In Tennessee, shareholders may file a lawsuit for injuries suffered by the company or by the shareholders individually. A shareholder files a derivative action when the company is entitled to some legal relief; and files a direct action when the shareholder, individually, is entitled to some legal relief.
But telling the difference between a derivative and direct action is not always that easy. If the shareholder gets it wrong, the case may get dismissed with disastrous consequences.
In a recent case, Keller v. Estate of McRedmond, 2016 WL 3688543 (Tenn. 2016), the Tennessee Supreme Court simplified the test for determining whether a shareholder’s claim is derivative or direct. Prior to Keller, courts looked at one or all three of the following criteria:
- Direct harm – whether the harm flowed first to the company, and secondarily to shareholders as a result of the company’s loss of value;
- Special injury – whether the harm claimed by the shareholder is distinct from a harm to the company; and
- Duty owed – whether the harm claimed flows directly from breach of a duty owed to the plaintiff independent of his status as a shareholder, investor or creditor of the company.
The last time the Tennessee Supreme Court addressed the derivative/direct action distinction was in 1988. In Haden v. City of Gatlinburg, 746 S.W.2d 687, 689 (Tenn. 1988), the Court said:
Stockholders may bring an action individually to recover for an injury done directly to them distinct from that incurred by the corporation and arising out of a special duty owed to the shareholder by the wrongdoer.
As subsequent courts have pointed out, this confusing standard seems to incorporate the direct harm, special injury and duty owed approaches into one analysis. One Tennessee court of appeals case even added another criterion to the special injury rule, that the injury suffered must be distinct not only from the company, but also all other shareholders.
In Keller, the Tennessee Supreme Court, adopting the Delaware standard in Tooley v. Donaldson, Lufkin, Jenrette, Inc., 845 A.2d 1031, 1036 (Del. 2004), has finally simplified the standard to be used in Tennessee. As a result, the issue of whether a shareholder claim is derivative or direct now turns solely on the following questions:
- Who suffered the alleged harm (the company or the suing stockholders, individually); and
- Who would receive the benefit of any recovery or other remedy (the corporation or the stockholders, individually)?
Answering these questions will depend largely on how the shareholder’s claims are pled, whether the claims are for wrongs committed against the individual or the company, and whether the relief sought will go to the individual or the company. However, we will still see some arguments over the true nature of a plaintiff’s claims, despite how they are pled. In other contexts, this argument is over the “gravamen” of the complaint.
So, what does this mean for you as a company or a shareholder? The new standard will not reduce lawsuits, but it will help the parties clarify the nature of the claims. With this clarity, the parties should be able to avoid lengthy and costly fights over what the case is about, and get to a more efficient resolution through settlement or trial.