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Direct Versus Derivative and the Law of Limited Liability Companies Daniel S Mitchell Hamline School of Law Mitchell Hamline Open Access Faculty Scholarship 2006 Direct Versus Derivative and the Law of Limited Liability Companies Daniel S. Kleinberger Mitchell Hamline School of Law, [email protected] Publication Information 58 Baylor Law Review 63 (2006) Repository Citation Kleinberger, Daniel S., "Direct Versus Derivative and the Law of Limited Liability Companies" (2006). Faculty Scholarship. Paper 233. http://open.mitchellhamline.edu/facsch/233 This Article is brought to you for free and open access by Mitchell Hamline Open Access. It has been accepted for inclusion in Faculty Scholarship by an authorized administrator of Mitchell Hamline Open Access. For more information, please contact [email protected]. Direct Versus Derivative and the Law of Limited Liability Companies Abstract The yh brid nature of limited liability companies causes us to re-invent, or at least re-examine, many doctrinal wheels. This Article will reexamine one of the most practical of those wheels-the distinction between direct and derivative claims in the context of a closely-held limited liability company. Case law concerning the direct/derivative distinction is still overwhelmingly from the law of corporations, although LLC cases are now being reported with some frequency. LLC cases routinely analogize to, or borrow from, the corporate law. This Article encompasses that law, analyzes LLC developments, and argues that courts should (i) avoid the "special injury" rule, (ii) embrace the "direct harm" approach, and (iii) engraft ot the direct harm approach an exception applicable when those in control of a limited liability company harm the company with the "purpose and effect" of injuring a particular member. Keywords LLC, limited liability company, derivative Disciplines Agency | Business Organizations Law This article is available at Mitchell Hamline Open Access: http://open.mitchellhamline.edu/facsch/233 DIRECT VERSUS DERIVATIVE AND THE LAW OF LIMITED LIABILITY COMPANIES Daniel S. Kleinberger* I. INTRODUCTION ......................................................................... 64 II. THE RELEVANCE OF CORPORATE CASE LAW ............................ 65 III. WHY THE DIRECT/DERIVATIVE DISTINCTION MATTERS PRACTICALLY ........................................................................... 70 A. The Risk ofDismissal (Whose Claim Is It?) ...................... 71 B. The Key Procedural Barriers ............................................ 74 C. The Demand Requirement ................................................. 76 D. The Special Litigation Committee ..................................... 81 E. Proceeds and Attorneys' Fees ........................................... 86 IV. THE CONCEPTUAL FUNDAMENTALS FOR MAKING THE DISTINCTION (WITHOUT REGARD TO CLOSELY HELD CHARACTER) ·········································································· .. 87 A. The Direct Harm Approach ............................................... 88 B. The Special Injury Rule ..................................................... 93 C. The "Duty Owed" Cases ................................................. 106 V. A SPECIAL RULE FOR CLOSELY HELD ENTITIES ..................... 11 0 VI. SPECIAL QUERIES WITH REGARD TO LIMITED LIABILITY COMPANIES ............................................................................. 115 A. Will the Pivotal Role ofthe LLC Operating Agreement Change or at Least Confuse the Direct/Derivative Analysis? ......................................................................... 115 B. Will Claims Asserting Oppression Provide an End- Run Around the Direct/Derivative Distinction? .............. 120 C. Will the Direct/Derivative Distinction Protect Oppressors Who Injure the Entity with "the Purpose *Professor of Law and Vice Dean for Academic Affairs/Programs, William Mitchell College of Law; A.B. 1972, Harvard University; J.D. 1979, Yale Law School. I appreciate the exemplary research assistance provided by Joy Anderson, William Mitchell, '07, and the helpful comments of J. William Callison, Professor Deborah A. DeMott, Professor Carol R. Goforth, Dean Emeritus Harry J. Haynsworth, Professor Douglas K. Moll, Professor Sandra K. Miller, Professor Niels B. Schaumann, and Thomas E. Rutledge. As always, my work depends most fundamentally on insights and support from Carolyn C. Sachs, Esq. HeinOnline -- 58 Baylor L. Rev. 63 2006 64 BAYLOR LAW REVIEW [Vo1.58:1 and Effect" ofInjuring a Minority Owner? .................... 121 D. Will Claims Seeking Judicial Dissolution Provide an End-Run Around the Direct/Derivative Distinction? ...... 126 E. In Federal Court, Might the Concerns ofDiversity Jurisdiction Skew the Direct/Derivative Analysis? ......... 