Attorneys Representing Corporations in Derivative Actions Must be Mindful of Rule of Corporate Neutrality

When a shareholder brings a derivative action, the corporation must be a party to the suit. Typically, the corporation is named as a nominal defendant. This is done because, although the plaintiff effectively prosecutes the claims for the corporation, the corporation itself is an indispensable party to the derivative action. And because the corporation is a party to the lawsuit and has its own interests, corporations must retain counsel to represent them.

Attorneys hired to represent nominal defendant corporations in derivative actions must be mindful of the rule of corporate neutrality. The rule of corporate neutrality provides that generally the corporation may not participate in a derivative action on the merits, unless the action threatens rather than advances the corporate interest. The shareholder who brings the action is the nominal plaintiff. In reality however, the corporation on whose behalf the action is brought is the real party in interest and thus is a nominal defendant. Because the plaintiff is in effect litigating claims for the corporation, the corporation must remain neutral for the duration of the derivative action.

The seminal case concerning the rule of corporate neutrality is Domanus v. Lewicki. In Domanus, the minority shareholders filed suit against the company’s other shareholders. The plaintiffs alleged that the company’s other shareholders along with their family members conspired to loot the company of more than $30 million in a fraud scheme that spanned over a decade. The minority shareholders brought both direct claims and derivative claims on behalf of the company.

Although the company stood to benefit if the plaintiffs prevailed on their claims against the majority shareholder defendants, the company took several actions hostile to the plaintiffs. These hostile actions included filing a cross-claim against the plaintiffs and asserting privilege in order to prevent producing documents to plaintiffs that would have helped them prosecute their derivative claims. The attorneys representing the company had been retained by the company’s board, which consisted of the majority shareholder defendants and their spouses.

In response to these actions, the plaintiffs sought to have counsel for the company disqualified for violating of the rule of corporate neutrality. The Court agreed with the plaintiffs that the attorneys for the company were not maintaining the company’s neutrality. Instead, the Court found that the company was actively seeking to defend the suit on its merits in conjunction with the majority shareholder defendants.

The Court reasoned that the actions of the company’s attorneys would have been justified only if the plaintiffs’ claims were a threat to the company itself. However, the Court concluded that the attorneys failed to provide any evidence that the plaintiffs’ claims posed a threat to the company. To the contrary, the Court found that the plaintiffs’ claims had a substantial likelihood of success, which would mean the company stood likely to recover some or all of the moneys that had allegedly been drained from it by the majority shareholders over the years.

The takeaway from the case is that attorneys representing nominal defendant companies in derivative actions must be scrupulous in maintaining the company’s neutrality, unless the derivative claims would harm the company. The attorneys must keep in mind who their client is, even if the individuals who hired the attorneys are named as defendants in the suit. They must also always remember to do what would benefit the client. Attorneys who keep these in mind should ensure they do not violate the rule of neutrality.

The derivative action attorneys at Lubin Austermuehle have more than three decades of experience defending and prosecuting claims on behalf of shareholders and LLC members directly and derivatively including those alleging breach of fiduciary duty and fraud claims and claims involving the freeze-out of minority shareholder and members. Our attorneys know business dispute law and keep abreast of changes and complexities in the law. We are committed to fighting for our clients’ rights at both the trial court and appellate level. We have successfully defended or prosecuted direct and derivative claims, achieving large settlements for our clients or winning them control of their businesses. Conveniently located in Chicago and Elmhurst, Illinois, we have successfully litigated business divorce, accounting and breach of fiduciary duty cases for clients all over the Chicagoland area. To schedule a consultation with one of our skilled attorneys, you can contact us online or give us a call at 630-333-0333.