February 10, 2021

The Role of the Company When Its Owners Face Off Against Each Other

Stuart L. Pachman

Owners of closely held corporations or LLCs often find themselves litigating for control of their “Company.” When that happens, on which side of the caption does the Company line up? What role should it play? And should either warring faction enjoy access to the Company’s assets to fund that side’s litigation costs?

When derivative claims are asserted, the Company must be a party, but when nothing is sought on behalf of or from the Company and all the owners are before the court, should the Company be a plaintiff or a defendant, or should it be left off the caption altogether? If it is not named as a party, the court may require the Company to become one so that it will be subject to the court’s orders.

When the Company is named a nominal defendant in the Complaint, the plaintiff runs the risk that the defendant owners will retain one lawyer to represent both them and the Company and pay that lawyer’s retainer (and eventually a lot more) from the Company’s treasury, even though as a practical matter that lawyer will be advancing one side’s position in the litigation against the other. In addition to whether that is fair, joint representation raises ethical issues. The result is that the choice of counsel, the authority to choose counsel, and the use of Company funds to pay counsel become issues in a soon-to-follow pretrial application for relief by the plaintiff.

These issues were addressed, but not conclusively resolved, in a case that came before the Texas Supreme Court on pretrial applications to disqualify defendants’ counsel. The underlying dispute, which had not yet been decided by the lower court, was between twelve LLC owners and six “Governing Persons” collectively divided into two factions. The disagreement arose from the majority’s firing of the previously unanimously elected president and managing member who, with his supporters, claimed that a unanimous vote was required for dismissal. The minority’s Complaint, asserting derivative as well as direct claims, included the LLC as a named plaintiff. The defendant majority engaged a law firm that had previously represented the LLC, funded its litigation costs from the Company treasury, and asserted counterclaims.

Late in the litigation, the minority moved to disqualify defendants’ counsel charging (1) that the law firm, having previously been counsel to the plaintiff LLC, could not appear against its former client, and (2) that the defendant faction had no authority to hire a law firm to act for the LLC.

The court noted that the core issue underlying the litigation was who had the right to control the LLC’s management, and as to this issue, each faction’s position was that the other side’s position was incorrect and harmful to the LLC. The court observed that when stripped of the baggage of the derivative label, the Company’s alignment in the caption was immaterial to this issue, noting that “[C]ompanies in derivative litigation are simultaneously ‘plaintiffs’ and ‘defendants’ depending on how you look at it.”

The court reviewed decisions from other jurisdictions questioning joint representation and found no categorical rule. Based on Texas law and the Texas Rule serving as the basis for one of the applications made below, and in light of the timing of the motions to disqualify, the Texas Supreme Court upheld the lower court’s discretion not to grant disqualification. The core merits question of control was capable of being fairly litigated by the factions and lawyers for both sides presently before the court.

Whether defendants had the authority to hire counsel at Company expense was not determined at this stage of the proceeding. The authority to hire counsel for an LLC often turns on whether it is a “major” or “material” or “extraordinary” or “not in the usual course of business” decision that requires unanimity or high vote under either statute or operating agreement. 

As to the inequity of one side’s use of Company money to pay its litigation costs, the court said that “adequate remedies exist” for subsequent recovery of any legal fees that may turn out to have been improperly paid from the other group’s interests in the LLC.

“Adequate remedies” after the fact may be viable if the personal resources of both sides fighting for control are such that each is able to fund its litigation costs without hardship. This may have been true in the Texas case. If one or both litigants have limited resources, the rights of one side to postlitigation remedies are of little avail when the other side is enjoying the real-time advantage of financing its position in the litigation with the Company’s funds. Courts do afford relief in those situations when timely application is made.

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    Stuart L. Pachman

    Brach Eichler L.L.C.

    Stuart L. Pachman is a member of Brach Eichler L.L.C. in Roseland, New Jersey and a member of the LPUE Committee of the Business Law Section.