Absence of Shareholder Standing Negates Right to Recover Attorney’s Fees for Derivative Settlement

• Posted on: Dec 11 2017

In prior posts, this Blog has discussed the elements required to assert a shareholder’s derivative action. (Here.) Today’s article focuses on the standing requirements needed to commence such an action and the consequences of not satisfying them.

What is a Derivative Action?

A shareholder’s derivative action is a lawsuit “brought in the right of a … corporation to procure a judgment in its favor, by a holder of shares or of voting trust certificates of the corporation or of a beneficial interest in such shares or certificates.” Marx v. Akers, 88 N.Y.2d 189, 193 (1996) (quoting Business Corporation Law § 626 (a)). Derivative claims against corporate officers and directors belong to the corporation itself. Auerbach v. Bennett, 47 N.Y.2d 619, 631 (1979).  As the New York Court of Appeals explained long ago:

The remedy sought [in a derivative action] is for wrong done to the corporation; the primary cause of action belongs to the corporation; recovery must enure to the benefit of the corporation. The stockholder brings the action, in behalf of others similarly situated, to vindicate the corporate rights and a judgment on the merits is a binding adjudication of these rights.

Isaac v. Marcus, 258 N.Y. 257, 264 (1932) (citations omitted.). See also Aronson v. Lewis, 473 A.2d 805, 811 (Del. 1984) (“The nature of the action is two-fold. First, it is the equivalent of a suit by the shareholders to compel the corporation to sue. Second, it is a suit by the corporation, asserted by the shareholders on its behalf, against those liable to it.”).

Standing Requirements

In New York, as in most jurisdictions, a derivative plaintiff must be a shareholder of the company “at the time of bringing the action,” and at the time of the alleged wrongdoing. See, e.g., BCL § 626(b); Pessin v. Chris-Craft Indus., 181 A.D.2d 66, 70 (1st Dept. 1992).  See also Lewis v. Anderson, 477 A.2d 1040, 1049 (Del. 1984). “[A] plaintiff who ceases to be a shareholder, whether by reason of a merger or for any other reason, loses standing” to sue derivatively. Lewis, 477 A.2d at1049. Accordingly, courts have focused on the plaintiff’s stock ownership during both points in time, and in particular at the time of the alleged misconduct.

In New York, the contemporaneous ownership rule is “strictly enforced.” Honzawa Holding Co. v. Hiro Enter. USA, 291 A.D.2d 318, 318 (1st Dept. 2002). To satisfy the requirement, the plaintiff must have owned stock in the corporation

throughout the course of the activities that constitute the primary basis of the complaint. This is not to say that a plaintiff must have owned stock in the company during the entire course of all relevant events. It does mean, however, that a proper plaintiff must have acquired his or her stock in the corporation before the core of the allegedly wrongful conduct transpired.

In re Bank of New York Deriv. Litig., 320 F.3d 291, 298 (2d Cir. 2003).

“[F]ailure to satisfy the . . . contemporaneous ownership requirement of § 626(b) is such a fundamental lack of capacity that it results in failure to state a cause of action.” Roy v. Vayntrub, 15 Misc. 3d 1127(A), 2007 NY Slip Op 50868(U) (Sup Ct. Nassau County 2007), at *6 (citing Barr v. Wackman, 36 N.Y.2d 371 (1975)). For this reason, courts require the plaintiff to plead contemporaneous ownership with particularity rather than through boilerplate assertions. See, e.g., Roy, In re Computer Sciences Corp. Deriv. Litig., 2007 WL 1321715, at *15 (C.D. Cal. Mar. 26, 2007) (“[G]eneral allegation[s] [are] insufficient to allege contemporaneous ownership during the period in which the questioned transactions occurred.”).

If a plaintiff voluntarily sells his/her shares during the pendency of a derivative action, his/her rights as a shareholder cease, and his/her interest in the litigation is terminated. Independent Investor Protective League v. Time, Inc., 50 N.Y.2d 259, 263-64 (1980) (citations omitted). “Being a stranger to the corporation, the former stockowner lacks standing to institute or continue the suit.” Id. at 264. When that occurs, another shareholder with standing can intervene to maintain the lawsuit because his/her rights are no longer represented. In re Extreme Networks, Inc. S’holders Deriv. Litig., 573 F. Supp. 2d 1228, 1237 (N.D. Cal. 2008) (after dismissing derivative complaint without prejudice because lead plaintiff sold all his shares in the company, the court requested other plaintiffs and intervening shareholders to file new motions to appoint lead plaintiff).

Exceptions to The Contemporaneous Ownership Rule

Business Corporation Law § 626(b) includes an exception to the requirement that shareholders commencing a derivative action must demonstrate that he/she owned stock both at the time the lawsuit was brought and when the transaction(s) occurred.  That exception provides that the shareholder’s “shares or his interest therein devolved upon him by operation of law.”

In that regard, an interest is conferred by operation of law under BCL § 626 only if it occurs automatically by application of some legal mandate or doctrine, not by the voluntary actions of private parties. Thus, where shares are acquired through a will or intestacy, they devolve by operation of law since neither the decedent nor recipient had any control over the death. Pessin, 181 A.D.2d at 71. In contrast, shares that are obtained through some deliberate act, such as by gift or contract, do not devolve by operation of law. Id.

