The Ali Principles of Corporate Governance Compared With Georgia Law--continued - Marjorie Fine Knowles and Colin Flannery

• Publication year: 1996

SPECIAL CONTRIBUTIONS

The ALI Principles of Corporate Governance Compared with Georgia Law—Continued^fby Marjorie Fine Knowles^* and Colin Flannery^**

I. Part VII, Chapter 1: The Derivative Action

Nothing in The American Law Institute's . . . Principles of Corporate Governance: Analysis and Recommendations . . . proved more controversial than the effort to develop fair and balanced standards for the derivative action. Only the topic of corporate takeovers seems to evoke an equally intense level of emotion among corporate lawyers. Not surprisingly then, Part VII (Remedies) of the Principles attracted the same attention from critics that a lightning rod does in a thunderstorm.¹

Indeed, the lobbying and scrutiny visited upon the American Law Institute's ("ALI") work on the derivative action from the various interest groups and academic critics rose to a level normally reserved for congressional legislation. This remedy occupies more than half of Volume 2 of the two volume set of the ALI Principles of Corporate Governance ("Principles");² much of this space is devoted to explanations of carefully compromised text.

By stark contrast, the Official Code of Georgia Annotated ("O.C.G.A.") devotes only nine sections directly to the remedy,³ one of which contains definitions⁴ and one of which applies only to foreign corporations.⁵

In reviewing the relevant provisions of the ALI Principles and those of the Georgia Code, it is important to bear in mind that, although they may differ in detail, both utilize the same fundamental mechanisms to constrain derivative litigation:

1) both recognize a central role for the board of directors in derivative litigation by positioning the board so that its evaluation of the action is given significant legal effect; and 2) both purport to establish an expeditious means for screening and dismissing nonmeritorious litigation.⁶

A. Direct and Derivative Actions Distinguished

First, the ALI Principles, in section 7.01, distinguish between derivative actions and direct actions. The crux of the distinction is, of course, the party that is primarily injured. Section 7.01(a) provides that:

A derivative action may be brought in the name or right of a corporation by a holder . . ., as provided in [section] 7.02 . . ., to redress an injury sustained by, or enforce a duty owed to, a corporation. An action in which the holder can prevail only by showing an injury or breach of duty to the corporation should be treated as a derivative action.⁷

On the other hand,

[a] direct action may be brought in the name and right of a holder to redress an injury sustained by, or enforce a duty owed to, the holder. An action in which the holder can prevail without showing an injury or breach of duty to the corporation should be treated as a direct action that may be maintained by the holder in an individual capacity.⁸

Comment c to section 7.01 provides a nonexhaustive list of actions that most courts consider to be direct actions,⁹ and comment d describes the relevant criteria to be taken into account when borderline cases are presented to the court.¹⁰ The comments conclude by stating that courts are more permissive in allowing the plaintiff to characterize the action as a direct one when the plaintiff is seeking only injunctive or prospective relief, "because typically the requested relief will not involve significant financial damages against corporate officials, the period in which the corporation is exposed to multiple suits will be relatively brief, and the relief will benefit all shareholders proportionately."¹¹

Section 7.01(c) allows a shareholder to commence and maintain direct and derivative actions simultaneously, and provides that special defenses or restrictions pertaining to the maintenance, settlement, or dismissal of one action should be regarded as inapplicable to the other.¹²

Section 7.01(d) specifically addresses cases in which a closely held corporation is a party. This section gives the court discretion to treat derivative claims as direct actions, provided that doing so will not "(i) unfairly expose the corporation or the defendants to a multiplicity of actions, (ii) materially prejudice the interests of creditors of the corporation, or (iii) interfere with a fair distribution of the recovery among all interested persons."¹³

A "derivative proceeding" is denned in section 14-2-740(1) of the Georgia Code as "a civil suit in the right of a domestic corporation or, to the extent provided in Code Section 14-2-747, in the right of a foreign corporation."¹⁴ The essential element of the definition is that the suit be "in the right of the corporation." This maintains the distinction observed in the ALI Principles between actions for the benefit of the corporation and actions for the benefit of the shareholder individually, which cannot be pursued derivatively.¹⁵ The ALI Principles do not address the issue of foreign corporations in its definition.

