Texas Supreme Court Recognizes Expanded Standing for Shareholders of Closely Held Corporations

On May 29, the Texas Supreme Court issued its decision in Sneed v. Webre, in which it tackled two issued regarding shareholder derivative suits involving closely held corporations: First, whether these suits may be barred by the business judgment rule, and, second, whether Texas recognizes the “double-derivative” standing of a parent company’s shareholder tof sue on behalf of a subsidiary. In an important win for shareholders’ rights after Ritchie v. Rupe, the Supreme Court answered both questions in favor of the shareholder.

A corporation’s executives owe the corporation certain duties, called fiduciary duties. When the executives’ misconduct breaches these duties and causes harm to the corporation’s value, the corporation, acting through its board of directors, generally has the right to sue the executive for damages. However, sometimes the corporation’s board fails to act in the shareholders’ best interest and refuses to file suit. In that case, the law allows shareholders to file suit on the corporation’s behalf. This is called a “shareholder derivative suit.”

The right to file a derivative suit is an important one for shareholders, because the law affords shareholders few direct remedies. The courts have held that corporation’s officers and directors owe no legal duties to individual shareholders, and that any remedy for injury to the corporation belongs to the corporation, and not to the shareholders. This means that even if a shareholder loses his investment because of an executive’s breach of fiduciary duty, the shareholder cannot directly sue the executive, but must either convince the corporation’s board to sue the executive or, failing that, file a derivative suit on behalf of the corporation.

For large, publicly traded corporations, Texas law requires a shareholder to make a written demand on the board to take action before filing a derivative suit. The shareholder may only file suit if the board fails to act, and then must prove that the board’s failure to act was based on something other than “unsound business judgment”-in other words, that the board acting with something other than the shareholders’ best interests in mind. This is an aspect of the “business judgment rule,” and it often makes it very difficult for shareholders to enforce their collective rights when the board refuses to do its job.

However, Texas law exempts shareholders of closely held corporations from the demand requirement. A closely held corporation is defined in Texas as a corporation whose stock is not publicly traded (including both exchange-traded stock and “over-the-counter” stock) and which has fewer than 35 shareholders. Unlike shareholders in publicly traded corporations, shareholders in closely held corporations typically cannot simply call their brokers and sell their stock if they are dissatisfied with how the corporation is being managed. For that reason, they are particularly vulnerable to abuse by the corporation’s management and are afforded some more legal protection than shareholders in publicly traded companies.

In Sneed, the corporation’s officers argued that even though there is no demand requirement in Texas for a shareholder in a closely held corporation to file a derivative suit, the court was still required to defer to the board’s business judgment in refusing to file suit. The Texas Supreme Court rejected this argument, citing the sections of the Texas Business Organizations Code allowing derivative suits involving closely held corporations to be treated like direct actions by the shareholder.

Also the Court held that the shareholder could file suit not only on behalf of the parent corporation in which he owned stock, but also on behalf of a wholly-owned subsidiary. The Court held that Texas recognizes a shareholder’s right to assert this form of “double derivative” standing because a corporation’s shareholders are the beneficial owners of a corporation’s assets, including any subsidiaries.

The Court’s holding in Sneed is an important win for shareholders in closely held corporations. This is particularly so after many of their rights were eviscerated by the same Court last year in Ritche v. Rupe, in which the Court held that there is no common-law cause of action for minority shareholder oppression in Texas.

If you or someone you know has lost an investment because of another’s fraud or misconduct, contact an attorney at Abraham, Watkins, Nichols, Agosto, Aziz & Stogner by calling (713) 222-7211 or toll free at 713-222-7211.