128 F. Has the LLC 's Partnership Heritage Liberated Courts to Find a New Kind ofDirect Injury? ............................. 132 VII. HOW THE REVISED UNIFORM LIMITED LIABILITY COMPANY ACT PROPOSES TO ADDRESS THE MATTER ............................. 136 VIII. CONCLUSION ........................................................................... 13 8 We shall not cease from exploration. And the end of all our exploring will be to arrive where we started and know the place for the first time. T. S. Eliot1 I. INTRODUCTION The hybrid nature of limited liability companies causes us to re-invent, or at least re-examine, many doctrinal wheels. 2 This Article will re­ examine one of the most practical of those wheels-the distinction between 1 T.S. ELIOT, Little Gidding, in FOUR QUARTETS 59 (Harvest Books 1968) ( 1943). 2 See Steven C. Bahls, Application of Corporate Common Law Doctrines to Limited Liability Companies, 55 MONT. L. REV. 43, 90--91 (1994) (stating that the LLCs' "combination of ... corporate and partnership attributes creates difficulties for courts when deciding whether to apply ... corporate and partnership doctrines to limited liability companies[]" and arguing that courts should develop new doctrines where needed instead of adopting all corporate or all partnership common law rules); Robert W. Hillman, Organizational Choices of Professional Service Firms: An Empirical Study, 58 Bus. LAW. 1387, 1393 (2003) (defining LLCs as hybrid organizations offering some of the advantages of both corporations and partnerships); Daniel S. Kleinberger, Sorting Through the Soup: How do LLCs, LLPs, and LLLPs Fit Within the Regulations and Legal Doctrines?, 13 BUS. L. TODAY 15, 15 (2003) [hereinafter Kleinberger, Soup]; DanielS. Kleinberger, The Closely Held Business Through the Entity-Aggregate Prism, 40 WAKE FOREST L. REv. 827, 838-40, 842-43, 868-75 (2005) [hereinafter Kleinberger, Prism]; Thomas E. Rutledge, The Lost Distinction Between Agency and Decisional Authority: Unfortunate Consequences of the Member-Managed Versus Manager-Managed Distinction in the Limited Liability Company, 93 KY. L.J. 737, 738 (2004-2005). See generally 1 CARTER G. BISHOP & DANIELS. KLEINBERGER, LIMITED LIABILITY COMPANIES: TAX AND BUSINESS LAW '1]1.03 (2003 & Supp. 2005). HeinOnline -- 58 Baylor L. Rev. 64 2006 2006] DIRECT VERSUS DERIVATIVE 65 direct and derivative claims in the context of a closely-held limited liability company. Case law concerning the direct/derivative distinction is still overwhelmingly from the law of corporations/ although LLC cases are now being reported with some frequency. LLC.cases routinely analogize to, or borrow from, the corporate law. 4 This Article encompasses that law, analyzes LLC developments, and argues that courts should (i) avoid the "special injury" rule, (ii) embrace the "direct harm" approach, and (iii) engraft to the direct harm approach an exception applicable when those in control of a limited liability company harm the company with the "purpose and effect" of injuring a particular member. The analysis proceeds as follows: Part II - The Relevance of Corporate Case Law. Part III - Why the Direct/Derivative Distinction Matters Practically. Part IV - The Conceptual Fundamentals for Making the Distinction (Without Regard to Closely Held Character). Part V - A Special Rule for Closely Held Entities. Part VI - Special Queries with Regard to Limited Liability Companies. Part VII - How the Revised Uniform Limited Liability Company Act Proposes to Address the Matter. Part VIII - Conclusion. II. THE RELEVANCE OF CORPORATE CASE LAW The data is overwhelming. 5 Almost all LLC cases addressing the direct/derivative distinction follow rules developed in corporate-law cases. 3 E.g., VGS, Inc. v. Castiel, No. C.A. 17995, 2003 WL 723285, at *II (Del. Ch. Feb. 28, 2003) ("[The] provision [in the Delaware LLC statute providing for derivative suits] originates from the well-developed body of Delaware law governing derivative suits by stockholders of a corporation. Accordingly, case law governing corporate derivative suits is equally applicable to suits on behalf of an LLC."); see also infra Part II. 4 See id. 5 One treatise offers the following collection of cases: HeinOnline -- 58 Baylor L. Rev. 65 2006 66 BAYLOR LAW REVIEW [Vol. 58:1 For cases using the corporate analogy, see Safety Techs., L.C. v. Biotronix 2000, Inc., 136 F. Supp. 2d 1169, 1172 n.3 (D. Kan. 2001) ("The court believes that the Kansas Supreme Court would also apply [corporate] precedent limiting lawsuits by individual shareholders to limit lawsuits by members of limited liability companies . The rationale of the rule, preventing the danger of multiplicitous suits by each shareholder ... applies equally to corporations and limited liability companies"). But see Ayres v.
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