Can a Shareholder or an LLC Member Really Sue My Company for That?

If you own or run a business, the prospect of being sued by one of your own shareholders or limited liability company (LLC) members can be both bewildering and alarming. After all, aren't these the very people who invested in the company's success? Yes, shareholders and members can sue, but sometimes they overstep. Understanding how these lawsuits work, what procedural barriers exist and what defense tools are available is essential for any executive who wants to protect the company and its leadership.

This Holland & Knight alert walks through the key concepts in plain language so you can have a more informed conversation with your legal counsel when the need arises.

Derivative vs. Individual Claims

Not every lawsuit filed by a shareholder or an LLC member is the same. The law draws a critical distinction between derivative claims (owned by the company) and individual claims (owned by one or more of its individual shareholders or members).

Derivative claims are brought on behalf of the company itself. The theory is that the company was harmed and the shareholder is stepping in to protect the company's rights as a whole. Any money recovered goes back to the company, not to the person who filed suit. A classic example: A minority shareholder discovers that the board approved a sweetheart deal with another company controlled by one of its directors, siphoning value away from the business. Because the injury is to the company's bottom line, the claim is derivative.

Individual (direct) claims are different. Here, the shareholder or member is saying, "I was personally injured in a way that is separate from any harm to the company." For instance, if a majority owner engineers a sham capital call designed to dilute a minority member's ownership stake or if the company refuses to let a member inspect the books and records he or she is legally entitled to see, those are injuries personal to the individual.

Why does it matter? It determines who controls the lawsuit, who keeps the recovery and, critically, what procedural hurdles the plaintiff must clear before the case can go forward. Derivative claims come loaded with pre-suit requirements, whereas direct claims generally do not.

Courts commonly apply what is known as the Tooley test, named after a well-known Delaware case: 1) Who suffered the harm – the company or the shareholder? and 2) Who would receive the benefit of any recovery? If the answer to both questions is the company, the claim is derivative. This framework applies in both corporate and LLC settings, though the details can vary by state.

Pleading Hurdles for Derivative Claims

Because a derivative suit is really the company's claim being prosecuted by an individual shareholder or an LLC member, the law imposes significant gatekeeping requirements:

The Demand Requirement. Before filing suit, a shareholder or member typically must make a formal written demand on the company's board of directors (or the managers of an LLC) asking the company to take action on its own. The rationale is straightforward: The decision whether to pursue litigation on the company's behalf is a business decision that properly belongs to the board or the LLC's manager, not any individual investor.

Demand Futility. Sometimes, making a demand would be pointless – for example, when a majority of the board members is the very people accused of wrongdoing or so closely tied to them that they could not evaluate the demand impartially. In those situations, a plaintiff can argue that demand is "futile" and skip the demand step entirely. Delaware applies a well-developed, director-by-director test (established in United Food & Commercial Workers v. Zuckerberg, 2021) that asks whether each director could impartially consider the demand. To plead futility, a plaintiff must show the majority of the board is so conflicted.

Board Refusal. If a shareholder does make a demand and the board declines to act, that refusal is protected by the business judgment rule, a powerful legal presumption discussed in more detail below. Overcoming a board's refusal of a demand is extremely difficult.

On top of these requirements, derivative plaintiffs face heightened pleading standards. A complaint must contain particularized factual allegations, not just general accusations, to survive a motion to dismiss. For LLCs, the same general framework applies. Delaware's LLC Act and California's Corporations Code both codify derivative suit procedures for LLCs, though the specifics differ.

Company Defense Tools

Companies facing derivative lawsuits are not without significant weapons of their own. Here are the most important ones:

