Protecting the HOA in Spite of Itself: Shareholder Derivative Actions

November 6, 2014

Unfortunately, construction defects are far from uncommon in townhome, condominium, and other common interest communities. When faced with defects, the typical response of an HOA Board of Directors is to retain legal counsel and pursue the developer, contractor(s), and/or design professionals, ultimately putting the financial burden of the needed repairs on those who caused the construction defects in the first place. What happens though when an HOA Board of Directors is unwilling to take legal action? Occasionally a Board refuses to consider litigation on principle alone (“independent and proud”, or maybe “tort reformers”). Sometimes the Directors on the Board have a conflict of interest in the decision, and aren’t willing to step aside to let others chart the course (“friends of the developer”, or maybe the developer him/herself). In such cases, the construction defects are likely to persist, causing ongoing headaches and expense to the Association and its owners. Luckily, a legal mechanism does exist that permits one or more homeowners in the defect-plagued community to take legal action into their own hands: the Shareholder Derivative Action.

A shareholder derivative action (“SDA”) permits a shareholder of a corporate entity (a homeowner in an incorporated homeowners association in this context) to bring a legal action on behalf of that corporation if-and-when the corporation refuses to assert its own rights. The shareholder plaintiff essentially steps into the shoes of the corporation to pursue the corporation’s legal claims.  SDAs are often used for shareholders to bring suit against the corporate Board members themselves for alleged wrongdoing or malfeasance. The other common use of a SDA is for a shareholder to bring suit against an outside third-party on the corporation’s behalf. This latter type of SDA can be useful for a homeowner in a homeowners association when the HOA Board of Directors will not assert the HOA’s rights against the third-parties responsible for construction defects.

Federal Civil Procedure Rule 23.1 provides that:

Rule 23.1. Derivative Actions

(a) Prerequisites. This rule applies when one or more shareholders or members of a corporation or an unincorporated association bring a derivative action to enforce a right that the corporation or association may properly assert but has failed to enforce. The derivative action may not be maintained if it appears that the plaintiff does not fairly and adequately represent the interests of shareholders or members who are similarly situated in enforcing the right of the corporation or association.

(b) Pleading Requirements. The complaint must be verified and must:

(1) allege that the plaintiff was a shareholder or member at the time of the transaction complained of, or that the plaintiff’s share or membership later devolved on it by operation of law;

(2) allege that the action is not a collusive one to confer jurisdiction that the court would otherwise lack; and

(3) state with particularity:

(A) any effort by the plaintiff to obtain the desired action from the directors or comparable authority and, if necessary, from the shareholders or members; and

(B) the reasons for not obtaining the action or not making the effort.

(c) Settlement, Dismissal, and Compromise. A derivative action may be settled, voluntarily dismissed, or compromised only with the court’s approval. Notice of a proposed settlement, voluntary dismissal, or compromise must be given to shareholders or members in the manner that the court orders.

Many states (including Colorado and Minnesota) have the same, or virtually the same state court civil procedure rule patterned after the Federal rule.

Any HOA has the maintenance and repair obligation for some or all of the common elements, limited common elements, and sometimes even for the townhome or condo units themselves. If there are problematic construction defects in those areas, and the HOA fails and refuses to assert its legal rights against the developer, contractor(s) or design professionals responsible, an individual homeowner can take matters into their own hands and hire a lawyer to pursue a SDA for their Association. A contingent fee attorney that advances litigation costs is a perfect choice for that kind of homeowner/shareholder because it’s the rare circumstance that a single owner has both the financial means and risk tolerance to pay lawyers and expert witnesses hourly to prosecute an entire lawsuit on their HOA’s behalf.

It’s not clear why there is very little precedent for homeowners or groups of homeowners using SDAs to seek recourse for common element construction defects on behalf of complacent HOAs.  The SDA mechanism does hold a lot of promise though for activist or neglected homeowners suffering from construction problems.  Benson, Kerrane, Storz & Nelson currently has several construction defect SDAs pending in Minnesota courts on behalf of multifamily homeowners associations. Those cases are still in their early stages, so it’s not yet clear to what extent or how the defense may try to challenge or limit the use of the SDA mechanism in the construction defect context. So, more to come…