Patrick v. Alacer Corp., 167 Cal.App.4th 995, 84 Cal.Rptr.3d 642 (Cal.App. 4 Dist., October 22, 2008).
The California court of appeals has decided an issue of first impression in California regarding the ability of a corporation to present a defense to a derivative action. Let me first note that the procedural posture of the typical shareholder derivative action can create extremely confusing scenarios that are ripe for abuse. Assume that a shareholder believes that the controlling majority on the board of directors is looting the corporation—violating their duties of loyalty to the corporation to enrich themselves. The controlling majority is able to do this because they are in control of the corporation. They will ignore any plea by a shareholder to stop. They will claim (and perhaps believe) that any effort by a shareholder to have the corporation seek redress for the wrongdoing is not in the best interest of the corporation. The principles of equity in every jurisdiction allow the shareholder in this situation to bring a derivative claim on behalf of the corporation, which claims the shareholder would otherwise not have standing to bring on his own behalf. The shareholder sues as the plaintiff, but the shareholder is only a nominal plaintiff—the real plaintiff is the corporation. It is the corporation whose rights are being vindicated and who will receive the benefit of any recovery. The plaintiff is acting as a fiduciary on behalf of the corporation. However, the law requires that the corporation be joined as a party to the litigation, if for no other reason than to ensure that res judicata applies to any judgment obtained on behalf of the corporation. Therefore, the corporation is an indispensable party, and the nominal plaintiff shareholder is required to sue the corporation as a defendant—but only as a nominal defendant because the corporation is really the plaintiff. Meanwhile, the controlling directors will naturally want the corporation to defend the lawsuit against them, to claim that the lawsuit is frivolous and not in the best interest of the corporation, and to pay for the expense of the defense—yet another example of taking corporate assets for their own personal benefit. Therefore, the poor shareholder often finds himself paying his own money to litigate against his own corporation (which is defending that lawsuit using money ultimately belonging to the shareholders) in an uphill battle to get money for that same corporation.
This was the situation that the California court of appeal recently encountered. The corporation had been started by a husband and wife, both of whom worked in the business, but the husband was the only record owner. The corporation was extremely successful, and the husband at one point transferred all his shares into a trust with instructions to distribute 46% of the stock to the wife upon his death to satisfy her community property interest. The trustees of the trust and others in league with them held a meeting when the 90-year-old husband was deathly ill, and persuaded the husband and the wife to cooperate with a scheme to place these individuals on the board of directors. Three weeks later the husband died; the trustees did not distribute the shares to the wife, but used their control over the stock to oust her from the board, fire her as an employee and officer, and install themselves as the corporate officers. Thereafter, they systematically looted the corporation through excessive compensation and self-dealing transactions. The wife ultimately brought a shareholder derivative action as a beneficial owner. (She also brought an individual action for defrauding her into voting for the election of the board; however the court held that this was properly dismissed for lack of causation because her votes ultimately would not have changed the outcome. She did not sue for shareholder oppression.) The trial court dismissed the case with prejudice on the basis of a demurrer filed by the corporation.
The court of appeals reversed the dismissal of the derivative claims on the grounds that the corporation was not permitted to contest the derivative claims on the merits:
"The issue arises from the basic nature of a shareholder derivative action. '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.' Jones v. H.F. Ahmanson & Co., 1 Cal.3d 93, 107, 81 Cal.Rptr. 592, 460 P.2d 464. (1969). '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.' Grosset v. Wenaas, 42 Cal.4th 1100, 1108, 72 Cal.Rptr.3d 129, 175 P.3d 1184 (2008). But 'the particular stockholder who brings the suit is merely a nominal party plaintiff.' Klopstock v. Superior Court, 17 Cal.2d 13, 21, 108 P.2d 906(1941). It is the corporation that "is the ultimate beneficiary of such a derivative suit.' Id. Thus, '[t]he corporation [is] the real party plaintiff in the action.' Russell v. Weyand, 5 Cal.App.2d 259, 260, 42 P.2d 381. (1935). Though the corporation is essentially the plaintiff in a derivative action, '[w]hen a derivative suit is brought to litigate the rights of the corporation, the corporation ... must be joined as a nominal defendant.' Grosset, 42 Cal.4th at p. 1108, 72 Cal.Rptr.3d 129, 175 P.3d 1184. The corporation must be joined because 'its rights, not those of the nominal plaintiff, are to be litigated Beyerbach v. Juno Oil Co., 42 Cal.2d 11, 28, 265 P.2d 1 (1954), and to offer the real defendants res judicata protection from later suits. Gagnon Co., Inc. v. Nevada Desert Inn, 45 Cal.2d 448, 453, 289 P.2d 466 (1955). Naming the corporation a defendant, not a plaintiff, follows from the joinder rules: 'If the consent of any one who should have been joined as plaintiff cannot be obtained, he may be made a defendant.' Code Civ. Proc., § 382. So 'although the corporation is made a defendant in a derivative suit, the corporation nevertheless is the real plaintiff....' Jones, 1 Cal.3d at p. 107, 81 Cal.Rptr. 592, 460 P.2d 464. The question now arises-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 '[t]he party against whom a complaint ... has been filed....' § 430.10. The complaint in a derivative action is filed on the corporation's behalf; not against it. Jones, 1 Cal.3d at p. 107, 81 Cal.Rptr. 592, 460 P.2d 464; Beyerbach, 42 Cal.2d at p. 28, 265 P.2d 1. It is only a 'nominal defendant.' Grosset, 42 Cal.4th at p. 1108, 72 Cal.Rptr.3d 129, 175 P.3d 1184. The only reason the corporation is named a nominal defendant is its refusal to join the action as a plaintiff. § 382. 'The corporation has traditionally been aligned as a defendant because it is in conflict with its stockholders over the advisability of bringing suit.' Note, Federal Courts-Diversity of Citizenship: Corporations-Corporation in Derivative Suit Must Be Realigned as Plaintiff When Not Dominated by Individual Defendants 68 Harv. L.Rev. 193, 194 (1954). In a real sense, the only claim a shareholder plaintiff asserts against the nominal defendant corporation in a derivative action is the claim the corporation has failed to pursue the litigation." 84 Cal.Rptr3d at 651-52.
The court held that the corporation may not defend a claim on the merits, when the claim is brought on behalf of the corporation—although the corporation may assert defenses contesting the shareholder's right to bring the claim on behalf of the corporation, such as lack of standing or the defense that a special litigation committee should control the litigation. See id. at 652. The question was one of first impression in California, but the court noted that other jurisdictions and authorities had reached the same conclusion. See id. at 653, citing Swenson v. Thibaut, 39 N.C.App. 77, 250 S.E.2d 279, 293-294(1978); Sobba v. Elmen, 462 F.Supp.2d 944, 947-950(E.D.Ark.2006); Rowen v. Le Mars Mut. Ins. Co. of Iowa, 282 N.W.2d 639, 645(Iowa 1979); Meyers v. Smith, 190 Minn. 157, 251 N.W. 20-21 (1933); accord Note, 68 Harv. L. Rev. at 194 ("in no case may the nominal defendant [in a derivative action] raise defenses of the real defendants"); Note, Defenses in Shareholders' Derivative Suits-Who May Raise Them 66 Harv. L. Rev. 342, 343 (1952) ("the proper party to invoke a given defense should be the party whom the defense is designed to protect"); see also id. at p. 345 ("The right of the corporation to defend, however, should be limited to those aspects of the case in which it is a real defendant").