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Put Your Money Where Your Mouth Is

When disgruntled investors file partnership lawsuits, seek a bond.

An often overlooked real estate litigation tool in partnership litigation is forcing the plaintiffs to post a bond. When a limited liability real estate development company is sued by disgruntled investors, the company should ask the investors to put their money where their mouth is.

Suing the Partnership
Real Estate developments are typically structured as Limited Liability Companies with the developer designated as the manager. The manager runs the project while the investors are silent partners.

However, when the project faces difficulties such as cost over-runs or delays, unhappy investors often file lawsuits. The lawsuit is either intended to take over the project or, more commonly, to extort a buy-out from the other members on preferential terms. The dissident member wants to get off the sinking ship.

What is a derivative action?
In most cases a lawsuit by a member of the LLC is a derivative action. An action is derivative if the injury is to the company rather than to an individual member. An action is direct if the injury is to an individual member.

For example, in a real estate development structured as an LLC, cost over-runs or other common development problems do not damage one particular member directly. It is the company as a whole that is injured and all members bear that injury equally. The injury is essentially a diminution in the value of the LLC.

A member cannot bring a direct action for damages against management on the theory that management’s alleged wrongdoing decreased the value of the member’s interest (e.g., by reducing company assets and net worth). The company itself must bring such an action. The logic behind this law is that it is the company that owns the lawsuit. Without this system, each and every member could bring a different lawsuit, basically ignoring the corporate entity. If a manager or a third party caused damage to the company, it is the company that must sue them. If the company does not agree to file such a suit, a member may bring a derivative suit on the company’s behalf.

In a derivative action, the plaintiff still prosecutes the action but in the name of the company. For example, if the dissident member believes that the manager is stealing money from the company, the member will sue the manage and the company. If the member believes that the contractor has breached its contract with the company, the member will sue both the contractor and the company event though the member has no contractual relationship with the contractor. Instead the dissident member is alleging that the contractor breached its contract with the company and is seeking to collect on behalf of the company for the breach. Any recovery goes to the company, not the plaintiffs.

Ask for a Bond
A useful tool in battling a member’s lawsuit is to ask the plaintiffs to post a bond in order to secure the company’s costs in fighting the lawsuit.

One of the grounds upon which the motion may be based is that there is no reasonable possibility that the prosecution of the complaint will benefit the company or its shareholders. This means that the company will have to show that the complaint has not merit and will not lead to any recovery.

The purpose of the security provision is to prevent unwarranted member derivative lawsuits. The idea is that the company, using its business judgment, has decided not to pursue a lawsuit. Therefore, the dissident member must post security if it wishes to substitute its judgment for that of the company.

In California, once the motion is filed, the entire action is stayed until the court rules on the motion or until the plaintiffs voluntarily post a bond. Practically speaking, the lawsuit typically arises due to a desire by the member to not invest any more money in the company. Fighting the motion and posting a bond will cause the member to incur more expenses. If the court orders the member to post a bond and no bond is posted, the lawsuit can be dismissed.

If the company wins the lawsuit, it can use the bond to pay its attorney’s fees.

Laine T. Wagenseller is the founder of Wagenseller Law Firm and specializes in real estate litigation in Los Angeles. The firm represents real estate developers, property owners and investors. Visit www.wagensellerlaw.com or contact Mr. Wagenseller at (213) 286-0371 or ltw@wagensellerlaw.com.

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