Aurora Credit Services, Inc. v. Liberty West Development, Inc.: An analysis of shareholder derivative suits in closely held corporations

Brigham Young University Law Review, 2002 by Yates, Robbie G

I. INTRODUCTION

Corporate laws that govern derivative suits attempt to dictate the type of lawsuit a shareholder may file on behalf of a corporation. These laws often protect the corporation at the expense of individual shareholders. A problem arises when a closely held corporation, operated and controlled by the majority shareholders, suffers a harm caused by its own board members. A strict interpretation of corporate law requires a shareholder that wants to pursue this claim on behalf of the corporation to make demand on the board of directors. The board then has to agree to instigate an action against itself on behalf of the corporation for the harm it caused.1 As a result of this problem, a conflict of interest arises for the board members to maintain their fiduciary duty to look after the corporation's best interests, but at the same time not agree to put themselves in a position to be held liable for the damages that they have caused. Hence, most directors or officers of closely held corporations do not agree to instigate the action demanded by the shareholder, and thus, the minority shareholders are left with little remedy. To resolve this concern, some courts have recognized "the right of a close corporation shareholder to sue directly, as an individual, on a cause of action which would normally have to be brought derivatively."2

In Aurora Credit Services, Inc. v. Liberty West Development, Inc.,3 the Utah district court faced this exact problem. The court dismissed Aurora Credit Services' ("Aurora") direct claims against Liberty West Development ("LWD") and granted LWD's motion for partial summary judgment regarding the derivative claims. The Utah district court stated that Aurora did not have standing to sue derivatively. However, on November 24, 1998, the Utah Supreme Court reversed the lower court's decision and adopted an approach promulgated by the American Law Institute, which holds that under certain circumstances a minority shareholder in a closely held corporation can sue directly "on a cause of action which would normally have to be brought derivatively."4 In the process of deciding the Aurora case, the Utah Supreme Court also held for the first time that a shareholder who sues a corporation directly has to satisfy the contemporaneous ownership requirement of Utah Rule of Civil Procedure 23.1.(5)

This Note will discuss why the Utah Supreme Court correctly decided to provide minority shareholders with a method of recourse other than a derivative suit, but will also illustrate the flaws in the court's holding that a direct action must now satisfy the contemporaneous ownership requirement. One such flaw is that the language the Utah Supreme Court used in fashioning the contemporaneous ownership requirement for direct actions was too broad and can be interpreted to apply not only to situations in which a minority shareholder is suing a closely held corporation directly, but also to any other direct action that a shareholder may file for unique wrongs sustained by that individual shareholder. Another problem with the court's holding is that the purpose of the contemporaneous ownership requirement in avoiding strike suits is not applicable to closely held corporations. This Note proposes that a shareholder of a closely held corporation should not be required to satisfy the contemporaneous ownership requirement when a direct action is substituted for a derivative action.

The analysis of the two Aurora holdings will proceed as follows: Part II of this Note provides a brief overview of corporate law, explains the distinguishing differences between a shareholder derivative suit and direct actions by shareholders against the corporation, and also provides an overview of the contemporaneous ownership requirement. Part III sets forth the facts of Aurora and briefly discusses the significance of the Utah Supreme Court's decision to allow minority shareholders to sue corporate officers directly. Part IV establishes the three options the Utah Supreme Court had in deciding the case and analyzes why the Aurora decision correctly allowed minority shareholders, under certain circumstances, to sue a closely held corporation directly. Part IV also analyzes why the Utah Supreme Court incorrectly applied the contemporaneous ownership requirement of Utah Rule of Civil Procedure 23.1 to direct actions filed by individual shareholders and why the court incorrectly assumed that the efficient market theory applies not only to publicly traded corporations, but also to closely held corporations. A brief conclusion will follow in Part V.

II. BACKGROUND

A. General Corporate Law

A corporation is a legal person separate from its shareholders and is entitled to its own profits and to the rights of any derivative action brought by shareholders on its behalf.6 "A corporation is, in its very nature, an entity operating for the benefit of its stockholders."7 An owner or shareholder of a corporation is one "who owns or holds a share or shares" in a corporation.8 "The distinguishing characteristics of a corporation are that it is an artificial person, a legal entity, capable of acting through its corporate officers and agents, of suing, being sued, of taking and holding property, and of contracting in its own name, and of continuing to exist independent of individuals who compose it."9