Corporate Litigation Attorneys Must Make Sure A LLC Member Has Standing to Maintain Derivative Claims.

Corporate Derivative lawsuits in California can be complicated in terms of both party standing and lawyer representation.  In a new corporate litigation opinion from California’s Court of Appeal, the court held that a trial court does not have the discretion to confer standing on a plaintiff in a derivative lawsuit who is not a member of the LLC.  This brings California’s LLC law in alignment with its corporate law.  Experienced business litigation attorneys representing Limited Liability companies must make sure that their proposed derivative plaintiffs actually have both contemporaneous and continuous membership in the LLC before bringing suit.

California’s Corporation Code §17709.02 requires both contemporaneous and continuous membership.

Corporation Code §17709.02 governs derivative lawsuits relating to limited liability companies (LLCs).  It states that “No action shall be instituted or maintained in right of any domestic or foreign limited liability company by any member of the limited liability company unless both of the following conditions exist:  (1) The plaintiff alleges in the complaint that the plaintiff was a member of record, or beneficiary, at the time of the transaction or any part of the transaction of which the plaintiff complains, or that the plaintiff’s interest later devolved upon the plaintiff by operation of law from a member who was a member at the time of the transaction or any part of the transaction complained of.”  The business lawyer must figure out the standing issue prior to filing a lawsuit.

However, additional language states that “Any member who does not meet these requirements may nevertheless be allowed in the discretion of the court to maintain the action on a preliminary showing to and determination by the court, by motion and after a hearing at which the court shall consider any evidence, by affidavit or testimony, as it deems material, of all of the following:  (A) There is a strong prima facie case in favor of the claim asserted on behalf of the limited liability company; (B) No other similar action has been or is likely to be instituted; (C) The plaintiff acquired the interest before there was disclosure to the public or to the plaintiff of the wrongdoing of which plaintiff complains; (D) Unless the action can be maintained, the defendant may retain a gain derived from defendant’s willful breach of a fiduciary duty; (E) The requested relief will not result in unjust enrichment of the limited liability company or any member of the limited liability company.”

What Is A Derivative Lawsuit?

The Sirott court first noted that “The principles governing derivative actions in the context of corporations apply to limited liability companies.  Under these principles, a corporation’s shareholders ‘have no direct cause of action or right of recovery against those who have harmed [the corporation],’ but they can ‘bring a derivative suit to enforce the corporation’s rights and redress its injuries when the [corporation] fails or refuses to do so.”  This is what corporation litigation attorneys call a derivative lawsuit.

The lawsuit is a derivative lawsuit because the essential injury alleged by the plaintiff is not actually to the plaintiff directly but to the corporation of which he is a shareholder.  In various California legal opinions, the court explains that the action is derivative, i.e., in the corporate right, if the gravamen of the complaint is injury to the corporation.  On the other hand, a stockholder’s individual suit is a suit to enforce a right against the corporation which the stockholder possesses as an individual.  In the Sirott case, the court held that the gravamen of the harm was to the LLC and not to either of the individuals.

California’s Corporation Code Requires Both Contemporaneous Membership And Continuous Membership In The LLC.

In Sirott the California Court of Appeal held that section 17709.02 of California’s Corporations Code requires both “contemporaneous” membership and “continuous” membership.  Contemporaneous membership in the limited liability company means that the party seeking to bring the derivative claim was a member in the LLC at the time of the challenged transaction (or became a member by gaining an interest from a party who was a member at the time of the transaction.  Continuous membership means that the party was a member throughout the litigation of a derivative claim.  This is in keeping with the California Supreme Court’s findings with regard to Corporations Code section 800 dealing with corporations (rather than limited liability companies).

What Is The Court’s Discretion?

For business litigation lawyers, the phrase ‘the court’s discretion’ muddies the water and opens up every analysis to uncertainty.  In Los Angeles, where attorneys face hundreds of judges, a ‘court’s discretion’ means that the same case could be subject to various different interpretations by various different judges.  The trial attorney is therefore less able to objectively determine the outcome of an issue prior to trial.

Corporations Code section 17709.02 does have a section that provides that “any member who does not meet these requirements may nevertheless be allowed in the discretion of the court to maintain [an] action on a preliminary showing to and determination by the court” of five enumerated circumstances, including that “the plaintiff acquired the interest before there was disclosure to the public or to the plaintiff of the wrongdoing of which plaintiff complaints” and that “the defendant may retain a gain derived from defendant’s willful breach of a fiduciary duty” if the action does not proceed.”

The court turned to a California Supreme Court case from 2008 entitled Grosset v. Wenaas, which addressed this same issue with regard to a corporation.  Noting that the LLC code section (§1709.02) and the section pertaining to corporations (§800) are nearly identical, it held that the findings of Grosset should apply to limited liability companies as well.

In the Sirott case, the plaintiff met the contemporaneous membership requirement because it was a member from 2009 until 2019, and all of the transactions the plaintiff challenge occurred during that time period.  However, it did not meet the continuous membership requirement because in 2019 it relinquished its membership interest in the LLC.

The only issue remaining is whether the court had discretion to conclude that the former member had standing to maintain the derivative claims on behalf of the LLC based on statutory or equitable considerations.

The Court of Appeal, in granting the writ of mandamus, held that the court’s discretion “does not include the discretion to confer standing on a plaintiff who is not a member.  The quoted language [of the Code] refers to a “member”, not a “plaintiff”, who fails to “meet these requirements.  The plaintiff in Sirott was not a “member who does not meet these requirements” since it had relinquished its membership.  Moreover, the appellate court noted that the Supreme Court clearly suggested in Grosset that a court had discretion to forgive the contemporaneous ownership requirement, not the continuous ownership requirement.

The court also recognized that there may be equitable considerations that warrant an exception to the continuous ownership requirement, such as if a merger itself is used to wrongfully deprive a plaintiff of standing, or if the merger is merely a reorganization that does not affect the plaintiff’s ownership interest.  However, the court here did not find, nor did the complaint allege, that defendants engaged in any wrongdoing involving the party’s distribution of its interest in the LLC to the individuals.

Lessons For Corporate Litigation Attorneys

Los Angeles corporate litigation attorneys need to establish their clients’ standing at the very outset of the case.  Moreover, the analysis must include both contemporaneous and continuous membership in the LLC.  Experienced corporate litigation lawyers already know that derivative lawsuits raise legal representation minefields that could lead to disqualification for the law firm and attorneys if the representation includes both the derivative plaintiffs and the corporation or LLC itself, who must be separately represented.  This case reminds us attorneys to establish standing as a part of our initial pre-lawsuit due diligence.

Los Angeles corporate litigation attorney Laine T. Wagenseller is the founder of Wagenseller Law Firm in downtown Los Angeles.  Wagenseller Law Firm handles numerous lawsuits among corporations, LLCs, partnership and other entities and their shareholders, members and partners.  For more information, visit www.wagensellerlaw.com or call at (213) 805-7445.

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