• Special Litigation Committees (SLCs). The board (or LLC managers) can appoint an independent committee of directors to investigate the derivative claims and decide whether pursuing the lawsuit is truly in the company's best interest. If the committee concludes it is not, the company can ask the court to dismiss the case. In Delaware, the court applies a two-step test: First, the SLC must demonstrate its independence, good faith and "the reasonableness" of its investigation. Second, the court may exercise its own independent judgment on whether dismissal is warranted. This gives the court a meaningful check on the process. In California, the court "must determine whether each SLC member was 'in a position to base his decision on the merits of the issue rather than being governed by extraneous considerations or influences'" and "employed proper procedures before rejecting the claim," but if the answer is yes to both questions, the court may not second-guess or otherwise "consider the merits" of the SLC's decision. 
• The Business Judgment Rule. This is one of the most powerful shields in corporate law. Courts presume that directors' decisions are made in good faith, on an informed basis and in the honest belief that they serve the company's best interest. A plaintiff seeking to overcome this presumption carries a heavy burden. The rule can support dismissal of derivative claims, particularly where the board followed proper process.
• Motions to Dismiss. Companies can challenge derivative suits on several procedural grounds: failure to make a demand, inadequate pleading of demand futility, failure to state a viable claim and standing defects. For example, most jurisdictions require the plaintiff to have owned shares at the time of the alleged wrongdoing (the "contemporaneous ownership" requirement).
• Exculpation Clauses. Delaware law allows companies to adopt charter provisions that eliminate director personal liability for monetary damages arising from breaches of the duty of care (though not the duty of loyalty or good faith). Since 2022, Delaware has extended this protection to certain senior officers as well. California permits similar but narrower exculpation provisions. A well-drafted exculpation clause can significantly limit a company's exposure.
• Attorneys' Fees. Generally speaking, attorneys' fees are not recoverable absent statutory authorization or a contractual basis for such an award. California Corporations Code Section 800 provides a statutory basis for an attorneys' fees award in derivative lawsuits. It also allows companies to seek a court order compelling shareholders or LLC members to post a $50,000 bond before being allowed to prosecute such lawsuits.

California vs. Delaware Law

Many businesses are formed in Delaware, but plenty of others – especially those with West Coast operations – are organized in California. The choice of state has meaningful consequences for derivative and direct claims:

• Demand Futility Standards. Delaware's unified Zuckerberg test is well-developed, structured and the subject of extensive case law. California's demand futility standard under Corporations Code Section 800 is broadly similar in concept but less extensively litigated and, as a result, somewhat less predictable.
• SLC Standards. Delaware's two-step Zapata test gives courts real flexibility, including the power to exercise independent judicial review. As stated above, after an SLC's independence and use of fair procedures has been established, California courts are not allowed to second-guess SLC decisions.
• Delaware's exculpation statute is broader and, since 2022, covers certain officers in addition to directors. California's equivalent is narrower in scope.
• LLC-Specific Differences. This is where the gap between the two states is most pronounced. Delaware's LLC Act is famously flexible – parties can contractually modify or even eliminate fiduciary duties through the operating agreement. California takes the opposite approach: Fiduciary duties in California LLCs are largely mandatory and cannot be waived by agreement. This distinction alone can be a deciding factor for business owners structuring a new venture.

The strategic takeaway is clear. Many businesses incorporate or form their LLCs in Delaware precisely because of its well-developed, predictable and management-friendly legal framework. Companies formed in California face a landscape that is somewhat less settled on derivative suit issues but may impose stricter fiduciary obligations that are harder to contract around.

Practical Takeaways: What You Can Do Now

Although derivative and direct claims are a fact of life in business, there is a great deal you can do proactively to minimize your exposure and strengthen your defenses:

• Review your charter and operating agreement to ensure you have adopted all available protective provisions – exculpation clauses, indemnification and advancement of expenses for directors and officers.
• If your entity is formed in Delaware, evaluate whether the operating agreement appropriately modifies default fiduciary duty standards to take advantage of the flexibility Delaware law provides.
• Maintain strong corporate governance practices. Proper board minutes, written conflict-of-interest policies and the use of independent directors are your front line of defense in any lawsuit.
• Consult counsel early if you receive a demand letter or a derivative suit threat. The strategic decisions made in the early stages – such as whether to form a special litigation committee or how to respond to a demand – can shape the entire trajectory of the case.
• Consider the state-of-formation question carefully. Whether you are forming a new entity or reevaluating an existing structure, the choice between California and Delaware has real consequences for your exposure to shareholder and member claims.

The best time to address these issues is before a dispute arises. On the other hand, and all too often, less experienced counsel waive a company's rights by failing to object and take timely action when a shareholder or an LLC member oversteps and commandeers a right or claim that actually belongs to the company in suing the company or its managers.

For more information or questions, please contact the author.

Information contained in this alert is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem, and it should not be substituted for legal advice, which relies on a specific factual analysis. Moreover, the laws of each jurisdiction are different and are constantly changing. This information is not intended to create, and receipt of it does not constitute, an attorney-client relationship. If you have specific questions regarding a particular fact situation, we urge you to consult the authors of this publication, your Holland & Knight representative or other competent legal counsel.