In a
decision approved for publication, New Jersey’s Appellate Division provides an
important reminder as to the crucial distinction between direct and derivative
claims in shareholder actions.  Specifically, in Tully v. Mirz, the
Appellate Division held that one of two shareholders of a closely-held
corporation could not bring a direct action against the other shareholder for
the other shareholder’s alleged mismanagement of the corporation and conversion
of corporate funds, but that he had the right to bring direct claims for the
other shareholder’s alleged breach of contract and breach of the covenant of
good faith and fair dealing.  See Tully v. Mirz, 2018 WL
6204908 (N.J. Super. Ct. App. Div. Nov. 29, 2018).  The facts are as
follows.

In 2005,
plaintiff and defendant formed Interstate Fire Protection, Inc. (“IFP”) and
were IFP’s only shareholders.  In 2009, plaintiff and defendant allegedly
entered into a written agreement stating they were equally responsible for
IFP’s liabilities “unless the losses are occasioned by the willful neglect or
default, and not the mere mistake or error, of any of the parties.”  IFP
defaulted on a line-of-credit loan with TD Bank in 2015.  In April 2016,
TD Bank obtained a $530,687.40 judgment against IFP and the guarantors on the
loan, including plaintiff, defendant, and another company owned by plaintiff.
Plaintiff later settled with TD Bank on behalf of himself and his company, and
TD Bank released them from the judgment in exchange for a payment of
$300,000.  Defendant and IFP remained liable to TD Bank.

In 2016,
plaintiff brought this action against defendant on his own behalf alleging,
among other things, that he loaned money to IFP that has not been repaid, that
defendant mismanaged IFP, and that defendant converted IFP’s funds for personal
use.  Based on these allegations, plaintiff pled six counts:  breach
of fiduciary trust (Count One); breach of contract relating to the 2009
agreement (Count Two); mismanagement (Count Three); breach of the covenant of
good faith and fair dealing relating to the 2009 agreement (Count Four);
conversion (Count Five); and fraud (Count Six).  After trial, the trial
court dismissed the action for lack of standing, finding that the action was
brought improperly as a direct action when it should have been brought as a
derivative action on behalf of IFP.  It stated:  “Although this Court
does have the discretion to treat Plaintiff’s claim as a direct action since
IFP was a closely held corporation, the fact that IFP has creditors who are
still seeking recovery from IFP funds precludes Plaintiff’s recovery as an
individual.”

On appeal,
the Court affirmed in part and reversed in part.  The Court first found
that a court has discretion to construe a derivative claim as a direct claim
for closely-held corporations so long as it will not “(i) unfairly expose the
corporation or the defendants to a multiplicity of actions, (ii) materially
prejudice the interests of creditors of the corporation, or (iii) interfere
with a fair distribution of the recovery among all interested persons.”
Here, because plaintiff and defendant were the only shareholders, the Court was
concerned only with whether construing these claims as direct claims would
materially prejudice the rights of IFP’s creditors.  Finding that the
record did not allow it to determine whether construing these derivative claims
as direct would prejudice IFP’s creditors, the Court affirmed the trial court’s
decision and dismissed Counts One (breach of fiduciary trust), Three
(mismanagement), Five (conversion), and Six (fraud), all of which “concern
IFP’s assets and operations rather than plaintiff as an individual.”
Nonetheless, the Court reversed the trial court on Counts Two (breach of
contract) and Four (breach of the covenant of good faith and fair
dealing).  In doing so, it held that these claims were direct because plaintiff,
and not IFP, was the party to the 2009 contract at issue and that plaintiff
therefore had the right to bring the claims directly.

This
decision is of note for creditors and owners of closely-held companies in
reinforcing who has standing to bring certain claims against a company’s
principals and when principals may sue each other.

For a copy
of the decision, please contact Michael O’Donnell at modonnell@riker.com or Dylan Goetsch at dgoetsch@riker.com.