Los Angeles Lawyer April 2015

Exper Guide to THE MAGAZINE OF THE LOS ANGELES COUNTY BAR ASSOCIATION t W PAGE it ne 38 sse s

APRIL 2015 / $4

EARN MCLE CREDIT PLUS 2014 Ethics Prosecuting Roundup Elder Financial page 23 Abuse page 30 Lender Liability after Foley page 12 Inverse Condemnation for Water Damage page 14 Secrecy in Doubling Mediation page 68 Down

Los Angeles lawyer Robert M. Heller argues that double derivative indemnity litigation may come to California page 16 by Robert M. Heller

Doubling Down Doubling Down California has yet to follow Delaware and other jurisdictions and allow double derivative standing

ALTHOUGH DOUBLE DERIVATIVE corporation is controlled by the wrongdoers who wished to reduce or eliminate the risk of standing has been adopted in many jurisdic- who may be expected to refuse to file suit breach of fiduciary duty and other actions tions outside California to address the mod- against themselves.3 On the other hand, when against themselves could simply form and ern corporate form,1 California courts have an individual owns an interest in a parent operate through a corporate subsidiary while yet to rule on whether it will be allowed in this company, and its subsidiary is the target of also controlling the parent.5 For this reason, state. Application of the double derivative wrongdoing, the individual does not directly numerous jurisdictions have kept stride with principle permits a shareholder of a parent own shares in the subsidiary.4 Classic single “the realities of the changing techniques and company to sue for harm to its subsidiary and derivative standing does not convey a right to structures of the modern corporation.”6 Courts prevents corporate fiduciaries from using the sue on behalf of the subsidiary, because the in other states have recognized and steadily parent-subsidiary form to circumvent share- individual only owns an interest in the par- expanded the double derivative category of holder derivative litigation. California’s pol- ent. Technically, only the parent, as the direct standing, which allows an owner in a parent icy of affording a right for every wrong, how- owner of the subsidiary, has single derivative company to file suit in favor of a subsidiary.7 ever, portends California’s adoption of double standing to sue on behalf of the subsidiary. Foreign Law derivative standing.2 What recourse, then, exists if the sub- Shareholders, limited partners, LLC mem- sidiary’s board refuses to file suit, and the Double derivative theory evolved over a cen- bers, and others may bring a derivative action board of the parent also refuses to bring a tury ago.8 It was well established in New York on behalf of an entity when that entity has suf- single derivative action on the subsidiary’s as early as 1948,9 in Delaware as early as fered harm and those controlling it refuse to behalf? If no other person has standing to sue, 1963,10 and has been applied and expanded file suit. The right of an individual to sue a subsidiary could be left without a remedy. in numerous other jurisdictions as well as in the derivatively is critical to ensure that insider The mere layer of a second corporate structure corporate wrongdoing is addressed. In fact, could insulate wrongdoers under a simple for- Robert M. Heller practices business litigation with

it is the only recourse available when the mula of abuse: corporate boards and officers an emphasis on shareholder disputes. KEN CORRAL

