order entered for the benefit of those shareholders as opposed to the corporation.

While the Keller case involved a corporation, not an LLC, it should be fully expected that the adoption of the Tooley test will apply, not just to corporate litigation, but also, to LLC litigation. If there is any doubt about whether a claim should be filed as a derivative claim or a direct claim, it makes sense tactically to file it as both. Then, your lawsuit will not be dismissed even if some of the claims are.