Prior to the creation of the first limited liability company (LLC), shareholders were able to sue the corporation through a direct or derivative lawsuit. Classifying the claim as direct or derivative would determine the procedure of the complaint, in addition to determining the remedy and likely outcome. Now, with the popularity of the LLC, the derivative and direct classifications are applying to members’ complaints about the operation of the LLC. Since LLC law does not have too many of these cases, it is beneficial to look at the corporate law (especially because LLC law often borrows from corporate law). In fact, as seen in several states, it is often corporate case law which determines the outcome of LLC disputes between a member and the LLC itself. For these reasons, a brief description of the differences between a direct and derivative lawsuit would be beneficial not only to a shareholder, but also to a member or manager of an LLC.
A direct claim allows the member or members to pursue the lawsuit in their own name(s). This is allowed only if the member or group of members were injured by the actions of the LLC, and it is those members (not the LLC) who would receive the benefit of recovery. However, if the entire LLC was injured by the action of a manager, the claim does not classify as direct. An example of a direct claim would be if the voting rights or interests of a certain member were lost. Here, it is not the entire LLC that is harmed, but only that member.
Furthermore, for a direct claim, the remedy sought is usually equitable, or non-monetary. In the example above, the proper remedy would not be money damages, but an injunction to prevent the LLC from harming the voting interest of the particular member. Overall, if a member is injured (not the LLC), and the remedy is equitable, then the claim is direct.
A derivative claim is much more complicated than a direct claim. A derivative lawsuit is one in which the entire LLC is harmed (by the LLC), rather than a specific member bring injured. In other words, the lawsuit is brought by a member on behalf of the entire LLC, against the LLC itself. An example of a derivative law suit would be if the LLC engaged in an agreement to pay an extraordinary amount of money to an individual who is not performing. Here, a law suit would benefit the entire LLC, and the remedy would be the money lost on the violated agreement.
A key difference between a derivative and direct lawsuit is that the concept of “demand.” Under a derivative lawsuit, the plaintiff is required to either make demand of the company, or prove that demand of the company is futile. Demand refers to demanding the LLC take on the case. Since the lawsuit is meant to benefit the entire LLC, courts have mentioned that the LLC should have the ability to investigate and determine the validity of the case itself. However, it is apparent that if an LLC hears about the complaint and chooses to investigate, a conflict of interest could result in the LLC dismissing a valid claim, rather than bringing the suit. Furthermore, since courts often defer to the business judgment of business entities like the LLC, there is a low likelihood that a plaintiff will be able to show that the LLC wrongfully dismissed the suit.
For all of the problems associated with making demand of the company, the plaintiff in this type of suit usually chooses to show demand futility. To show demand futility, the plaintiff usually has to show that there is reasonable doubt that the managers and directors are independent, or that there is doubt that the agreement/transaction was a valid business decision. In California, however, there is not a specific test to show demand futility. If demand futility is shown, then the suit proceeds. If not, then the suit is dismissed because demand should have been made.
The next step in a derivative lawsuit is based on whether the LLC has hired a special litigation committee (SLC). An SLC is a committee often employed by the LLC to settle these types of disputes. A court will defer to the decision of the SLC, as long as the SLC is independent. To test this, courts analyze how the SLC came to it’s conclusion, evaluating whether the SLC used good faith in it’s reasonable investigation. If the SLC was not independent, the court could apply it’s own business judgment to determine the value of the suit. After this, the derivative suit has taken all possible steps, and the suit either proceeds, settles, or has been dismissed along the way.
As one can easily imagine, the direct law suit is much easier for a plaintiff to bring than the derivative suit. On the other hand, the LLC would prefer a suit to be classified as derivative, because of the multiple opportunities to dismiss the suit, through the demand doctrine or an SLC. Therefore, if an issue arises in your LLC, be sure to investigate the complaint to determine what steps can and should be taken to protect yourself and the LLC.