As discussed before, corporations have a very long history that goes back to antiquity. In contrast, the limited liability company—a hybrid business entity that provides the limited liability of a corporation but permits members to actively participate in management and control—came to California only in 1994. As such, the caselaw governing corporations is more developed than that of LLCs. And despite the differences between the two entities, the caselaw on corporations is sometimes applied to resolve legal questions for LLCs.
A recent case from the California Court of Appeal illustrates this. The case involved the ability of a former LLC member to bring a “derivative” claim. In the context of a corporation, a shareholder may have a direct legal claim against the corporation or other shareholders to redress an injury that was done to that shareholder. But what about where the injury is not to the shareholder directly, but rather to the corporation itself? The shareholder may ultimately suffer from such an action, so suit is permitted. But it is said to be a “derivative” claim, where the shareholder brings the action on behalf of the corporation, and it is subject to special requirements.
A shareholder plaintiff’s standing to bring a derivative suit on behalf of a corporation is governed by California Corporations Code §800. That section provides that “[n]o action may be instituted or maintained in right of any domestic or foreign corporation by any holder of shares” unless certain requirements are satisfied. One such requirement is that the plaintiff was a shareholder at the time the challenged action occurred (with an exception not relevant here). This is known as the “contemporaneous” requirement. Section 800 vests the court with discretion to exempt shareholders from this requirement under certain circumstances.
Another requirement is that the shareholder continue to hold her shares during the pendency of the derivative lawsuit. This is known as the “continuous” requirement. In 2008, the California Supreme Court ruled that this was necessary due to the statute’s use of the phrase “instituted or maintained”—which “seems to imply that only a shareholder may initiate or maintain a derivative action.” The Court also suggested that a court may not exempt a plaintiff from this requirement; a court’s discretion to bypass the “contemporaneous” requirement did not apply to the “continuous” requirement.
The recent Court of Appeal case involved the ability of an LLC member to bring a derivative claim when that member disposed of its ownership share before the suit was completed. California Corporations Code §17709.2 governs standing in LLC derivative actions, and it is almost identical to the above-discussed §800 governing corporations. Coupled with the Supreme Court’s 2008 interpretation of §800 that it imposes a “continuous” requirement that cannot be excused under a court’s discretion, and the general rule that “[t]he principles governing derivative actions in the context of corporations apply to limited liability companies,” this was fatal to the plaintiff’s case. While the “continuous” requirement might be excused where the plaintiff was wrongfully deprived of her LLC interest, this was not present in the case before the court. Thus LLC members must be on guard to avoid disposing of their interest if they might wish to pursue a derivative claim in the future.