This case originated as a dispute between brothers over the managerial rights of a family owned LLC. Each member owned a 48% interest in the company.- I have written extensively before about derivative lawsuits.
- To summarize, a derivative lawsuit is brought by members of the LLC on behalf of the LLC to enforce a company cause of action against a third party.
Introduction to the case
Interestingly, in this case the brother bringing the lawsuit did not assert a derivative claim on behalf of himself and/or the members of the LLC because his attorney did not believe NJ law allows members of a small closely owned LLC to bring derivative claims on behalf of the LLC. Defendant counter claimed and added a derivative action claim. Defendant argued that the court should treat derivative claims by an owner of a closely-held company the same way as an individual claim if the court finds that recovery will not: (1) unfairly expose the company or the defendants to a multiplicity of actions, (2) materially prejudice the interests of the creditors of the company, or (3) interfere with a fair distribution of any recovery among all interested persons.
The brother cited the New Jersey Revised Uniform Limited Liability Company Act (N.J.S.A. 42:2c-68) which states that a member may maintain a derivative action to enforce the right of a limited liability company to demand action by management, and if made and refused, or if such a demand would be futile a derivative case can be brought. He argued that the only precondition of the statute is that the member filing the derivative action be a member in good standing at the time the action is commenced and remains a member as the action continues.
Courts’ legal analysis of the case
Several sources of law govern derivative actions by shareholders and LLC members. New Jersey Court R.4:32-3 governs derivative actions and states the following:
“In an action brought to enforce a secondary right on the part of one or more shareholders in an association, incorporated or unincorporated, because the association refuses to enforce rights which may properly be asserted by it, the complaint shall be verified and allege that the plaintiff(s) was(were) a shareholder(s) at the time of the transaction complained of. The complaint shall also set forth with particularity the efforts of the plaintiff to secure from the managing directors or trustees and, if necessary, from the shareholders such action as is desired, and the reasons for the requested action.”
The Revised Uniform Limited Liability Company Act (hereinafter “LLCA”) also outlines the procedures for the members of LLCs to bring derivative actions. The LLCA allows for both direct actions by a member and for derivative actions. The direct-action section states the following:
Direct Action by Member.
- a) Subject to subsection b. of this section, a member may maintain a direct action against another member, a manager, of the limited liability company to enforce the member’s rights and interests under the operating agreement or this act or arising independently of the membership relationship.
- b) A member maintaining a direct action under this section shall plead and prove an actual or threatened injury that is not solely the result of an injury suffered or threatened to be suffered by the limited liability company.
N.J.S.A. 42:2C-67 states the following:
Derivative Action.
A member may maintain a derivative action to enforce a right of a limited liability company if:
- a) the member first makes a demand on the other members in a member-managed limited liability company, or the managers of a manager-managed limited liability company, requesting that they cause the company to bring an action to enforce the right, and the managers or other members do not bring the action within a reasonable time; or
- b) A demand under subsection a. of this section would be futile. J.S.A. 42:2C-68
The LLCA also includes a “proper plaintiff” section which states the following:
Proper Plaintiff.
- Except as otherwise provided in subsection b. of this section, a derivative action under section 68 of this act may be maintained only by a person that is a member at the time the action is commenced and remains a member while the action continues.
- If the sole plaintiff in a derivative action dies while the action is pending, the court may permit another member of the limited liability company to be substituted as plaintiff. N.J.S.A. 42:2C-69
Holding of the Court
Here, the Court said the plaintiffs were correct that the LLCA applies to a closely held LLC. The LLCA does not include any language requiring that a plaintiff when bringing legal action to adequately represent the interests of the company or other members. However, the LLCA must be read in conjunction with the language of the NJ court rules which explicitly requires a plaintiff in a derivative action to “fairly represent the interests of the shareholders or members similarly situated in enforcing the right of the corporation or association.” The Court found no conflict between the LLCA and R. 4:32-3 as the statute outlines who constitutes a proper plaintiff when bringing a derivative lawsuit while the court rule imposes fair representation in all derivative actions brought to enforce a protected right either incorporated or unincorporated.
Here, the Court found that substantial antagonism exist between the brothers and the other members of the LLC such that the basic purpose of a derivative action would be frustrated. The 3rd Federal Circuit Court of Appeals which covers NJ has held that a plaintiff’s derivative action should be dismissed if the court finds that “the class representative has interests antagonistic to those of the class.” Id. The court outlined several factors which help in determining whether a plaintiff’s interests may be antagonistic to those of other shareholders. These factors include:
- economic antagonisms between representative and class;
- the remedy sought by plaintiff in the derivative action;
- indications that the named plaintiff was not the driving force behind the litigation;
- plaintiff’s unfamiliarity with the litigation;
- other litigation pending between the plaintiff and defendants;
- the relative magnitude of plaintiff’s personal interests as compared to his interest in the derivative action itself;
- plaintiff’s vindictiveness toward the defendants; and
- the degree of support plaintiff was receiving from the shareholders he purported to represent.
The Court found that several of these factors were present here. The Defendant had no support from the other shareholders that he purports to represent, other litigation is pending between the Defendant and Plaintiffs as both sides have asserted claims and crossclaims, and personal antagonism exists between members and the Plaintiffs. Additionally, the Court found that the personal interests of the Defendant outweigh his interest as a putative plaintiff in the derivative action because the Defendant has an interest in maintaining the derivative action in order to create a conflict of interest for Plaintiffs’ counsel. Moreover, the Court found that maintaining the derivative action on behalf of the LLC would create a conflict of interest for the Defendants’ counsel when the Defendants are also asserting claims in other consolidated actions before a different court. For the foregoing reasons, the Court dismissed the Defendants’ derivative claims with prejudice.
To discuss your NJ LLC / Shareholder litigation matter, please contact Fredrick P. Niemann, Esq. toll-free at (855) 376-5291 or email him at fniemann@hnlawfirm.com. Please ask us about our video conferencing or telephone consultations if you are unable to come to our office.
By Fredrick P. Niemann, Esq. of Hanlon Niemann & Wright, a Freehold Township, Monmouth County, NJ LLC / Shareholder Litigation Attorney