June 26, 2022

Volume XII, Number 177

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California Court of Appeal Clarifies that a Derivative Plaintiff Must Demonstrate Both “Contemporaneous” and “Continuous” Ownership to Maintain a Derivative Suit on Behalf of a Limited Liability Company

In Sirott v. Superior Court, 2022 Cal. App. LEXIS 389 (Cal. App. May 5, 2022), the First Appellate District of the California Court of Appeal (Humes, J.) analyzed the ownership requirements a plaintiff must satisfy to pursue derivative claims on behalf of a limited liability company.  Under California Corporations Code § 17709.02 (“Section 17709.02”), a putative derivative plaintiff must show both “contemporaneous” and “continuous” ownership to proceed with a derivative lawsuit.  Subject to certain statutorily defined exceptions, the contemporaneous ownership prerequisite requires the plaintiff to plead that it was a member of the limited liability company at the time of the transaction or any part of the transaction of which the plaintiff complains took place.  The continuous ownership requirement, in turn, obligates the plaintiff to remain a member of the limited liability company through the conclusion of the litigation.  In Sirott, the plaintiff’s derivative claims were properly ordered dismissed because the plaintiff lacked standing after it lost its interest in the limited liability company—i.e., the real party in interest with respect to the derivative claims.    

The plaintiffs in Sirott sued certain members of 400 Taylor Holdings, LLC (“Taylor”), a special purpose vehicle that owned a commercial building.  One of the plaintiffs, EBO Properties North, LLC (“EBO”), had been a member of Taylor.  EBO asserted putative derivative claims contending that Taylor had been harmed by defendants’ refusal to lease space to EBO.  During the litigation, EBO transferred its interest in Taylor.  In response, defendants filed a demurrer, arguing that pursuant to Section 17709.02 EBO lacked standing to assert the derivative claims because it no longer could satisfy the continuous ownership requirement.  The California Superior Court for the County of Contra Costa overruled the demurrer reasoning that Section 17709.02 granted the court statutory discretion to allow EBO to maintain its derivative claims despite EBO’s failure to satisfy the continuous ownership requirement.  On a petition for writ of mandate, the Court of Appeal reversed holding that EBO lacked standing to pursue derivative claims on behalf of Taylor after relinquishing its interest in that limited liability company. 

The Court of Appeal began by noting that the principles governing derivative claims on behalf of corporations generally apply to derivative litigation on behalf of limited liability companies.  Section 17709.02 sets forth what is required of a plaintiff who seeks to pursue a derivative claim on behalf of a limited liability company.  Under subsection (a) of Section 17709.02, a derivative plaintiff must demonstrate both contemporaneous and continuous ownership. 

A court has statutory discretion under Section 17709.02 to waive the contemporaneous ownership requirement if the plaintiff can show (i) a strong prima facie case, (ii) there are no other similar actions pending or likely to be instituted, (iii) the plaintiff was unaware of the alleged wrongdoing at the time it acquired its interest, (iv) the action is necessary to remediate a wrongful gain by the defendants, and (v) the limited liability company will not be unjustly enriched if the plaintiff prevails on the derivative claim.  The Court of Appeal noted that the plain language of the statute establishes that this statutory exception exists only to the contemporaneous ownership requirement.  The trial court, thus, erred when it found that EBO was statutorily excused from satisfying the continuous ownership requirement. 

Equitable considerations may permit a former member of a limited liability company to continue with a derivative claims despite its inability to satisfy the continuous ownership requirement.  The Court of Appeal, however, found that the trial court did not consider any of the recognized equitable considerations when it overruled the defendants’ demurrer.  For this reason, the Court of Appeal reversed with instructions that the trial court should consider whether EBO should be granted leave to amend the derivative claims. 

The Sirott decision is in harmony with well-established principles of corporate law.  A derivative lawsuit is an equitable exception to general rule that claims by a business entity belong to the business entity.  The pursuit of corporate claims is, thus, ordinarily within the purview of the managers of the entity.  An owner, however, may rely on a derivative lawsuit to protect its interest in the business when there is a dereliction of duty by the managers.  If the plaintiff loses its ownership interest during the litigation, then such plaintiff has neither a direct nor derivative interest in the outcome of the derivative litigation. 

Copyright © 2022, Sheppard Mullin Richter & Hampton LLP.National Law Review, Volume XII, Number 143
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About this Author

John Stigi securities law  corporate attorney Sheppard Mulli, law firm
Partner

John Stigi is a partner in the Business Trial Practice Group in the firm's Century City and New York offices, and leader of the firm's Corporate/Securities Litigation Team.

Mr. Stigi's practice focuses on securities class action and shareholder derivative action defense, SEC investigation defense, internal corporate investigations, complex contract and commercial litigation, and M&A and corporate governance litigation.  He has extensive experience representing issuers, officers, directors and auditors in all areas of securities, corporate...

310-228-3717
Alejandro Moreno, Attorney, Sheppard Mullin,  Business Trial Practice
Partner

Alejandro (“Alex”) Moreno is a partner in the Business Trial Practice Group in the Firm's San Diego office. He is the firm’s 2021 Leadership Council on Legal Diversity (LCLD) Fellow

Areas of Practice

Alex practices general business and commercial litigation in state and federal courts. He is also experienced in private dispute resolution and arbitration, including FINRA arbitration, and has succeeded on behalf...

619-338-6664
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