16 Los Angeles Lawyer April 2015 n Model Business Corporations Act.11 The ques- actions also had equitable, rather than purely California practitioners representing the tion of whether California will adopt double statutory, origins. would-be double derivative plaintiff may cite derivative standing can, in part, be evaluated California courts are also likely to look to the foreign cases discussed above and may fur- by examining the reasons double derivative Delaware decisions.19 For decades, Delaware ther consider advancing additional arguments standing has been adopted in other states. courts have recognized double derivative to secure standing. A particularly illustrative opinion was standing, and in 2010, the Delaware Supreme First, Corporations Code Section 800(b), issued in 1988 by the Illinois Supreme Court Court greatly expanded the theory in Lam- which authorizes shareholder derivative suits, in Brown v. Tenney.12 There, three share- brecht v. O’Neal.20 The Lambrecht court expressly permits derivative actions by “a holders formed a corporation, appointed first reviewed prior Delaware decisions, such shareholder, of record or beneficially.” The themselves to its board of directors, and oper- as Sternberg v. O’Neil,21 in which the parent legislature added the term “beneficially” to ated the business. They then formed a sepa- company acquired the subsidiary before the Section 800(b) in 1975, but did not define the rate corporation to act as a holding com- alleged wrongdoing had occurred. The term. Pearce v. Superior Court,26 a 1983 pany, exchanged their shares for an equal Lambrecht court confirmed: “In these cir- appellate court decision, was the first case to percentage of the holding company’s shares, cumstances, our law recognizes a right to examine the new term, observing that bene- and elected themselves as directors of the proceed double derivatively. Otherwise, there ficial shareholder standing was added as part holding company. would be no procedural vehicle to remedy the of “the 1975 liberalization of the standing The plaintiff, a minority shareholder in the claimed wrongdoing in cases where the par- requirements” to bring California in line with parent, alleged that the defendants breached ent company board’s decision not to enforce the majority rule.27 Framing the term within their fiduciary duties by converting corporate the subsidiary’s claim is unprotected by the the context of both the legal definition and funds of the subsidiary and that both the business judgment rule.”22 The Lambrecht that of usage in ordinary social discourse, parent and the subsidiary were controlled court further reasoned that double derivative Pearce stresses that a “liberal and expansive by the wrongdoers, who refused to sue. The standing arises “where the parent corpora- reading of section 800 and the phrase ‘share- plaintiff shareholder brought a derivative tion’s board is shown to be incapable of mak- holder…beneficially’” is proper.28 lawsuit on behalf of the parent and its sub- ing an impartial business judgment regarding Pearce holds that a beneficiary of corpus sidiary. The trial court refused to recognize whether to assert the subsidiary’s claim.”23 of a trust was a “beneficial stock owner” double derivative theory for the subsidiary’s The Lambrecht case, however, presented under Section 800(b), even though the ben- suit, the appellate court reversed, and the an even more complex issue. The Lambrecht eficiary did not personally own the corporate Illinois Supreme Court accepted the appeal. plaintiff had initially owned shares in the stock. In a subsequent case, Patrick v. Alacer The Illinois Supreme Court noted that a corporation at issue individually and directly, Corporation, the wife of a shareholder with “double derivative action is a long-standing and had properly filed a single derivative a community property interest in her hus- doctrine of equity jurisprudence” and the case on behalf of that nominal defendant band’s shares was deemed a beneficial owner “overwhelming weight of authority does corporation. During the litigation, the nom- with derivative standing, despite the fact the accept the double derivative action.”13 The inal defendant entity merged with another stock was not in her name.29 Thus, Section Illinois high court agreed with the plaintiff, corporation, thereby causing plaintiff to lose 800(b) expressly creates an exception to direct finding that “this court should not be derailed direct shareholder status. The court noted stock ownership, opening the door to the by convenient corporate formations which do that a “post-merger double derivative action” argument that a parent company shareholder not reflect business realities.”14 Illinois had a was “a new, distinct action in which stand- is a “beneficial” owner of the subsidiary’s well-settled principle to look beneath the cor- ing to sue double derivatively rests on a stock and, as such, expressly granted stand- porate veil and disregard legal fictions “when different temporal and factual basis—namely, ing by legislative enactment. used as a shield for wrongful acts.”15 The the failure of the [current] board, post-merg- Second, California’s creation of single court was more concerned with protecting the er, to enforce the premerger claim of its derivative law was initially based in equity,30 natural persons for whom the corporations wholly-owned subsidiary.”24 Despite the more and California strongly supports the “fun- were created rather than the “artificial crea- complicated ownership issues presented, the damental principle of our system of jurispru- tures in whom legal title is vested.”16 Delaware Supreme Court nevertheless con- dence that for every legal wrong there is a The Illinois Supreme Court was further firmed that “Delaware case law clearly en- remedy.”31 California compensates injured persuaded that corporate officers and direc- dorses the double-derivative action as a post- parties for all damage proximately caused tors are fiduciaries and that single-derivative merger remedy” and extended double- by the wrongdoer unless a departure from the standing evolved to ensure someone could derivative standing to those circumstances basic principle is “mandated by a legislative represent the interests of corporations and as well.25 exception or by strong public policy.”32 When shareholders should the fiduciaries fail to act individuals are subjected to conduct by oth- California Law properly. The court reasoned that double ers that is deemed unfair and contrary to derivative standing merely extended single Despite the acceptance of double derivative public policy, the courts have full power to derivative theory, so that the “beneficiary is standing elsewhere, the theory has remained afford necessary protection.33 Thus, even if a in turn also a fiduciary” that deserves repre- an elusive issue of first impression in Cal- California court were to find in Section 800(b) sentation should interlocking directorates or ifornia and has avoided full evaluation in a that “beneficial” shareholder language did not collusion result in lack of representation.17 published decision in the state’s courts. legislatively sanction double derivative stand- Otherwise, “the subsidiary is accountable to California’s lack of precedent complicates ing, California is rife with authority to sup- no one since its shareholder, the holding com- matters for California practitioners since, port the theory based on equity alone. pany, is controlled by the wrongdoers.”18 given the popularity of the parent-subsidiary Third, California opinions that have had The Illinois court rejected the defendants’ form, the double derivative standing issue indirect brushes with double derivative the- contention that recognizing double deriva- will likely arise in shareholder disputes. ory are favorable. In Gaillard v. Natomas tive actions was tantamount to judicial legis- Moreover, since a successful lack of standing Company,34 the court considered double lation. The court swiftly disposed of that defense can terminate all liability, fiduciary derivative theory in the context of a merger. argument by noting that single derivative defendants will likely contest the issue. Before the merger was effective, the plaintiff

