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Derivative Lawsuit: Compulsory Cross-Complaints and Derivative Actions

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Corporate Litigation Attorneys Cannot Side Step The Rules In A Derivative Lawsuit

1. The compulsory cross-complaint statute is designed to prevent ‘piecemeal litigation’.

Business litigation attorneys in Los Angeles and throughout California are familiar with California Code of Civil Procedure section 426.30(a) relating to cross-complaints.  The section provides that “if a party against whom a complaint has been filed and served fails to allege in a cross-complaint any related cause of action which (at the time of serving his answer to the complaint) he has against the plaintiff, such party may not thereafter in any other action assert against the plaintiff the related cause of action not pleaded.”

In other words, if a party has a claim, the lawyer must assert it in any ongoing litigation through a cross-complaint rather than waiting for another time to bring it up.

Moreover, an attorney responding to a claim that was subject to the statute can use the statute as a bar to the lawsuit.  The Code specifically provides that this section is “an affirmative defense that completely disposes of any cause of action to which it applies.”  In other words, if you failed to bring a cross-complaint and you try to file a new lawsuit, the defendant can use this section to get the lawsuit dismissed.

The rationale behind the compulsory cross-complaint rule is to prevent ‘piecemeal litigation’, legal disputes that never seem to end.

“The law abhors a multiplicity of action, and the obvious intent of the Legislature in enacting the counterclaim statutes was to provide for the settlement, in a single action, of all conflicting claims between the parties arising out of the same transaction.  Thus, a party cannot by negligence or design withhold issues and litigate them in successive actions; he may not split his demands or defenses; he may not submit his case in piecemeal fashion.”

One of the requirements is that the related cause of action must be one that was in existence at the time of service of the answer.  Otherwise, the failure to assert it in prior litigation is not a bar under the statute.

As you can see, another requirement is that the cause of action be ‘related’.  Related is defined as a cause of action which arises out of the same transaction, occurrence, or series of transactions or occurrences as the cause of action which the plaintiff alleges in his complaint.

2. Does the compulsory cross-complaint rule apply to derivative lawsuit actions?

A derivative action is a lawsuit brought by a shareholder or member on behalf of a corporation and seeking redress for injury the company suffered (rather than the shareholders themselves).  Any recovery in a derivative action belongs to the company, not to the shareholders directly.

In a derivative action the corporation is named as a nominal defendant, but, again, the claim is really on behalf of the corporation.  A derivative action arises in situations where the Board of Directors or those controlling the corporation refuse to bring the lawsuit on behalf of the corporation.  While the shareholders prosecute the action, any ultimate recovery belongs to the corporation.

Because the plaintiffs are ‘standing in the shoes’ of the corporation, they are also generally subject to the procedural rules that apply to the corporation.  Because the right of action belongs to the corporation, not its shareholders or members, it may be forfeited, waived, or adjudicated by the direct actions of the corporation.

In a recent California Court of Appeals case called Heshejin v. Rostami, plaintiffs brought a derivative action against a LLC for conspiracy to commit fraud, fraud by concealment, breach of fiduciary duty, declaratory relief, conversion and accounting.  The plaintiffs were minority shareholders of a limited partnership which was the sole owner of the corporation they sought to represent derivatively.

The corporation had already been involved in litigation over the alleged joint venture at issue.  In that litigation the corporation’s attorney had filed an answer but not a cross-complaint.  Interestingly, the corporation did not notify the minority shareholders of the litigation and they did not participate in that prior litigation.

When faced with a demurrer premised on the compulsory cross-complaint statute, the plaintiffs did not dispute that the derivative claims they are now asserting existed at the time of the prior litigation.  They also conceded that the derivative claims were ‘related causes of action’ which arose from the same joint venture.  Instead, they argued that the compulsory cross-complaint statute did not apply in this situation because they were not parties to the prior lawsuit.  Moreover, they argued that even if they had known of the prior lawsuit, the corporation would not have listened to them and filed the cross-complaint and so any demand was futile.

The Court of Appeal had sympathy for their position.  But it affirmed an order of dismissal after the granting of a demurrer without leave to amend.  The Court pointed out that although the plaintiffs did not know of the lawsuit at the time, a derivative action is brought on behalf of the corporation and they are standing in the shoes of the corporation, not on behalf of themselves individually.  While they might consider it unfair to be barred from bringing this cross claim, it is equally unfair to the party who was involved in the prior litigation with the corporation.  That party would be subject to ‘piecemeal litigation’ through no fault of its own.

Because the corporation had already been involved in litigation with the other party and because the corporation and its litigation attorney had not alleged any cross causes of action against the party, the plaintiffs could not now file a complaint alleging related causes of action on behalf of the corporation at a later date.  In other words, the compulsory cross-complaint statute applies in derivative actions.

Laine T. Wagenseller is the founding attorney of Wagenseller Law Firm in downtown Los Angeles.  Wagenseller Law Firm handles many partnership and corporate lawsuits among partners, shareholders and members.  For more information, please call us at (213) 805-7445 or visit our website at www.wagensellerlaw.com.

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