2

I heard this story from Peter (not actual name):

  1. Peter co-founded a company with John.
  2. John earns 80% of shares while Peter owns 20% of shares.
  3. John being greedy empties all company coffers transfering all assets to another company (his new company).
  4. Peter brings John to court for fiduciary breach of trust.
  5. Peter wins the lawsuit but the company has no money left to pay him! The company simply closes down.
  6. John gets away with everything in his new company!

As mentioned, I heard this story from Peter but don't know the full nitty gritty details. My question, couldn't Peter sue John (and his new company) instead of the old company?

2

couldn't Peter sue John (and his new company) instead of the old company?

That depends on the intricacies of corporate law in the [unspecified] jurisdiction at issue. For instance, the applicable legislation might require John to sue the old company, which in turn would proceed as third-party plaintiff to go after John. Regardless, it seems safer for Peter to sue both the old company and John, perhaps pursuing a finding of joint-and-several liability because of John's role in the matter.

Item 4 in your description reflects that Peter actually sued John (unless by "Peter brings John to court" you mean it in an unusually limited capacity such as a non-party witness). It is unclear from your description why Peter was unable to recover his funds despite having brought also John to court. John's mere portrayal of the transfer of assets as a corporate transaction might be wanting, and a finding of fraud committed by John would forfeit his protections pursuant to LLCs. See the notion of piercing the corporate veil.

| improve this answer | |
  • Thank you for the answer. But as I understand this is not a 'Fraud' this is a "fiduciary breach of trust". – user1034912 Sep 13 at 23:18
  • And it's not even a tort because there is a governing contract in place (i.e. the company constitution) – user1034912 Sep 14 at 1:33
  • 1
    @user1034912 I hear you, but your description gives no details about the company constitution so as to ascertain whether or why John had a fiduciary duty toward Peter (and/or toward other shareholders). Nor is it clear in what capacity John made the wrongful transfer of assets. "Peter brings John to court for fiduciary breach of trust", but (see 2nd paragraph of the answer) it is unclear from your description why Peter was unable to recover from John despite prevailing in the lawsuit he filed against John (not just against the old company). – Iñaki Viggers Sep 14 at 8:45
  • Thank you Inaki. Its always a pleasure to read your answers. As I mention I don't know the full story, just I heard it from Peter, who may have simplified the matter to a layman like myself. I guess there were more things to it. – user1034912 Sep 15 at 9:04
  • +1 for mentioning piercing the corporate veil! – user1034912 Sep 15 at 9:05
1

Derivative Claims

Normally, in the fact pattern presented, Peter would need to bring a derivative action against him for the benefit of the company as a whole, following the special procedures for such actions, because the harm of the misappropriation of the funds affects all shareholders proportionately, and is a harm to the company, rather than particular to the individual.

A derivative action is a lawsuit brought by an individual in the name of the company, usually a non-controlling owner of the company, alleging that the people who control the company have failed to take action to enforce a right belonging to the company to protect its interests. Usually, the complaint must either be preceding by a formal demand that the company enforce the right, or allege that it would be futile to do so because the party to whom the demand is addresses is the wrongdoer himself or herself (this exception often applies in closely held companies and rarely applies in publicly held companies).

If a formal demand is made to enforce the right to the company and the company fails to take action, the court has to evaluate whether the company's non-enforcement is justified or not as a preliminary matter before allowing the lawsuit against the wrongdoer in the name of the company to go forward on the merits. Among the reasons that would be honored by a court for not allowing the case to go forward would be:

  • The amount at issue is nominal and not worth the expense.

  • The claim is too weak on the merits to pursue for some specified legal reason or due to lack of evidence that can be proven in court.

  • The negative publicity of such an enforcement action could reasonably be seen as more harmful than the benefits associated with prevailing in the lawsuit.

None of these justifications is likely to prevail except the first in a case where the total assets of the company where just a few thousand dollars, or all that was appropriated was a phone number, an assignment of an office lease, and some office supplies. If the amount appropriated was in the five or six figures or more, the suit would probably be allowed to go forward, and it is very likely that the court would excuse the formal notice process as futile in any case in a situation like this one.

One important reason for requiring this to be in the derivative mode, rather than as a direct action, is that only 20% of the harm would be owed to the suing shareholder. The other 80% would be damage that John has done to himself.

Also, in a more complex context, in which there are additional shareholders who are neither suing nor being sued (e.g. shares owned by junior employees), the derivate suit format would ensure that the other minority shareholders would also benefit from the recovery in proportion to their interests.

In a derivative action, the attorneys' fees of the person bringing the lawsuit are payable out of the assets of the company including any "common fund" created by the recovery of assets from the wrongdoer for the benefit of the company, before the company gets what is left over after attorneys' fees. But, in a fact pattern like this one, where the company is insolvent as a result of the breach of fiduciary duty, the action would effectively be a prevailing party fee recovery only, even though usually a derivative action is payable out of corporate funds once it clears the requirements to move forward and is brought in good faith, even if the person bringing it doesn't prevail on the merits in full, or at all, for some reason.

The company bringing suit in a derivative action through the minority shareholder would probably have claims against both John (e.g. breach of fiduciary duty, conversion, civil theft, breach of employment contract), and his new company (e.g. conspiracy to commit various torts, construction trust, return of stolen property).

Direct Claims

John would have legal duties that run directly to the minority shareholder for this conduct only in rare circumstances that don't seem to be present here in most U.S. states.

But since this kind of lawsuit would be a matter of state law, one state might recognize a duty giving rise to an ability to bring a direct lawsuit, while another might not.

There might be a right to bring a direct lawsuit arising from its express creation in an organization document of the company that would not otherwise exist.

These would be the rare exceptions to the rule, rather than the norm, however.

Other Claims

Frequently, a derivative action would be joined to an action seeking removal of one or more officers or directors of the company.

If the old company was not viable without John's cooperation, and John was removed as a director and officer, the minority shareholder might also seek judicial dissolution of the company. But if it was a turnkey operation that could be operated by an outside hired manager in a cost effective manner, judicial dissolution would probably not be available as a remedy.

The people who have standing to bring these claims would vary from state to state.

Criminal Law Remedies

In some circumstances, the minority shareholder could also convince law enforcement and a prosecuting attorney to bring a criminal action against John which might give rise to a restitution award payable to the company.

But that would be the exception, rather than the rule, and would rarely be what is best for the minority shareholder since restitution is not as generous as civil damages, since the burden of proof is higher in a criminal case, and because imprisonment would reduce the ability of John to pay for the damages caused and any penalties.

Typically, criminal action in a case like this would be sought by victims only when they can't afford legal counsel of their own to enforce their rights and when the wrongdoer has spent the money anyway.

| improve this answer | |

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.