Direct Actions vs. Derivative Actions for California LLC Members

Members of a California Limited Liability Company (LLC) may face situations where they need to initiate legal action to protect their rights or the interests of the LLC. California law provides two primary categories of legal actions for LLC members—direct actions and derivative actions. Understanding the distinctions between these two types of lawsuits is critical. Below, we explore the differences between direct and derivative actions under California law, provide examples, and outline key considerations for members deciding which type of action to pursue. Relevant legal statutes and case law are cited to provide a solid foundation for these points.

Direct Actions

A direct action is a lawsuit initiated by an LLC member to enforce their individual rights against the company, another member, or a third party. The defining feature of a direct action is that the harm alleged affects the plaintiff (the suing member) individually, rather than the LLC as a whole.

Examples of Direct Actions

Typical scenarios that may give rise to direct actions include:

• Breach of operating agreement: For instance, if the LLC’s operating agreement grants a member the right to participate in specific decisions and another member or manager excludes them from doing so, the aggrieved member may file a direct action.
• Denial of distributions: If the LLC fails to pay a member their rightful share of distributions, the member may sue directly to recover the unpaid funds.
• Voting rights disputes: When a member’s right to vote is unlawfully denied, they can initiate a direct action to seek redress.

Direct actions focus on addressing the personal grievances of the suing member. Any damages awarded in a direct action are paid directly to the plaintiff, compensating them for their individual loss.

Derivative Actions

By contrast, a derivative action is a lawsuit brought by an LLC member on behalf of the LLC. These actions are filed when the harm alleged affects the LLC as a whole, such as mismanagement or fraud that depletes the company’s assets.

Examples of Derivative Actions

Derivative actions may be appropriate in situations such as:

• Breach of fiduciary duty: If a manager or controlling member acts in a manner that benefits themselves at the expense of the LLC, an injured member might file a derivative action to address the harm.
• Mismanagement: Members may sue on behalf of the LLC when its leadership engages in reckless practices that harm the company’s operations or overall value.
• Third-party misconduct: If a third party damages the LLC—for instance, by breaching a contract—and the managers refuse to act, members may pursue a derivative claim.

Damages won in a derivative action belong to the LLC rather than the plaintiff. The benefits are distributed proportionally among all members according to their ownership interests.

Key Considerations When Choosing an Action

When deciding whether to file a direct or derivative action, LLC members need to evaluate their circumstances carefully. It is also important to keep in mind that you can proceed with either a direct action, a derivative action, or you can pursue both.  Holistic Supplements, L.L.C. v. Stark, 61 Cal. App. 5th 530, 542 (2021).  Below are key considerations:

1. Nature of the Injury

The most critical distinction between a direct and derivative lawsuit is the nature of the alleged harm. A direct action is appropriate where the harm is individual—such as a withheld distribution or voting rights violation. On the other hand, injuries that harm the LLC’s overall financial health—for example, an embezzling manager—should be addressed through a derivative action.

2. Procedural Requirements

Derivative actions involve stricter procedural requirements. For example, under California Corporations Code § 17709.02, a derivative plaintiff must allege with particularity their efforts to prompt the LLC’s managers to address the issue or explain why making such efforts would be futile. Additionally, plaintiffs must balance procedural complexities like a court’s requirement for demand futility or the appointment of a special litigation committee (SLC) to evaluate claims.

3. Recovery of Damages

A key difference lies in how recovery is distributed. Direct actions benefit the suing member alone, which makes them an appealing choice when seeking individual compensation. Conversely, derivative actions benefit the LLC, meaning the suing member’s personal benefit depends on their ownership stake and how well the LLC performs after recovery.

4. Continuous and Contemporaneous Ownership

California law further regulates derivative actions by requiring both contemporaneous and continuous ownership under § 17709.02. This ensures that only current members with a vested interest in the LLC can bring derivative claims. The California Court of Appeal reinforced these requirements in Sirott v. Superior Court, 78 Cal.App.5th 371 (Cal. Ct. App. 2022), dismissing a derivative lawsuit because the plaintiff no longer satisfied the continuous ownership standard. The ruling in Sirott clarifies that failure to abide by these requirements, such as losing membership during litigation, may disqualify a plaintiff from continuing a derivative lawsuit.

5. Costs and Relationships

Direct actions tend to be less costly and adversarial, which may make them preferable where working relationships need to be maintained. Derivative suits are more resource-intensive due to their higher legal hurdles and procedural demands.

6. Legal Guidance

Deciding between a direct and derivative action requires a thorough understanding of the relevant legal framework. It’s always advisable to consult an attorney to assess the specific facts of the case and determine the best strategy.

The Impact of Damages on Decision-Making

The difference in damage allocation significantly influences the choice between a direct and derivative action. For instance, if pursuing a derivative action would result in negligible financial gain for the suing member due to a small ownership interest, they might opt for a direct action, provided their harm is personal. Conversely, derivative actions may be vital when the LLC’s existence or financial stability is at risk, even if the suing member gains only indirectly.

Conclusion

Direct and derivative actions serve distinct purposes under California law, enabling members to address individual grievances or protect the greater interests of the LLC. Direct actions are suitable where the harm affects a specific member, while derivative actions aim to redress wrongs that harm the LLC itself.

Under statutory guidelines, including California Corporations Code §§ 17709.02, as well as case law like Sirott, the procedural requirements for derivative actions ensure that only legitimate claims proceed. These legal guardrails emphasize careful preparation before filing. Carefully evaluating the nature of the harm, procedural complexities, and potential outcomes with legal counsel can help members achieve the most favorable resolution.