Business Law

Owner of Closely Held Corporation Must Use Derivative Action to Sue Director

, The Legal Intelligencer

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partnership

However, Hill alleged that once Ofalt assumed control, he began using the business as a "cash cow," Olson said. Hill alleged that Ofalt gave free drinks to family and friends, voided transactions to conceal the free food and drinks, pocketed money, diverted funds and deducted money from employees' paychecks, portraying them as requiring tax withholding.

The restaurant closed, and the business fell into arrears to taxing authorities. The state Department of Revenue imposed a $79,000 lien against Hill and the restaurant. The company also defaulted on the loans that Hill and Ofalt had personally guaranteed. According to Olson, Hill and the company were exposed to debts in excess of $500,000.

Hill then filed a complaint alleging breach of contract, breach of fiduciary duty, unjust enrichment and conversion, Olson said.

Ofalt filed preliminary objections arguing that the complaint was legally insufficient because the injuries were suffered by the corporation and the suit was filed as an individual action instead of a shareholder derivative action. Ofalt further argued that he did not owe Hill any fiduciary duty.

The trial court sustained the preliminary objections and held that Hill did not have standing to institute a direct action for individual damages. The action, the court said, was more appropriate as a shareholder derivative suit.

Before the Superior Court, Hill argued he had standing to institute a direct action against Ofalt because, within the complaint, he alleged that he was individually harmed by Ofalt's actions. Hill also argued that, pursuant to Section 7.01(d) of the ALI's Principles of Corporate Governance: Analysis and Recommendations, he is entitled to bring an action as a member of a closely held corporation.

Hill cited the 1997 Supreme Court's decision in Cuker v. Mikalauskas, in which the court adopted sections of the ALI's Principles of Corporate Governance and authorized the court to consider and use other parts of the principles if they were found to be helpful and consistent with state law.

Olson, however, found that while the Supreme Court might adopt the procedural aspects of Section 7.01(d), such as excusing the demand requirement for derivative actions filed on behalf of closely held corporations, the high court would not adopt the substantive aspects of the principle because it conflicted with state law.

The court further noted that the section grants courts the option to ignore the corporate form of a closely held corporation and to treat the corporation as an "incorporated partnership." Olson, however, agreed with the U.S. Court of Appeals for the Seventh Circuit's 1990 decision in Bagdon v. Bridgestone/Firestone, which said corporations are not partnerships.

"Although we believe that our Supreme Court might adopt some portions of Section 7.01(d), we conclude that our high court would not allow individuals such as appellant to sue directly—and individually recover—for injuries that were sustained by the closely held corporation," Olson said.

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