When a shareholder claims that a director or officer has harmed a corporation through his or her improper conduct, these claims typically must be brought through a derivative action, in which the shareholder sues on behalf of the corporation. Ordinarily, however, a corporation’s board of directors has the authority to bring lawsuits on the company’s behalf, for the benefit of all of the shareholders.  Thus, a shareholder who wants the company to pursue claims must first make a demand upon the board to file a lawsuit, unless such a demand would be futile.  As courts in Delaware and elsewhere have determined, so-called “demand futility” may be found where there is a “reasonable doubt that, as of the time the complaint is filed, a majority of the board could have properly exercised [their] independent and disinterested business judgment in responding to a demand.”  In these situations, a demand would be futile because “a shareholder would be effectively asking a majority of the board of directors to cause the corporation to sue themselves.”  If a shareholder attempts to bring a derivative suit without first making a demand or without showing futility, that suit may be dismissed on a motion by the defendants.

In Smith v. Tarter, a United States District Court in Kentucky recently dismissed derivative claims by certain family-owned business shareholders because they did not make a proper demand upon the corporations to bring the claims on their own and did not demonstrate that such a demand would have been futile.

According to the Court’s opinion, the Tarter Companies manufacture farm gates and animal management equipment.  The Companies have been family owned since 1945 and are now managed by the fourth generation.  Plaintiff Ana Lou Tarter Smith and her two children collectively own 50% of the Companies.  The remaining 50% is owned by Joshua Tarter and his two siblings, each of whom individually own 16.6%.

Plaintiffs alleged that Joshua Tarter, who exercised executive authority on behalf of all the Tarter Companies, and a company manager, Thomas Gregory, conspired to use confidential company information to divert cost savings from the Companies to their own benefit. Specifically, Plaintiffs claimed that Tarter and Gregory directed the Companies to begin sourcing components from Chinese suppliers in 2009. Plaintiffs alleged that this practice should have resulted in substantial cost savings to the Companies.  At that time, however, Tarter and Gregory formed a separate company, QMC, which allegedly funneled the cost savings to themselves.  To that end, Tarter and Gregory allegedly caused the Companies to order the components from QMC and not from the Chinese suppliers directly.  According to Plaintiffs, QMC then placed the orders with the suppliers, who billed QMC the “true cost” of the components.  QMC, in turn, then allegedly “substantially inflated” the price and invoiced the Tarter Companies the higher amount.  In that way, QMC allegedly absorbed the cost savings that the Tarter Companies would have received if they had purchased directly from the suppliers.  In total, Plaintiffs claimed that the Tarter Companies paid QMC over $70 million for component parts over a seven-year period.

Plaintiffs attempted to assert derivative claims on behalf of the Tarter Companies, and ultimately all of the shareholders. Among other claims, they alleged that Tarter and Gregory breached their fiduciary duties to the Companies by usurping corporate opportunities of the Companies, by failing to disclose their ownership interest in QMC, and by failing to disgorge and turn over the profits they made from QMC.  Tarter and Gregory moved to dismiss the derivative claims on the grounds that the Plaintiffs did not make any pre-suit demand upon the Companies to bring the claims on their own.  In response, Plaintiffs argued that such a demand would have been futile because, “due to ownership percentages,” the Tarter Companies were deadlocked regarding QMC issues.  However, as the Court determined, the only defendant with any ownership interest in the Companies was JoshuaTarter, who owned 16.6% of the Companies.  With that ownership percentage, the Court noted, Tarter “cannot unilaterally reject a demand for the Tarter Companies to bring suit, and the presumption that such a demand would be futile is not warranted.”

The Court further stated that, in order to invoke the demand futility exception, Plaintiffs would need to plead that Tarter’s siblings could not have properly exercised their independent and disinterested business judgment in responding to a demand upon the Companies to bring the action. Referring to Delaware law, the Court noted that in order to properly assert that a director is “interested” in the challenged transactions, Plaintiffs must allege that the director “(i) received a personal financial benefit that was not shared by the other stockholders from the challenged conduct; (ii) might suffer a ‘materially detrimental impact’ from the proposed legal action; or (iii) was incapable, due to domination and control, of objectively evaluating a demand to assert the company’s claims.” Plaintiffs did not make any such allegations.  Instead, they made only conclusory assertions that “the personal relationship between [Tarter] and his siblings would undermine the siblings’ independence” and that Tarter and his siblings would no longer control 50% of the Companies if he were forced to give up his ownership interest. The Court determined that, without more, these unsupported allegations were insufficient to excuse the Plaintiffs’ demand requirement.  The Court thus determined that Plaintiffs could not maintain the derivative action on the Companies’ behalf and dismissed all claims against Tarter and Gregory.

The Smith v. Tarter decision serves as a reminder that a corporate shareholder ordinarily must make a demand upon the company to bring a lawsuit on its own in order to address claims arising from a director or officer’s misconduct.  If the shareholder does not make such a demand, he or she must plead specific facts as to why it would be futile to do so.  Notably, in a family-owned business setting, the mere fact of a close familial relationship typically will not, without more, support a claim of interestedness or lack of independence among directors to excuse a demand.  For their part, corporate directors should take steps to ensure that independent and disinterested directors are available to fully and fairly evaluate any shareholder demands to investigate claimed misconduct and, as appropriate, to pursue claims to recover any damages to the corporation.  By following such practices and procedures, parties may be able to avoid lengthy and costly litigation over who is authorized to sue on the company’s behalf.