When shareholders of a company believe the leaders of the company have breached their fiduciary duties to it, they can bring a lawsuit against those leaders in one of two ways. Shareholders can bring the suit in their own names (a direct suit), or they can bring it on behalf of the company if the company failed to bring claims against the leaders on its own (a derivative suit). If the injuries the shareholders are alleging were only suffered by the company, they cannot move forward with any direct claims.

When bringing a derivative claim in federal court, the plaintiffs must comply with Federal Rule of Civil Procedure 23.1. The rule, besides explaining what a derivative complaint must include, prevents a plaintiff from bringing a derivative lawsuit if the plaintiff “does not fairly and adequately represent the interests of shareholders or members who are similarly situated in enforcing the right of the corporation or association.”

In shareholder derivative lawsuits brought by shareholders of large public or private companies, rarely does this “adequate representation” element pose a problem. Plaintiffs’ attorneys spend an inordinate amount of time vetting would-be derivative suit plaintiffs to ensure that, based on the factors courts look at, the shareholder(s) they represent will almost certainly pass this test. And with hundreds or thousands of shareholders to choose from in these situations, plaintiffs’ attorneys often have the luxury of never having to settle for an “inadequate” shareholder.

But in the closely held company world, derivative lawsuits are a whole other ballgame. With a smaller number of shareholders, there’s a greater risk that the relationships between potential shareholder plaintiffs and the leaders of the company—who may be other shareholders—or the company itself cloud the ability for those potential plaintiffs to pass the “adequate representation” test.

A recent decision out of the Eastern District of Pennsylvania deals with this scenario. In it, the judge held that the minority shareholders failed the test. Interestingly, had the minority shareholders brought the claims in a Pennsylvania court, they likely would have received a passing grade thanks to Pennsylvania’s more minority-shareholder-friendly approach to derivative claims.

The students become the teacher[’s adversaries]

In Jannuzzio v. Danby, James Jannuzzio and Trevor Nix, two minority shareholders of Greenville Ventures, an e-commerce jewelry seller, sued Peter Danby, the owner of a corporate entity that owns the 70% of Greenville. James was Peter’s student at the University of Delaware when they met in 2017. James began working for one of Peter’s companies, and in 2018 recruited Trevor, a fellow University of Delaware Blue Hen, to do so too.

Eventually, the three co-founded Greenville and signed an operating agreement in 2019. Peter’s corporate entity contributed 70% of the initial equity, while James and Trevor contributed 25% and 5% respectively. Greenville quickly became a multi-million dollar company. However, James and Trevor alleged Peter began defrauding them and Greenville in violation of his fiduciary duties.

They alleged he made more than $7 million in improper payments from Greenville to himself, the mother of his child, and other companies he owned; made more than $1 million in unaccountable “loans” to himself and his other companies; caused Greenville to enter unfair agreements with his other companies; and failed to pay James and Trevor the profit distributions they were entitled to.

In March 2022, James and Trevor sued Peter as individuals and on behalf of Greenville in a derivative capacity. Among their legal claims, they alleged Peter violated both the Racketeering Influenced and Corrupt Organizations Act (“RICO”) and his fiduciary duties to them and Greenville.

In deciding Peter’s motion to dismiss the claim, the judge held James and Trevor did not adequately plead their RICO claim brought in their individual capacities, and then dismissed the derivative federal claims because James and Trevor did not pass Federal Rule of Civil Procedure 23.1’s “adequate representation” test.

The wrong people for the job

As to the RICO claim, the judge ruled James and Trevor failed to properly allege they suffered a concrete loss to their personal business or property. The judge noted that James and Trevor’s allegations of harm caused by Peter are derivative of harm to Greenville, not of harm to them personally. The judge also ruled that James and Trevor failed to plead facts that show RICO violations were the proximate cause of their injuries. Again, the judge focused on the fact that their allegations of harm caused by RICO violations were harms to Greenville and did not cause the injuries to them they alleged had occurred.

(James and Trevor could have probably saved a fair bit of their attorneys’ fees by reading this post from October 2020 in which I discussed the interplay between direct and derivative claims in closely held corporate disputes, and this post from May 2021 in which I explained why civil RICO claims in business divorce cases are a hard sell in Pennsylvania federal courts.)

