Corporate Fraud Lawsuits:  The Role of The Corporation In A Derivative Lawsuit

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Corporate Directors Accused of Looting The Corporation May Not Shift The Cost of Their Defense To The Corporation.

Corporate fraud lawsuits often center around Directors who loot the corporation.  Or Members who loot the LLC.  Their tortious conduct can include stealing or embezzling money from the corporate bank account.  Sometimes they award themselves bloated salaries or direct corporate opportunities to themselves or their secret entities.  They may award themselves sweetheart deals or loans and even forgive those loans later on.

The aggrieved shareholders or members, upon discovering the fraud, will file a lawsuit for breach of fiduciary duties, unfair business practices and typically a request for injunctive relief.  Their lawsuit will allege these causes of action against the Directors or Members who have done these tortious acts.

However, the recovery in a case like this does not go directly to the aggrieved shareholders.  Instead, the complaint seeks to allege these claims on behalf of the corporation.  In other words the damage has been done to the corporation.

However, if the wrongdoers are in control of the corporation, they will not instruct the corporation to file suit and therefore it is up to the aggrieved shareholders to file what is commonly called a “derivative action”.  However, the corporation or LLC must become a party to the litigation.  It is therefore added as a “nominal defendant”.

What Is The Role Of The Corporation In A Derivative Lawsuit?

“The management of a corporation owes to the stockholders a duty to take proper steps to enforce all claims which the corporation may have.  When it fails to perform this duty, the stockholders have a right to do so.  The shareholders may bring a derivative suit to enforce the corporation’s rights and redress its injuries when the board of directors fails or refuses to do so.”  Patrick v. Alacer Corp. (2008) 167 Cal.App.4th 995, 1003.

“But the particular stockholder who brings the suit is merely a nominal party plaintiff.  It is the corporation that ‘is the ultimate beneficiary of such a derivative suit.’  This, ‘the corporation is the real party plaintiff in the action.”  Id.

However, and somewhat counter-intuitively, the corporation is added as a “nominal defendant.”

Why Is The Corporation Named In The Lawsuit?

The first issue that arises is why is the corporation or LLC even named as a party in the lawsuit at all.  The corporation must be joined because its rights, not those of the nominal plaintiff, are to be litigated.  For example, in case of embezzlement, the wayward Director is accused of stealing money from the corporation.  And it is to the corporation that any recovery must be given.

The addition of the corporation as a party also provides the real defendants res judicata protection from later suits.

Corporate litigation attorneys must keep in mind that, although named a nominal defendant, the corporation is really the real plaintiff.

Who Can Represent The Corporation?

The most common mistake in a derivative lawsuit is when a lawyer purports to represent both the alleged wrongdoers and the corporation itself.  This is a conflict of interest that will lead to disqualification of the attorney.  The corporation must have separate counsel from the alleged wrongdoers since the corporation is really a plaintiff, not a defendant, in the action.

Can The Corporation Oppose The Lawsuit?

In practice the alleged wrongdoers may control the corporation.  And they may believe that they have done nothing wrong.  They will be responsible for retaining a litigation attorney to fight the lawsuit by the aggrieved shareholders.  As noted above, the corporation must have separate representation from the Directors accused of the wrongdoing.

Assuming that separate counsel is in place but that both lawyers are controlled by the Director defendants, the issue often arises as to whether the corporation can oppose the action.

In the Patrick v. Alacer Corp. case, supra., the corporation filed a demurrer to challenge the complaint of the plaintiffs.  The appellate court posed the following question:  if the corporation is the real plaintiff in a derivative action and the potential beneficiary of any recovery, how can it oppose the action?

“A demurrer may be filed only by the party against whom a complaint has been filed.  The complaint in a derivative action is filed on the corporation’s behalf; not against it.”  Id. at 1004.  The Patrick court notes that the corporation may only challenge the plaintiff’s standing (e.g., plaintiff is not a shareholder) or assert a “special litigation committee” defense (corporation has already appointed a committee of disinterested Directors to investigate the challenged transaction.)

Other than those two grounds, “it suffices to hold the corporation has no ground to challenge the merits of a derivative claim filed on its behalf and from which it stands to benefit.”  Id. at 1005.

The Patrick court reviewed court decisions from courts all across the country and highlighted some notable holdings:  (1)  “The Swenson court found ‘apparent’ the ‘anomaly of a corporation, in whose name and right a derivative action is brought, being allowed to defend itself against itself”; (2)  “The anomaly ‘is particularly apparent where the alleged wrongdoers are in control of the corporation”; (3)  “The Swenson court held ‘the corporation, except as noted above, may not defend itself against the derivative action on the merits and must limit its defenses, if any, to the pretrial matters proper to it.  Where a corporation seeks to extend its defenses beyond those areas in which it may properly conduct them, dismissal will lie against it”; (4)  “The Sobba court struck the corporation’s answer in a derivative action because it asserted affirmative defenses on behalf of the individual defendants”; (5)  “Because the claims asserted and the relief sought in the derivative complaint would, if proven, advance rather than threaten the interests of the nominal defendants, the nominal defendants must remain neutral in this action”; (6)  “Allowing the nominal corporate defendants to defend on the merits in effect would allow the individual defendant to shift the cost of his defense of the derivative suit to the corporations against which he has allegedly committed tortious conduct”; (7)  “The corporation should take no active part in the controversy, merely awaiting the outcome and reaping the fruits of any judgment for plaintiffs”; and (8)  “The corporation is a nominal party only with no right to here step in and, by answer, attempt to defeat what is practically its own suit and causes of action.  Nor have the two individual defendants, in control thereof, any right to use the corporation for any such purpose or to impose on the corporation the burden of fighting their battle.”

In the Alacer case, the court held that “the Director defendants lack any right to use the corporation to impose on the corporation the burden of fighting their battle.  The court erred by entertaining, let along sustaining, Alacer’s demurrer on any ground other than lack of standing.”

Lessons for Los Angeles Corporate Derivative Lawsuit Litigation Attorneys

Los Angeles corporate litigation attorneys who deal with derivative lawsuits should make sure that the corporation as nominal defendant is represented by neutral counsel in order to avoid disqualification.  Moreover, the attorney representing the corporation must stay focused on the role of the corporation in the derivative lawsuit in order to avoid creating conflict problems.  The corporation must remain a neutral party and not fight the substance of the lawsuit.

Laine T. Wagenseller is a corporate litigation attorney in downtown Los Angeles.  He is the founder of Wagenseller Law Firm, whose attorneys can handle a derivative lawsuit and other lawsuits on behalf of corporations.  For more information please call (213) 804-7445.


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