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Conflicts Inherent in Shareholder Derivative Actions

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Conflicts Inherent in Shareholder Derivative Actions March2012_ Master.qxp 2/13/12 1:58 PM Page 20 by SA’ID VAKILI CORPORATIONSIN CONFLICT The potential for conflicts of interest in shareholder derivative lawsuits is high, leading to complex issue for courts and attorneys to resolve SHAREHOLDER DERIVATIVE LAWSUITS the most important are the potential con- and its shareholders and with such care, have not diminished. Indeed, in industries flicts between the shareholder and the cor- including reasonable inquiry, as an ordinar- such as finance and technology, the number poration, between the plaintiff shareholder ily prudent person in a like position would use of these lawsuits is growing.1 A shareholder and other shareholders, and between the cor- under similar circumstances.”4 In addition to derivative suit is typically an action by one or poration and its counsel. Some of these poten- the duty of care, directors also owe a fiduciary more shareholders against some or all of the tial conflicts may also pose ethical challenges duty of loyalty to the corporation they serve. officers or directors of a corporation to redress to the attorneys involved. “Loyalty” means placing corporate and share- corporate mismanagement. While the cor- Although myriad acts can underlie a claim, holder interests ahead of any other business poration itself is usually named as a defen- shareholder derivative actions usually emerge or personal interests.5 dant, its status as defendant is nominal. In as a result of breaches of fiduciary duties by Discharging these obligations requires the practice, the interests of the shareholder and officers or directors. These duties, long rec- exercise of sound business judgment. Courts the corporation are considered aligned, and ognized at common law, have been codified the plaintiff benefits only as a shareholder. in Corporations Code Section 309.3 Pursuant Sa’id Vakili is a partner with the Los Angeles firm Even through the shareholder may be the to these authorities, each director owes a of Vakili & Leus, LLP. His practice emphasizes busi- plaintiff named in the lawsuit, any recovery fiduciary duty of care to the corporation and ness and employment litigation. He wrote this goes to the corporation rather than to the its shareholders, and he or she must serve “in article in collaboration with Peter Zablotsky, plaintiff-shareholder.2 These dynamics give good faith in a manner such director believes Professor of Law at Touro College Jacob D. Fuchsberg rise to significant conflicts of interest. Among to be in the best interest of the corporation Law Center in New York. MICHAEL CALLOWAY 20 Los Angeles Lawyer March 2012 March2012_ Master.qxp 2/13/12 1:58 PM Page 21 Los Angeles Lawyer March 2012 21 March2012_ Master.qxp 2/13/12 1:58 PM Page 22 have ruled that this obligation includes man- angle, the interests of the plaintiff share- holder access to information. This conflict aging proactively: “A director cannot close his holder and the corporation are considered appears to be resolved firmly in favor of the eyes to what is going on about him in the con- aligned, and the shareholder only benefits plaintiff shareholder. duct of the business of the corporation and through the corporation. As such, the primary Specifically, California law grants the right have it said that he is exercising business mechanism for eliminating a conflict between of inspection to shareholders unconditionally. judgment.”6 Similarly, “the [business judg- the plaintiff and the corporation, despite the The critical components of the right are statu- ment] rule does not immunize a director from fact that the officers and directors of the cor- tory and are codified in Corporations Code liability in the case of his or her abdication of poration are being sued, is the straightforward Section 1601.19 Subsection (a) provides, “The corporate responsibilities.”7 requirement that the plaintiff be a share- accounting books and records and minutes of Officers also have fiduciary duties to the holder. proceedings of the shareholders and the board corporation. These duties include a “duty, Corporations Code Section 800(b)(1) sets and committees of the board of any domes- not only affirmatively to protect the interest the prerequisites for bringing a shareholder tic corporation, and of any foreign corpora- of the corporation committed to his charge, derivative action under California law.15 A tion keeping any such records in this state or but also to refrain from doing anything that derivative plaintiff will qualify to initiate an having its principal executive office is this would work injury to the corporation.”8 action on a corporation’s behalf if 1) the state, shall be open to inspection upon the Here, the courts can impose a higher