The judge next turned to determining whether James and Trevor satisfied Rule 23.1’s “adequate representation” test. The test has two prongs. The first is whether the plaintiff’s attorney is “qualified, experienced, and generally able to conduct the proposed litigation.” The second is whether the plaintiff has “interests antagonistic to those of the class.” The court focused on the second prong because the first prong wasn’t at issue.

As a starting point, the judge noted that James and Trevor, as the only minority shareholders of Greenville, were not automatically entitled to bring a derivative suit on behalf of it. They still had to prove they would adequately enforce the rights of Greenville in a lawsuit against Peter.

The judge then held that significant conflicts of interest existed between James, Trevor, and Greenville that prevented them from doing so—despite them being the only minority shareholders. According to the judge, those conflicts included:

  • James and Trevor resigned from Greenville and launched a competing e-jewelry retailer, creating direct economic antagonism between them and Greenville;
  • James and Trevor sought remedies in their individual capacities, requiring Greenville to pay that money out of whatever it recovered from the suit (instead of the company being able to keep its recovery);
  • James and Trevor sought a court order requiring Greenville to distribute profits in proportion to the shareholders’ ownership interests even though whether they were entitled to those distributions was an open question, and that money would have come from the same pool of money Greenville would recover in the lawsuit;
  • Ongoing separate litigation between James, Trevor, Peter, and Greenville, and another defendant in which James and Trevor are alleged to have “looted” Greenville on their way out and infringed the copyrights of the other defendant; and
  • James and Trevor prioritizing their personal interests and agendas over Greenville’s interests by seeking profit distributions from money they’d recover in the lawsuit and by seeking a buyout of their ownership shares in the company.

As a result, the judge dismissed the derivative claims without prejudice, allowing James and Trevor to file an amended complaint.

When stymied by Federal Rule 23.1, minority shareholders have an alternative path under Pennsylvania law

Despite the contentious relationship between James, Trevor, Peter, Greenville, and the other parties to the lawsuit—which is par for the course in disputes inside closely held companies—forbidding the only minority shareholders from being able to bring a derivative claim seems like it could lead to a worse result than Greenville having to pay profit distributions to James and Trevor.

If Peter and his corporate entity that owns 70% of Greenville do not respond to James and Trevor’s demand to investigate Peter’s/his corporate entity’s alleged wrongdoing, and they will not allow the company to sue itself and him, who, exactly, is left to advance any claims on behalf of Greenville? Preventing the only minority shareholders from bringing a derivative claim allows a majority shareholder to skirt any legal repercussions for their wrongdoing.

Luckily for James, Trevor, and any other minority shareholders who find themselves in this predicament, Pennsylvania Rule of Civil Procedure 1506 provides an alternative path if they were to bring their derivative claims in Pennsylvania state court. The relevant part of Pa. Rule 1506 states, with my emphasis added:

If it appears that the plaintiff does not fairly and adequately represent the interests of the shareholders or members similarly situated in enforcing the right of the corporation or association, an appropriate person shall be substituted as plaintiff or, if an appropriate person is not substituted, the action shall be dismissed [as stated in the rule].

Though neither the rule nor Pennsylvania courts provide any guidance as to who this “appropriate person” can—or must—be, there is no requirement that this person must be another shareholder of the company. This is significant for groups of minority shareholders who, like James and Trevor, are prevented from bringing derivative claims in federal court under Federal Rule 23.1 but are the only minority shareholders in a position to bring such claims.

To take advantage of Pa. Rule 1506, minority shareholders would need to file their derivative claims in Pennsylvania state court, which could bring with it particular strategic advantages or disadvantages given their situation and other claims they might include in their lawsuit. But given the decision in Jannuzzio v. Danby, if minority shareholders and their counsel believe they’ll have an uphill battle passing Federal Rule 23.1’s (and Pa. Rule 1506’s) “adequate representation” test, they may have no choice but to file their lawsuit in Pennsylvania state court to give them the flexibility to substitute in an “appropriate person” as permitted by Pa. Rule 1506.

In certain situations, it might be minority shareholders’ only shot at holding a majority shareholder liable for their alleged wrongdoing.