Counsel in North Carolina Derivative Actions can Represent Company, and Targeted Directors who do not Face “Serious Charges of Wrongdoing”

Amidst a “bitter family dispute” over future control of a closely held oil company, can the same law firm represent the directors paving the way for their son to take the reins and the company that minority shareholders seek to protect from the heir’s perceived shortcomings? In Mauck v. Cherry Oil Co., Inc, 2021 NCBC 59, the Business Court took a first impression look and adopted a subjective standard that would disapprove of such dual representations only when allegations of “serious wrongdoing” are made against the directors sued in a derivative action.

Defendants Jay and Ann Cherry own and control about 66% of Cherry Oil, a propane and refined fuel distribution business. Jay’s sister, Louise, controls about 34% of the company along with her husband. The dispute centers around Jay’s plans to retire, and the apparent interest he and his wife have in passing to their son, Jason, a controlling interest in the company. ¶¶ 4-5, 7-8. Aunt Louise and Uncle Armistead, the plaintiffs, sued over the unease they have with their nephew taking charge, alleging he lacks “commit[ment] to developing the skills or doing the work necessary to succeed on individual merit, rather than nepotism.”  Id. ¶ 6.

Womble Bond Dickinson (US) was counsel for defendants Jay and Ann Cherry, and over the repeated objections of the plaintiffs, the firm subsequently was retained to represent Cherry Oil. As Judge Davis aptly noted, the plaintiffs drew little comfort from Womble Bond purporting to protect the interests of the majority shareholders and the company (id.¶¶ 13, 25):

In essence, the Plaintiffs’ argument is that an attorney cannot represent one client at the same time that it is investigating that client for potential wrongdoing against another client.

The Business Court surveyed differing approaches from other jurisdictions, but ultimately settled on a rule that would allow the same law firm to represent both company and directors in a derivative action unless there are “serious charges of wrongdoing” against the directors. Judge Davis was influenced by comments to Rule 1.13 of the North Carolina Rules of Professional Conduct that suggest a conflict could exist if there were such “serious charges” alleged against “those in control of the organization.” Id. ¶ 35. Cf. In re Conduct of Kinsey, 660 P.2d 660, 669 (Or. 1983) (separate counsel needed unless claim “patently sham or patently frivolous”); Rowen v. LeMars Mut. Ins. Co. of Iowa, 230 N.W.2d 905, 914 (Iowa 1975) (potential conflict of interest “well established” when counsel seeks to represent company and “corporate insiders accused of wrongdoing”).

The Court’s application of the newly adopted standard shows that following the judicial course may be more complicated than charting it.  There are, Mauck concludes, instances when a law firm should not represent both company and targeted directors in a derivative action but discerning them depends on a subjective determination of when alleged director misconduct amounts to “fraud, theft, self-dealing, or usurpation of corporate opportunities.” 2021 NCBC 59, ¶ 36. The analysis of whether Jay and Ann Cherry’s mixing of personal estate and corporate succession planning amounted to “self-dealing” may show the appeal of a bright-line standard for these dual representations.

The minority shareholders allege that Jay and Ann Cherry took a concerted series of steps “for the benefit of themselves and what they call their ‘next generation’ to the exclusion and at the expense of Armistead and Louise and Cherry Oil.” Id. ¶ 8. Further, they alleged that the effort was advanced by attempts to remove each of the plaintiffs from the company’s board, and that an allegedly reconfigured board sought to implement a “call” of plaintiff’s shares. Id. ¶ 13.

Yet, the Court noted the defendant directors were alleged to have engaged in self-dealing “to consolidate their power,” but not “in its traditional sense” as, for example, transactions motivated by personal benefit, being allied with a competing business, or undertaking unauthorized transactions. Instead, the Court held, alleged efforts by the defendant directors to consolidate their power and lessen the influence of the minority shareholders was a debate about “current mismanagement and future direction,” not the sort of “theft, fraud, or gross financial conflicts of interest that courts have found sufficient to constitute serious charges of wrongdoing.” Id. ¶¶ 38, 39.

Takeaways

• A fact-specific, subjective standard for when a law firm can represent both company and alleged wrongdoer directors in derivative actions forecasts frequent disputes over counsel which purport to investigate director conduct – and defend it.

Brad Risinger is a partner in the Raleigh office of Fox Rothschild LLP.