LLC Derivative Actions

LLC Derivative Actions: Understanding when an LLC Member Has Standing to Bring Suit on Behalf of the LLC

The concept of derivative actions emerged in American jurisprudence in the nineteenth century. It was first applied to corporations and slowly filtered down to other business entities including limited partnerships and limited liability companies (LLCs). At its core, a derivative lawsuit is a mechanism by which members of an LLC may seek relief for wrongs done to the LLC itself. Derivative lawsuits are one of the remedies that courts of equity designed for situations where those managing the LLC have declined to take the proper steps to assert the rights of the LLC. In such situations, the members of the LLC are allowed to take the initiative and file the suit on behalf of the LLC.

Injuries in the context of LLC members can come in one of two forms: direct or indirect. Direct injury is in which the harm is suffered directly by the LLC member. Indirect injury is where the harm is suffered by the LLC and the LLC member is injured only as a consequential effect of the injury to the LLC itself. To be a direct injury, the injury to the LLC member must be unique from that suffered by the other members. Freeze-out or squeeze-outs are common examples of direct injury to a member. Stolen business opportunities or fraud committed by a managing member of the LLC are common examples of indirect injury that may indirectly harm a member by reducing the value of that member’s membership interest in the LLC.

Similar to derivative actions involving corporations, a derivative action is brought by the LLC member in the name of the LLC and seeks to recover damages owed to the LLC itself. The derivative (or representative) nature of actions by members on behalf of the LLC makes conceptual sense. Illinois courts have repeated and reiterated consistently that legal entities like LLCs are distinct from their members (like shareholders are distinct from corporations). Though as legal entities, LLCs can only act through others, namely its members. Thus, where the LLC has suffered harm, some individual must act on behalf of the LLC to recover. If those in charge of the LLC won’t act on its behalf, derivative actions allow another member to step up and do so. The Illinois Limited Liability Company Act, 805 ILCS 180/1-1 et al., permits successful members who file derivative actions to recover expenses and attorney’s fees incurred in bringing the action. After the member plaintiff’s expenses and attorney’s fees are removed from the recovery, the remainder goes to the LLC.

Illinois treats derivative actions virtually the same in the context of LLCs, limited partnerships, and corporations. In comparison, derivative actions are inapplicable to general partnerships. Some other states expressly provide for derivative actions on behalf of LLCs. LLC managers and directors are subject to the same fiduciary standards as are corporate officers and directors.

Determining whether the injury the member has suffered is direct or indirect is a crucial inquiry. There are several practical ramifications to this inquiry including who retains the recovery, the risk of dismissal, the demand requirement, and the ability to recover attorney’s fees.

As explained in derivative actions, the LLC receives the damages recovered; in a direct action, the LLC member retains the recovery. In derivative actions, a successful plaintiff may receive an award of attorney’s fees and expenses; in a direct action, the plaintiff almost always must pay its own attorney’s fees and litigation expenses.

Then there is the demand requirement. An LLC member may bring a derivative claim on behalf of the LLC only after those members or managers with authority to bring such an action refuse to do so. Nonetheless, there is a recognized exception known as “demand futility” which allows a member to bring an action without having first made such a demand if such a demand would have been futile.

The most fundamental consequence a plaintiff who fails to properly characterize a derivative cause of action as such but instead files the claim as a direct one is the risk of having the claim dismissed. As explained, a derivative claim belongs to the LLC and a member has no standing to bring such a claim except on behalf of the LLC. A plaintiff who mischaracterizes a derivative claim as a direct claim cannot control whether a judge will dismiss the claim without prejudice (in which case the error can be corrected and the claim refiled) or with prejudice (in which case the dismissal is dispositive and the plaintiff cannot refile the claim). For this reason, it is imperative to consult with a knowledgeable LLC law attorney who will understand the nature of the claim and the pleading or demand requirements that must be fulfilled in order to successfully maintain a claim.

Lubin Austermuehle’s business dispute and LLC member-rights attorneys have more than thirty-five years of experience helping business clients unravel the complexities of Illinois and out-of-state business laws. Our Chicago business dispute litigation lawyers serve clients throughout Illinois and the Midwest. If you’re a member of an LLC and considering filing or are facing a direct or derivative action, the experienced Illinois breach of fiduciary duty attorneys at Lubin Austermuehle can help. To set up a consultation with one of our Chicago shareholder dispute attorneys and Chicago business trial lawyers, please call us toll-free at 833-306-4933 or contact us online.

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