standard plaintiff is a shareholder of record, holder of written demand of the corporation of any of care on an officer, as compared to a direc- a beneficial interest, or holder of a voting shareholder.”20 The statute goes on to grant tor, because officers are often more closely trust certificate, 2) the plaintiff was a share- the right of inspection “for a purpose rea- involved in running the corporation and have holder when the wrong to the corporation sonably related to such holder’s interest as a more direct responsibility for the prepara- that gave rise to the action took place (the shareholder.”21 Section 1601(b) provides that tion of “information, reports, or statements contemporaneous-ownership rule), and 3) an attorney for the shareholder may be pre- on corporate affairs.”9 Finally, an officer the plaintiff made a reasonable effort to sent during the inspection, and that “the who participates in corporate management inform the corporate directors about the right of inspection includes the right to copy and who exercises some discretionary author- action and induce them to commence suit and make extracts.”22 ity owes a fiduciary duty of loyalty to the against the responsible parties, unless such Court interpretations of this section have corporation, even if the officer’s authority efforts would have been “useless” or “futile.” affirmed the rights of shareholder inspec- falls short of having control over the corpo- Section 800(b)(1) also provides that the court tion. Regarding the quality of the records ration.10 has discretion to waive the contemporaneous made available for inspection, Section 1601 In establishing what the appropriate exer- ownership requirement if it finds that there is generally guarantees that the records pro- cise of these duties entails, courts have held, no one else to enforce the claim on the cor- vided be adequate and correct.23 At least one for example, that unreasonable salaries or poration’s behalf and that defendants would court has held that an inspector’s inability to other compensation paid to management otherwise retain the benefits derived from make sense of the ledgers or financial state- may be challenged as a waste of corporate their willful breach of fiduciary duty unless the ments due to the lack of any specifics in infor- assets, and that, even when approved by a action is permitted to proceed.16 mation was a failure to provide any mean- “disinterested” board, “unreasonably” large One federal court has permitted share- ingful inspection under Section 1602.24 payments to officers and directors may con- holders to act as plaintiffs in a derivative Courts have also held that a “reasonable” stitute a “waste” of corporate assets and thus action despite positions adverse to the defen- purpose for an examination includes inves- violate a director’s fiduciary duties to the dant directors in an earlier relationship. In tigating the disparity in value between the corporation.11 It has also been held that direc- Tyco Laboratories, Inc. v. Kimball,17 the published report and market value of out- tors or officers may not seize a corporate plaintiffs who brought the derivative action standing shares,25 determining if the out- opportunity for themselves without first offer- owned a substantial interest in the corpora- standing shares are held by an oligopoly of a ing it to the corporation.12 For example, a tion and may previously have been in a posi- shareholders who dictate the accounting poli- fiduciary may not acquire property in which tion adversarial to the defendant directors cies,26 and examining corporate assets to the corporation has an interest or tangible regarding control of the corporation. But the determine if they have been used in self-deal- expectancy when a proposed activity is rea- court found that this did not disqualify the ing.27 Based upon these holdings, other rea- sonably incident to the corporation’s present plaintiffs from representing the corporation’s sonable interests would appear to include or prospective business and is one in which shareholders in a derivative action, because prosecuting a shareholder derivative com- the corporation has the capacity to engage. the plaintiffs were pursing common interest plaint for the benefit of a nominal defendant Or, the purchase of corporate stock by one of with the corporation by seeking redress for corporation and its shareholders in order to its directors could be an appropriation of a alleged breaches of fiduciary duties and other recover monies converted by officers or direc- corporate opportunity.13 Pointedly, at least violations of state and federal laws on the cor- tors, ascertaining whether assets are grossly one court has held that a corporation’s finan- poration’s behalf, and because any recovery undervalued, ascertaining whether transac- cial inability to take advantage of the oppor- would
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