Lawyers May Simultaneously Represent a Corporation and Its Directors Against Derivative Claims That Do Not Allege “Serious Wrongful Conduct”
In a case of first impression in North Carolina, a judge for the North Carolina Business Court was recently asked to decide whether a single law firm may simultaneously represent both a corporation and its individual directors who are alleged to have engaged in wrongdoing against the company. In answering "yes" to that question, the court rejected any blanket rule requiring disqualification and instead adopted a practical approach that focuses on the nature of the wrongful conduct alleged against the controlling directors.
The case, Mauck v. Cherry Oil Company, Inc., 2021 NCBC 59 (Sept. 20, 2021), arose out of a dispute between siblings over the operation of a family propane and refined fuel distribution business. The minority shareholders, a sister and her husband, initially submitted a derivative demand to the company based on allegations that the majority owners, her brother and his spouse, were improperly seeking to promote their son within the business and to "undermine" plaintiffs’ interests. The derivative demand was followed in short order by a lawsuit alleging various claims against the brother and his spouse based on essentially the same conduct that gave rise to the derivative demand. The lawsuit was later amended to add derivative claims on behalf of the company.
The company retained separate counsel while the individual defendants’ lawyers determined whether they could represent the interests of both the company and the majority shareholders. After counsel concluded that it could represent all defendants, plaintiffs moved to disqualify the firm based on an alleged irresolvable conflict. The court began by noting that "[T]he drastic nature of disqualification requires that courts avoid overly-mechanical adherence to disciplinary canons at the expense of litigants’ rights to freely choose their counsel; and that they always remain mindful of the opposing possibility of misuse of disqualification motions for strategic reasons" (quoting Harriott v. Central Carolina Surgical Eye Associates, P.A., 2015 NCBC 39 ¶ 23 (Apr. 28, 2015)). The court then reviewed cases from other jurisdictions, noting a split of authority on the question of whether the same law firm could represent both the company and individual directors, officers or shareholders in defending derivative claims.
While recognizing that some jurisdictions require separate counsel in all but the most frivolous cases, the court observed that other jurisdictions take a more practical approach, reasoning that the interests of a corporation and its controlling officers or directors are often aligned and that separate counsel is not required unless an actual divergence of interests arises. The most common approach under those cases is to require separate counsel only where "serious" allegations of fraud or self-dealing have been alleged against the individual defendants.
The court also reviewed the North Carolina Rules of Professional Conduct and found that they provided helpful guidance. In particular, the court focused on Comment 14 to Rule 1.13 of the Rules, which notes that "most derivative actions are a normal incident of an organization’s affairs, to be defended by the organization’s lawyers like any other suit." A conflict may arise, however, if the claim involves "serious charges of wrongdoing" by those in charge of the organization. The court interpreted Comment 14 to implicitly suggest that, in cases where serious charges of wrongdoing have not been alleged against the directors, dual representation of the organization and its directors can be permissible.
Because the North Carolina courts have not defined what constitutes serious charges of wrongdoing for purposes of Comment 14 to Rule 1.13, the court looked again to case law from other jurisdictions with similar ethical standards. Reviewing those cases, the court found that in identifying serious charges of wrongdoing courts typically relied upon allegations of misconduct amounting to fraud, theft, self-dealing or usurpation of corporate opportunities. Allegations of misconduct that merely involve mismanagement or a breach of the duty of care generally are not enough.
The court then analyzed the allegations of the Complaint and concluded that plaintiffs had not alleged serious wrongful conduct against the individual defendants, despite repeated allegations of "self-dealing." Instead, the court characterized the claims as nothing more than a bitter family squabble over the current management and future direction of the business, which was devoid of the sort of allegations of theft, fraud or gross financial conflicts of interest sufficient to constitute serious charges of wrongdoing. Accordingly, the court concluded that plaintiffs had not met their "steep burden" to show that disqualification was required.
As a decision of the trial court on an issue that has not yet been addressed by any North Carolina appellate court, the opinion in Mauck does not constitute binding precedent. It nonetheless provides useful guidance for company counsel presented with the common question of whether the same attorneys may properly represent both the company and its directors or officers in responding to derivative claims. The Business Court’s practical approach provides necessary flexibility and maximum efficiency by allowing the company and its directors to be represented by a single law firm in cases involving ordinary claims of corporate mismanagement, where the interests of the company and its directors and officers frequently are aligned.
As a practice pointer for plaintiffs concerned with possible conflicts, the decision also makes it clear that, in assessing requests for disqualification of defense counsel, trial courts should be wary of conclusory allegations of "self-dealing" that do not involve traditional examples of self-interested transactions, such as where the director or officer has deliberately hidden material facts from the minority shareholder or engaged in transactions that were unfair to the corporation and clearly resulted in a personal financial benefit to the interested directors.