Members of Nonprofit Corporations Can Bring Derivative Actions – But They May Have to Pay a Price

A recent decision by the North Carolina Court of Appeals serves as a reminder to North Carolina nonprofit corporations that their members can bring derivative actions on behalf of the nonprofit. But, if such actions are brought without reasonable cause, the members may be required to pay the defendant's attorney fees.   

Derivative actions are lawsuits brought by members of a nonprofit corporation on behalf of the corporation. They are a powerful tool that members can use as a platform to file suits they are not permitted to file in their own name. For instance, disgruntled members generally cannot sue corporate officers for breach of fiduciary duty in their own name because the officers’ fiduciary duties are owed to the corporation rather than to the individual members. But, members can make derivative claims on behalf of the nonprofit against the directors.

In McMillan v. Ryan Jackson Properties, LLC, No. COA13-270 (N.C. Ct. App. Jan. 21, 2014), the North Carolina Court of Appeals considered a derivative action brought by two condo owners on behalf of their condominium association, which is organized as a nonprofit corporation under North Carolina law. The action asserted negligence claims against the condominium building contractor for issues related to flooding in the basement of the building. The lawsuit was ultimately dismissed by the trial court, and the building contractor obtained an order awarding it attorneys’ fees under North Carolina’s Nonprofit Corporation Act, which allows recovery of attorneys’ fees incurred in defense of derivative actions “brought without reasonable cause”. N.C. Gen. Stat. § 55A-7-40(f). The Court of Appeals generally affirmed the attorneys’ fees award and explained that a derivative action is brought “without reasonable cause” if there is no reasonable belief that there is a sound chance that the claim could be sustained.  

Beyond the issue of attorneys’ fees, the case drives home the point that while nonprofit corporations operate under similar laws as business corporations, the laws are not identical. Indeed, when it comes to the laws governing derivative actions, nonprofit corporations are operating under a different set of rules. Among other things, the different rules mean that there are relatively less stringent procedural restrictions to filing derivative suits on behalf of nonprofit corporations. For instance, the Nonprofit Business Corporation Act does not necessarily require that a demand (asking the corporation to pursue the claims at issue) be made on the corporation prior to filing a lawsuit. Compare N.C. Gen. Stat. § 55A-7-40(b) with § 55-7-42. 

Derivative proceedings are potentially high-stakes affairs because of the potential for a recovery of attorneys’ fees. If the plaintiffs (i.e., the members of the nonprofit) are successful in their derivative action, the statute authorizes an award of attorneys’ fees directly to them. However, if the plaintiffs are not successful, the statute authorizes an award of attorneys’ fees to the defendant if the court finds that the lawsuit was brought “without reasonable cause.” That is precisely what the court found in McMillan, and thus the plaintiffs not only lost their suit but were required to pay the defendant’s attorneys’ fees related to the derivative action.