18 Los Angeles Lawyer April 2015 stockholder filed a single derivative share- Supreme Court in Lambrecht seemingly soon be expressly adopted in this state. In holder suit against Natomas’s officers and pulled the rug out from under the Grosset Kruss v. Booth,46 the plaintiff’s second directors challenging their substantial bene- decision, expressly recognizing that double amended complaint alleged double derivative fits approved as part of the merger. Within derivative standing does, in fact, exist under theory. The appellate court reversed the trial hours after the complaint was filed, the merger Delaware law to afford standing in the post- court and permitted the pleading to stand concluded, forcing the plaintiff to exchange merger context.42 Because Grosset did not on demurrer, thus implicitly recognizing that her shares in Natomas for common stock in consider double derivative standing, Grosset double derivative standing exists in California. the second company, which became the sole is not controlling on that issue and remains Additionally, in Villari v. Mozilo,47 the shareholder of Natomas’s common stock. one of first impression in California. The plaintiff alleged multiple double derivative The trial court held that the plaintiff lost question thus remains whether California actions after a postcomplaint merger, but standing to proceed derivatively when she courts will follow Delaware’s numerous opin- then dropped the double derivative theory was no longer a Natomas shareholder. Upon ions, including Lambrecht, which hold that of standing on appeal. Despite this, the court reversing the decision, the took the opportunity to appellate court framed the cite and even quote exten- issue before it narrowly with- sively from Lambrecht, in single derivative theory, concluding “The continu- and concluded that Section ous ownership rule, how- 800(b)(1) did not require the ever, does not preclude a plaintiff to maintain con- double derivative action by tinuing shareholder status a former shareholder.”48 throughout the litigation, as Apparently, the only thing it would “leave Gaillard and standing in the way of dou- all those similarly situated ble derivative standing in without a remedy.”35 Villari was the fact that the The Gaillard cour t’s con- plaintiff had abandoned it. cern over its plaintiff’s po- California courts may tential lack of remedy was also be influenced by the prompted by its further com- Ninth Circuit’s holding ments about double deriva- in In re Imperial Corpora- tive standing, whereby the tion of America,49 in which court concluded that double the Ninth Circuit consid- derivative standing could not ered whether double deriv- aid its plaintiff “in the context ative standing existed in of this case.”36 First, Gaillard the context of the doctrine reasoned that a double deri- of claim preclusion (res vative action would be dis- judicata).50 The court ob- missed as moot under its served that claim preclu- unique facts because it re- sion bars not only claims sulted in the “anomalous” sit- that were actually litigated uation of a corporation, post- but also any claims that merger, “suing itself for its own benefit, because double derivative standing is, and has been, could have been litigated. In a prior lawsuit, of acts it performed.”37 Second, the court rea- a viable theory for decades, whether under the the shareholders brought and settled a single soned that its plaintiff did not own the parent postmerger cases or otherwise. derivative action against the officers and company at the time of the alleged wrongdo- It seems likely that California will do so, directors relating to the failure of Imperial ing or filing of the complaint, and thus could given that California courts have historically Savings Association, which was a wholly not meet the contemporaneous shareholder been persuaded by and often follow Delaware owned subsidiary of Imperial Corporation of requirement for the parent company. The corporate case law.43 Grosset itself illustrates America.51 However, the shareholders only Gaillard court carefully limited its holding, a circumstance in which the action of the sued the parent company Imperial Corpor- thereby implicitly recognizing that double California Supreme Court could be inter- ation of America and did not bring a double derivative standing could be viable based on preted as desiring to parallel Delaware law.44 derivative lawsuit on behalf of the subsidiary. other facts and circumstances.38 A number of Moreover, given that the Grosset court has The Federal Deposit Insurance Corpor- authorities continue to describe Gaillard as already concluded that Delaware’s statutory ation (FDIC), as receiver for the failed sub- looking favorably on the double derivative “contemporaneous ownership” requirement sidiary, brought a separate action on behalf suit concept.39 is the same as, if not narrower, than Cali- of the subsidiary against the same officers and In Grosset v. Wenaas,40 the California fornia’s requirement for the purpose of sin- directors for the same conduct. After con- Supreme Court overruled Gaillard’s holding gle derivative standing,45 California courts cluding that the FDIC was in privity with the on postmerger standing. Without address- will be hard pressed to now attempt to dis- prior shareholder plaintiffs (a requirement for ing double derivative theory, and under what tinguish California law from Delaware law or claim preclusion), the court further examined was essentially a single derivative analysis, the otherwise conclude that double derivative which claims the prior shareholder plain- Grosset court concluded that under both standing cannot exist in California in light of tiffs had or could have brought. Although the Delaware’s and California’s contemporaneous Lambrecht. subsidiary was not a named defendant or a ownership rules a postmerger plaintiff does Since Lambrecht, two California appellate party to the settlement in the prior litigation, not have standing and dismissed the appeal.41 courts have seemingly concurred and tele- the Court cited Gaillard for the definition of However, two years later, the Delaware graphed that double derivative standing may double derivative and held that the prior

