Derivative Suits in Kentucky: Suing on Behalf of the LLC or Corporation

A manager diverts a lucrative contract to his own side company. A majority shareholder pays herself a salary three times what the job is worth. A director approves a lease with his brother-in-law at double the market rate. In each case the person harmed is the company itself, and under Kentucky law that creates a problem for the owner who wants to do something about it. The company’s claim is the company’s to bring, and the people who control the company are the ones who did the wrong. The derivative suit exists to solve that problem.

Direct versus derivative: the threshold question

Kentucky courts draw a line between direct claims and derivative claims. A direct claim is one for an injury to the owner personally: a distribution the operating agreement guaranteed but was never paid, a refusal to honor a buy-sell right, denial of statutory inspection rights. The owner sues in his own name and keeps the recovery.

A derivative claim is one for an injury to the company: wasted assets, a usurped opportunity, an unauthorized insider payment, a breach of fiduciary duty that reduced the value of the business as a whole. The owner sues on the company’s behalf, and the recovery goes to the company. Each owner benefits only indirectly, in proportion to his stake.

Plaintiffs frequently plead derivative harms as direct claims, and defendants frequently move to dismiss on exactly that ground. Figuring out which bucket each claim belongs in is the first job in any co-owner dispute.

Corporations: KRS 271B.7-400

For Kentucky corporations, the derivative procedure is set out in KRS 271B.7-400. In broad strokes, the plaintiff must have been a shareholder when the challenged transaction occurred (or have acquired shares by operation of law from someone who was), must fairly and adequately represent the interests of the corporation, and must file a verified complaint that alleges with particularity the demand made on the board and the board’s response, or the reasons a demand would have been futile. The court must approve any settlement or dismissal, because the claim belongs to the corporation and not to the individual plaintiff.

Limited liability companies

Kentucky’s LLC Act contains its own derivative-action provisions, which track the corporate model in most respects: the member must have been a member at the time of the challenged conduct, the complaint must set out the demand made on the managers or members with authority to act, or explain why demand was excused, and the court supervises any resolution. Because the LLC Act gives such weight to the operating agreement, the agreement may also impose its own requirements for bringing claims on the company’s behalf, and those provisions are generally enforced.

The demand requirement

Before suing derivatively, the owner ordinarily must demand that the company’s governing body pursue the claim itself. The demand should be in writing, identify the wrongdoers and the conduct, and ask the company to take action. If the board or managers investigate in good faith and decline, courts give that decision considerable deference, which can end the case.

Demand is excused as futile where the people who would have to authorize the suit are the same people who committed the wrong or are otherwise incapable of exercising independent judgment. In a two-member LLC where one member is the wrongdoer, or a corporation where the defendant controls the board, futility is often plain. Even so, a complaint that pleads futility must do so with particular facts, not conclusions.

Who controls the litigation

Once a derivative suit is filed, the company is a nominal defendant, and the defendants are usually the insiders. The company may appoint an independent committee to investigate and recommend whether the suit should proceed, and a court may dismiss the case on the committee’s recommendation if the committee was truly independent and acted in good faith. The plaintiff’s counsel drives the case day to day, but the court’s oversight role never goes away.

Attorney’s fees and expenses

Because the recovery goes to the company, a derivative plaintiff who wins can usually recover reasonable attorney’s fees and expenses from the company, on the theory that the plaintiff conferred a benefit on it. The flip side is that a plaintiff who brings a derivative suit without reasonable cause, or for an improper purpose, can be ordered to pay the defendants’ fees. That risk is why derivative complaints should be built on documents, not suspicion.

Closely held companies: a possible shortcut

Some courts have allowed owners of very small, closely held companies to pursue what would otherwise be derivative claims directly, where there are no outside creditors or shareholders to protect and the formalities of the derivative procedure would serve no purpose. Kentucky has not adopted that approach wholesale, and an owner should not count on it. But in a two-owner company where every dollar diverted from the business came out of one owner’s pocket, the argument has real force and is worth preserving.

Practical sequence

A well-run derivative matter usually follows a sequence: exercise inspection rights to gather records; send a demand letter that doubles as the statutory demand; evaluate the company’s response; then file a verified complaint pleading direct claims directly and derivative claims derivatively, with the demand history set out in detail. Done in that order, the case arrives in court with the procedural objections already answered.

If you believe the people running your company have harmed it for their own benefit, call (859) 225-9540 or contact us online. We can help you decide whether a derivative suit, a direct claim, or both is the right path.

Joseph D. Buckles is a civil litigation attorney at Buckles Law Office, PLLC in Lexington, Kentucky, with a focus on civil litigation and probate litigation.