When can a direct action be brought in the context of a closely held company?

By: Arend J. Abel, Attorney

On June 1, the Indiana Court of Appeals addressed the circumstances in which a shareholder in a closely held limited liability company could sue another shareholder for breach of fiduciary duty arising out of alleged mismanagement of the corporation.   Ordinarily, such actions must be brought derivatively, but the Court noted that Indiana law provides an exception in some circumstances.

Typically, a claim of corporate mismanagement involves harm to the corporation, and as such must be brought derivatively.  However, the policies requiring a derivative action are the protection of third party shareholders and creditors.  Under Barth v. Barth, 659 N.E.2d 559 (Ind. 1995), where those  policies are not implicated, a derivative action is not required.

Thus, in  Bioconvergence, LLC v. Menefree, the Court of Appeals found that a direct action against a majority shareholder in a closely-held limited liability was permissible, or at least non-frivolous, because the only shareholder other than the plaintiff was the defendant, and there were no creditors.

A direct action by a shareholder against a fellow shareholder may be the only effective remedy for a minority shareholder in situations where a majority shareholder is either mismanaging a business or siphoning off funds.  A derivative action contains a number of procedural hurdles.  Importantly, with derivative actions, the corporation may take over a derivative action, form an independent litigation committee, and on the recommendation of that committee dismiss the action, leaving a minority shareholder without a remedy.