D&O Liability - California Supreme Court Rules That California Law Generally Requires Plaintiff In Derivative Action to Maintain Continuous Stock Ownership Throughout the Litigation
On February 14, 2008, in Grosset v. Wenaas, No. S139285, the Supreme Court of California held, as a matter of California law, that a shareholder lacked standing to continue litigating a derivative action when he no longer
owned company stock as a result of a merger transaction. The unanimous opinion was authored by Justice Baxter.
In Grosset, a shareholder, Sik-Lin Huang, was granted the right to intervene in order to prosecute a derivative action on behalf of JNI Corporation (“JNI”), a company incorporated in Delaware and headquartered
in California. Subsequently, a special litigation committee created by JNI’s Board to investigate the allegations in the derivative action determined that the lawsuit was not in the best interests of the company and successfully
moved to dismiss the action. Before Mr. Huang appealed the dismissal, JNI’s shareholders voted to approve a merger with a wholly-owned subsidiary of Applied Micro Circuits Corporation (“AMCC”), requiring Mr.
Huang to sell his JNI stock to AMCC, the new sole shareholder of JNI. The defendants in the derivative action subsequently moved to dismiss Mr. Huang’s appeal for lack of standing. The appellate court, applying Delaware law,
granted the defendants’ motion, finding that Mr. Huang’s sale of his JNI stock in the merger resulted in his loss of standing to maintain the appeal. In the alternative, the appellate court found that the application
of California law also would result in Mr. Huang’s loss of standing because California law also imposes a continuous ownership requirement.
On review, the California Supreme Court first noted that Delaware law is clear that a plaintiff in a derivative action must retain stock ownership for the duration of the litigation. The Court went on to analyze whether California
law is in accord, with specific reference to Section 800 of California Corporations Code, which provides, in part: “No action may be instituted or maintained in right of any domestic or foreign corporation by any holder of
shares…unless…[t]he plaintiff alleges in the complaint that plaintiff was a shareholder, of record or beneficially… at the time of the transaction or any part thereof of which plaintiff complains….”
The Court noted that the introductory language “instituted or maintained” appeared to be more restrictive than the corresponding Delaware statute (which uses the sole term “instituted”), indicating
that a continuous ownership requirement may apply. The Court went on to explain, however, that (1) no California decision has construed the “instituted or maintained” language as requiring a plaintiff to maintain continuous
stock ownership throughout the course of a derivative action; (2) two California appellate cases – Heckmann v. Ahmanson, 168 Cal.App.3d 119 (1985) and Gaillard v. Natomas Co., 173 Cal.App.3d 410 (1985) –
stated opposite conclusions regarding the matter of continuous ownership; and (3) nothing in the language or legislative history of Section 800 either expressly rejects or imposes a continuous ownership requirement.
Nonetheless, the Court determined that other considerations support an interpretation of the statute to include a continuous ownership requirement. In particular, the Court reasoned that a shareholder’s right to assert a derivative
action is “justified only by the stockholder relationship and the indirect benefits made possible thereby, which furnish the stockholder with an interest and incentive to seek redress for injury to the corporation.”
Once that relationship ceases to exist, the derivative plaintiff lacks standing because he “no longer has a financial interest in any recovery pursued for the benefit of the corporation.” The Court also noted that a
majority of other jurisdictions, considering varying statutory language, have reached the same result.
The Court rejected the plaintiff’s argument that a rule of continuous ownership should not apply in situations, like this case, where the plaintiff’s loss of stock was the result of a merger and thus involuntary. The
Court reasoned that a plaintiff who loses his shares, whether voluntarily or involuntarily, “no longer has even an indirect interest in any recovery pursued for the corporation’s benefit.” The Court also rejected
the argument that requiring continuous ownership would be unfair where, as here, a stockholder has litigated a claim for years, only to be precluded from proceeding further because of a merger. According to the Court, even in that
situation, “[t]he fact remains that a derivative claim belongs to the corporation, not to the plaintiff asserting the claim on the corporation’s behalf,” and, “[t]o ensure that the corporation’s
interests are adequately represented, the derivative plaintiff must maintain a proprietary interest in the corporation sufficient to motivate the plaintiff ‘to engage in a zealous prosecution.’” The Court noted,
however, that equitable considerations may warrant an exception to the continuous ownership requirement if the merger itself is wrongfully used to deprive the plaintiff of standing, or if the merger is merely a reorganization that
does not affect the plaintiff’s ownership interest, although neither situation was presented by this case.