Business Law

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

, The Legal Intelligencer

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An individual owner of a closely held corporation may not directly sue a director over alleged breach of duty to the company, the state Superior Court has ruled, holding that under Pennsylvania law such an action should be pursued as a derivative action on behalf of the corporate entity.

In Hill v. Ofalt, the frontline appeals court rejected a provision of the American Law Institute's corporate governance principles that say a court may treat those derivative claims as a direct action.

The panel, upholding a trial judge's decision to throw out the direct action, said the ALI principles are inconsistent with Pennsylvania law and would likely not be adopted by the state Supreme Court.

Superior Court Judge Judith Ference Olson wrote for the majority that the ALI's rule conflicted with the state's Business Corporation Law Section 1717, which limits standing.

"We conclude that our Supreme Court would not simply ignore the corporate form and allow courts to 'treat an action raising derivative claims as a direct action ... and order an individual recovery,'" Olson said, quoting Section 7.01(d). "At the outset, it would appear that, in the vast majority of cases, the substantive aspects of Section 7.01(d) expressly conflict with Pennsylvania statutory law."

Olson, however, ultimately held that the trial court erred by failing to preclude the plaintiff from amending the pleadings. She noted that recent amendments to Rule 1033 of the Pennsylvania Rules of Civil Procedure explicitly allow the plaintiff to add the corporation as a party to the suit. She remanded the case. Judges Sallie Updyke Mundy and Eugene B. Strassburger joined the opinion.

Attorney Paul J. LaBelle, who represented the defendant, said he agreed with the court's decision and maintained that the alleged injuries were only sustained by the corporation and not by the plaintiff individually.

"With this decision, the sanctity of shareholder derivative suits is being preserved by the Pennsylvania courts," LaBelle said. "If we don't preserve the derivative action scenario, then we're going to have shareholders suing shareholders all over the place if they don't like what was done."

According to Olson's opinion, plaintiff Thomas Hill and defendant Ronald J. Ofalt Jr. formed Milestone Restaurant Co. to create a bar and restaurant. The two agreed to have an equal stake in the corporation and agreed Hill would provide start-up capital, expertise and good credit to establish the restaurant. Months after incorporating, the two procured a $250,000 bank loan and a $50,000 small business association loan.

Hill worked to set up the restaurant for four months and then Ofalt took over heading the company, as per the agreement.

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