Los Angeles Lawyer April 2015 19 shareholder plaintiffs “could have brought a proper double derivative suit” on behalf of the parent in the prior action.52 After recognizing that double derivative standing would have allowed the prior shareholder plaintiffs to sue on behalf of the subsidiary, the court concluded that the FDIC’s claim on behalf of the subsidiary was barred by claim preclusion in the present action.53 The primary function of double derivative theory is to provide a remedy to individuals when both the parent company and the subsidiary refuse to act; it favors sub- stance over form and promotes equity for the individual rather than the fiction of the corporate structure. Although California courts have yet to issue a clear, published decision on whether a double derivative plaintiff, in fact, has standing in this state, the nationwide move in that direction and the compelling reasons in favor of the theory should be persuasive argument leading to the formal, explicit approval of double derivative standing in California I

1 Webre v. Sneed, 358 S.W. 3d 322, 334 (Tex. App. 2011) (“Many other jurisdictions” recognize double derivative standing.); West v. West, 825 F. Supp. 1033, 1054 (N.D. Ga. 1992) (citing 3B MOORE’S FEDERAL PRACTICE §23.1.16[1] (1991) (“The general rule under existing federal case law is that double or multiple derivative actions are permissible.”). 2 “It is a fundamental principle of our system of jurisprudence that for every legal wrong there is a remedy (CIV. CODE §3523), and that an injured party should be com- pensated for all damage proximately caused by the wrongdoer unless a departure from the basic principle is mandated by a legislative exception or by strong public policy.” Barbara A. v. John G., 145 Cal. App. 3d 369, 376 (1983). 3 FRIEDMAN, CALIFORNIA PRACTICE GUIDE: CORPOR- ATIONS §§6:602-03 (2006). 4 The use of subsidiaries has become “increasingly popular with the growth and sophistication of the modern corporate enterprise. The reasons for this are complex and varied. Subsidiaries may be useful for tax reasons, for achieving the advantages of limited liability, for centralizing control in a relatively small percentage of stock ownership, for qualifying to do business under the laws of the various states, for reasons related to ﬁnancing, and doubtless for a number of other pur- poses.” William H. Painter, Double Derivative Suits and Other Remedies with Regard to Damaged Subsidiaries, 36 IND. L. J. 143 (1961). 5 “The holding company has given rise to numerous new problems of the protection of stockholders from the misconduct of their directors.” Note, Remedies of Stockholder of Parent Corporation for Injuries to Subsidiaries, 50 HARV. L. REV. 963 (1937). 6 Brown v. Tenney, 532 N.E. 2d 230, 233–234 (Ill. 1988). 7 See, e.g. Bivens Gardens Office Bldg., Inc. v. Barnett Banks of Florida, Inc., 140 F. 3d 898, 910 n.5 (11th Cir. 1998); Pessin v. Chris-Craft Indus., Inc., 181 A.D. 2d 66, 72 (N.Y. App. Div. 1992); Webre v. Sneed, 358 S.W. 3d 322, 334 (Tex. App. 2011); West v. West, 825 F. Supp. 1033, 1054 (N.D. Ga. 1992); and cases discussed below. 8 Ryan v. Leavenworth, Atchison & Northwestern R.R. Co., 21 Kan. 365, 402-04 (1879) (“If any other rule were adopted, the plaintiffs would be denied all

20 Los Angeles Lawyer April 2015