A derivative suit is a procedural device that can be used by a member of a limited liability company to assert a claim on behalf of the LLC against a manager or managing member of the LLC that is breaching its fiduciary or contractual obligations to the LLC. But an LLC’s decision to initiate a lawsuit is normally up to the managers, so a derivative suit by its nature interferes with the managers’ authority. For that reason a member is expected to exhaust its remedies within the LLC by first making a demand on the managers that they take action to resolve the wrongdoing. This “demand requirement” is reflected in many state statutes, rules of civil procedure, and case law.
That’s all well and good, but what if the controlling manager is the one accused of wrongdoing? How likely is it that a manager accused of breaching its fiduciary obligations to the LLC will fairly consider causing the LLC to sue itself, just because of a member’s demand? This is such a common scenario that many statutes and case law recognize an exception to the demand requirement when the plaintiff can show that making a demand would be futile. Potential plaintiffs in a derivative action often resist making a demand because of fears that the managers will cloak their refusal to take action as a reasonable business decision, or take control and manage the lawsuit in a less than diligent manner.
The Decision. The Georgia Court of Appeals recently had to decide whether the plaintiff in an LLC derivative suit should be excused from making a demand of the LLC’s majority member before commencing a derivative suit in the name of the LLC. The plaintiff had not demanded that the LLC take action before filing the derivative action in Pinnacle Benning, LLC v. Clark Realty Capital, LLC, 724 S.E.2d 894 (Ga. Ct. App. March 6, 2012). The court declined to adopt a futility exception to the demand requirement and dismissed the derivative claims. Id. at 901.
The plaintiff was a 30% member and one of two managers of Clark Pinnacle Benning LLC (CPB). The two affiliated defendants controlled CPB – one was a 70% member and the other was the second manager. CPB in turn was the managing member of an LLC that operated a military housing project at Fort Benning, Georgia. The plaintiff claimed that the two affiliated defendants controlled CPB and through it the housing project, and that they had taken steps in bad faith to audit the plaintiff’s management operations at Fort Benning and to terminate its interests as the property manager, in violation of their fiduciary obligations. Id. at 896-97.
The trial court dismissed the derivative claims because the plaintiff had not demanded, prior to filing its lawsuit, that CPB initiate suit against the defendants. (Presumably the plaintiff thought that it would be an exercise in futility to demand that the two defendants cause CPB to sue themselves.)
The Court of Appeals began by examining Georgia’s LLC Act. The Act lists five conditions under which a member may commence a derivative action in the right of the LLC, one of which is: “The plaintiff has made written demand on those managers or those members with such authority requesting that such managers or such members take suitable action[.]” Ga. Code Ann. § 14-11-801(2). The Act makes no reference to any exception to the demand requirement.
The court noted that the Georgia Business Corporation Act requires a demand on the corporation prior to commencement of a derivative suit and makes no mention of any exception. The court pointed out that the Corporation Act had previously been interpreted by the Court of Appeals to allow for no exceptions to the demand requirement. Pinnacle Benning, 724 S.E.2d at 900.
Guided by the prior corporate ruling, the court found the legislature’s intent to be clear: The LLC Act’s procedures for LLC derivative suits contain a pre-filing demand requirement with no futility exception. Id. at 900-01. The plaintiff contended that it had cured any procedural defect by filing a demand letter with its response to the defendants’ motion to dismiss the complaint, but the court found that unavailing because the LLC Act requires that the derivative suit not be commenced until at least 90 days after the demand was made. Accordingly, the Court of Appeals affirmed the trial court’s dismissal of the derivative suit.
Dismissal of the suit may only be round one of this dispute, however. That’s because, as the Court of Appeals pointed out, “the trial court’s dismissal of Pinnacle’s action was actually due to a lack of subject-matter jurisdiction based upon Pinnacle’s failure to meet a procedural prerequisite prior to filing suit.” Id. at 902. The court accordingly remanded the case to the trial court for entry of an order dismissing the derivative claims, without prejudice. Id. A dismissal without prejudice is not an adjudication on the merits, and the plaintiff could therefore refile the complaint if the jurisdictional defect can be cured.
Georgia’s Minority Position. Georgia is not the only state to require a demand of management before an LLC derivative suit can be filed, with no futility exception. Arizona, for example, has a comparable provision in its LLC Act. Ariz. Rev. Stat. Ann. § 29-831. But this appears to be a distinctly minority view.
I have checked the LLC Acts of 12 states chosen at random (including Georgia). My review showed that the LLC Acts of nine of the 12 had a futility exception from the demand requirement for an LLC derivative suit. I think this is a large enough sample to draw the general conclusion that most states include the futility exception in the derivative suit rules of their LLC Acts.
Two states of particular interest to me, Washington (where I practice) and Delaware (a leading state for LLC formations), have in their statutes a futility exception to the pre-filing demand requirement for LLC derivative suits. Washington’s LLC Act gives members the right to bring a derivative suit if either (a) the managers or managing members have refused to bring the action, or (b) “an effort to cause those managers or members to bring the action is not likely to succeed.” Wash. Rev. Code § 25.15.370. This is consistent with Washington’s limited partnership statute, which requires a pre-filing demand before a limited partner can bring a derivative suit, unless “[a] demand would be futile.” Wash. Rev. Code § 25.10.706.
The Delaware LLC Act excuses a pre-filing demand for LLC derivative suits in language similar to Washington’s. Del. Code Ann. tit. 6, § 18-1001. The same is true for the Delaware limited partnership statute, which excuses a pre-filing demand for limited partnership derivative suits if a demand is not likely to cause the general partners to bring the action. Del. Code Ann. tit. 6, § 17-1001.