The Georgia Code allows a shareholder to bring a derivative suit for the following relief:

(1) To compel the defendant to account for official conduct or to decree any other relief called for by his official conduct in the following cases:

(A) The neglect of, failure to perform, or other violation of his duties in the management of the corporation or in the disposition of corporate assets;

(B) The acquisition, transfer to others, loss, or waste of corporate assets due to any neglect of, failure to perform, or other violation of duties; or

(C) The appropriation, in violation of his duties, of any business opportunity of the corporation;

(2) To enjoin a proposed unlawful conveyance, assignment, or transfer of corporate assets or other unlawful transaction where there is sufficient evidence that it will be made; and

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12. Id. Sec. 7.01(c).

13. Id. Sec. 7.01(d).

14. O.C.G.A. Sec. 14-2-740 (1994).

15. See Hacienda Corp. v. White, 280 Ga. App. 879, 880, 400 S.E.2d 323, 325 (1991), in which the court held that a shareholder could not bring a derivative action to set aside a deed conveying all of the corporation's assets on the basis that the requisite notice was not given to minority shareholders. The court held the statute requiring the notice to be for the benefit and protection of minority shareholders, not the corporation, hence there was no basis for asserting the corporation's rights derivatively. Id.

(3) To set aside an unlawful conveyance, assignment, or transfer of corporate assets where the transferee knew of its unlawfulness and is made a party to the action.¹⁶

The Georgia Code does not specifically address the issues of simultaneous direct and derivative suits by a holder, or special treatment for cases involving closely held corporations. Case law, however, has filled the gap. The Georgia Court of Appeals has held that, in cases involving closely held corporations, an exception exists to the general rule that only a derivative action may be used to seek redress of corporate injuries.¹⁷ It has also held that shareholders have a right to bring direct and derivative actions simultaneously.¹⁸

B. Standing to Commence and Maintain a Derivative Action

Section 7.02(a) of the ALI Principles provides that an equity security holder has standing to commence and maintain a derivative action if the holder:

(1) Acquired the equity security either (A) before the material facts relating to the alleged wrong were publicly disclosed or were known by, or specifically communicated to, the holder, or (B) by devolution of law . . . from a prior holder who acquired the security as described in the preceding clause (A);

(2) Continues to hold the equity security until the time of judgment, unless the failure to do so is the result of corporate action in which the holder did not acquiesce, and either (A) the derivative action was commenced prior to the corporate action terminating the holder's status, or (B) the court finds that the holder is better able to represent the interests of the shareholders than any other holder who has brought suit;

(3) Has complied with the demand requirement of section 7.03 . . .; and

(4) Is able to represent fairly and adequately the interests of the shareholders.¹⁹

The comment to section 7.02 notes that this approach departs from that of the majority of states because the Principles permit the court to use the date of disclosure, rather than that of the actual consummation of the wrong, in determining the standing of a shareholder/plaintiff under the contemporaneous ownership doctrine.²⁰ The comment to section 7.02 also states that subsection (2) departs from the majority approach by allowing two limited exceptions to the continuing ownership rule.²¹ The latter requirement in subsection (4) recognizes and seeks to address the potential abuses that attend the necessary, and sometimes involuntary, trust the shareholders must place in the derivative plaintiff.²²

The factors considered in determining whether the plaintiff can adequately represent the interests of the shareholders are: "(i) the existence of any conflict of interest . . ., (ii) the competence of the attorney representing the plaintiff, and (iii) any other evidence suggesting that the action will not be prosecuted vigorously."²³ To augment these provisions, section 7.02(b) permits intervention by a holder where that person's interests are not already fairly and adequately represented. Here the Principles are consistent with the majority rule.²⁴

Section 7.02(c) addresses the issue of whether a director of a corporation has standing to commence and maintain a derivative action. The Principles accord standing to such persons, subject to the same fair and adequate representation standard applied to other shareholders seeking to bring a derivative action.²⁵

The Georgia Code is very brief in its elucidation of standing requirements. O.C.G.A. section 14-2-741 provides that

[a] shareholder may not commence or maintain a derivative proceeding unless the shareholder:

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