Austin TX Business Law Blog

Friday, June 26, 2015

Texas Supreme Court Approves Shareholder Lawsuit in ‘Closely Held’ Corporation

I am one of a few shareholders in a small corporation. What are our rights in the event the board of directors engages in misconduct?

Texas law maintains a distinct body of law applicable to small corporations with just a few shareholders. The concept, known as a ‘closely held’ corporation, is explained in Section 21.563 of the Texas Business Organizations code, which states:

(a) In this section, "closely held corporation" means a corporation that has:
(1) fewer than 35 shareholders; and
(2) no shares listed on a national securities exchange or regularly quoted in an over-the-counter market by one or more members of a national securities association.
(b) Sections 21.552-21.559 do not apply to a closely held corporation.

In Section (b), the restrictions on closely held corporations refer to the rights of shareholders to initiate “derivative proceedings,” or lawsuits, against boards of directors alleged to be engaging in misconduct. While the code may allow for such lawsuits ‘in the interests of justice,’ this area of the law has been historically misunderstood – triggering several lawsuits and judicial inquiries. 

In May, 2015, the Texas Supreme Court considered the concept of a ‘double derivative lawsuit’ within the context of a closely-held corporation, and found the notion applicable and available to shareholders looking to obtain justice in light of wayward leadership. 

Basics of Sneed, et al. v. Webre, Jr., et al.

In the recent Sneed decision, the Court was faced with whether shareholders of a small family-run business, which was further divided with a wholly-owned subsidiary, could launch a lawsuit against the board of directors following a ‘bad business transaction’ approved by the subsidiary entity. The board objected to the petition, citing the statute listed above and noting the well-established principle that boards should be permitted to make their own decisions without intervention (known as the Business Judgment Rule). 

The shareholders, however, asserted that the situation was actually distinguishable from a straightforward derivative suit referred to in the code, and should be treated as such.  The Court agreed, and allowed the lawsuit to proceed against the board. In its analysis, it reasoned that the legislature likely did not intend to prevent small corporations from pursuing valid claims of fraud or breach of fiduciary duty simply because the corporate structure had created a wholly-owned subsidiary arrangement. Otherwise, this notion would prompt all corporate boards to structure the business as such, thereby allowing an unfair legal loophole to the detriment of shareholders. 

If you are facing a difficult situation with a board of directors, or would like more information about a derivative lawsuit in Austin, Texas, please do not hesitate to contact the business law attorneys at the Kumar Law Firm today by calling (512)960-3808.

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