Another exception to the rule is the continuing wrong doctrine. Under this exception, the contemporaneous ownership requirement will not apply where the alleged wrong is occurring at the time the shareholder bought his/her stock even if it began before the shareholder purchased the stock. Courts in New York have recognized the continuing wrong doctrine as a limited exception to the contemporaneous ownership rule. See, e.g., Chaft v. Kass, 19 A.D.2d 610, 610 (1st Dept. 1963); Ripley v. Int’l Rys. of Cent. Am., 8 A.D.2d 310, 324 (1st Dept. 1959) (explaining that the continuing nature of a wrong did not prevent shareholders from bringing a derivative action with respect to acts that occurred after they became shareholders), aff’d, 8 N.Y.2d 430 (1960); Weinstein v. Behn, 65 N.Y.S.2d 536, 540-41 (Sup. Ct. NY County 1946), aff’d, 272 A.D. 1045 (1st Dept. 1947) (holding that the plaintiff had not satisfied the contemporaneous ownership requirement, noting that the “allegations refer[red] back to the alleged original wrongs specified in some detail under other paragraphs of the complaint, all of which occurred sometime before plaintiff obtained her stock.”).  

Standing for Derivative Action Involving Insolvent Company Subject to Bankruptcy Court Jurisdiction

Upon the commencement of a bankruptcy proceeding, derivative claims become the property of the bankruptcy estate and are subject to the control of the bankruptcy court. See, e.g., Thornton v. Bernard Tech., Inc., 2009 WL 426179, at *3 (Bankr. D. Del. Feb. 20, 2009); In re The 1031 Tax Group, LLC, 397 B.R. 670, 680-81 (Bankr. S.D.N.Y. 2008) (holding that breach of fiduciary duty and negligence claims are derivative and belong to the trustee). The right to bring a derivative action asserting claims for injury to the debtor corporation by its officers and directors vests exclusively with the trustee. Thornton, 2009 WL 426179, at *3 n.9.

If a derivative action is pending at the time the bankruptcy petition is filed, it must be dismissed unless the plaintiff is able to show: (1) the bankruptcy trustee has affirmatively assigned or abandoned the derivative claims to the plaintiff; and (2) the bankruptcy court approves of the plaintiff’s continued prosecution of the derivative claims. Thornton, 2009 WL 426179, at *3-4 (dismissing derivative suit because the plaintiff failed to show that the trustee had abandoned or assigned the derivative claims).

Sakow v. Waldman

Recently, the Second Department considered the standing requirements in BCL § 626(b), holding that the plaintiff was not entitled to a fee award for successfully litigating a derivative action because he lacked standing to bring the action. Sakow v. Waldman, 2017 N.Y. Slip Op. 08403 (2d Dept. Nov. 29, 2017) (here).

The case was brought by Walter Sakow (“Sakow”) individually and derivatively on behalf of Mawash Realty Corp. (“Mawash”) against Michael Waldman (“Waldman”) and Mawash. Sakow and Waldman each held an ownership interest in Mawash: Sakow owned 25% and Waldman owned 75% of the company. Mawash owned an apartment building located at 264-266 West 25th Street in Manhattan (the “25th Street Property”). Sakow and Waldman also owned an apartment building at 237 East 10th Street in Manhattan (the “10th Street Property”) as tenants in common.

Sakow, both individually and derivatively on behalf of Mawash, commenced the action, alleging that Waldman had retained all of the net income derived from the operation of both apartment buildings without accounting to Mawash or to Sakow, and had pledged or caused Mawash to pledge the two properties as collateral security for a number of loans, with Waldman allocating the proceeds of the loans to his own benefit. The matter proceeded to a nonjury trial. After concluding that Sakow was individually entitled to 50% of the $6,679,958, or $3,339,979, in net income and loan proceeds that related to the 10th Street Property, and 25% of the $5,122,388, or $1,280,597, in net income and loan proceeds that related to the 25th Street Property, the trial court awarded a judgment to Sakow, individually, in the principal amount of $4,620,576, or $3,339,979, plus $1,280,597, and awarded Mawash nothing.

On appeal, the Second Department modified the judgment by, among other things, awarding damages to Mawash on a cause of action asserted derivatively on its behalf by Sakow, and remitted the matter to the trial court for the entry of an amended judgment. See Sakow v. Waldman, 124 A.D.3d 860 (2d Dept. 2015) (here).

Sakow then moved pursuant to BCL § 626(e) for an award of an attorney’s fees from Mawash. On June 18, 2015, the trial court granted the motion, awarding Sakow $324,204 in attorney’s fees. On September 8, 2015, the court entered a money judgment upon the order. Mawash appealed from the order and the money judgment. That appeal was dismissed.

Subsequently, Mawash moved for leave to renew its opposition to Sakow’s motion for an award of an attorney’s fees, arguing that it had recently discovered that Sakow was not a shareholder of Mawash when the action was commenced and, therefore, he lacked standing to commence a derivative action and was not entitled to an award of an attorney’s fees under BCL § 626(e). In opposition, Sakow did not dispute that he had transferred his Mawash stock to nonparty Mawash Realty Trust (the “Trust”) more than two years before the action was commenced. However, Sakow asserted that he had standing to initiate the derivative action because he was acting as a nominee of the Trust. Upon granting renewal, the trial court adhered to its determination that Sakow was entitled to an award of an attorney’s fees under BCL § 626(e), but lowered the award to $300,000 and vacated the money judgment. Mawash appealed.

The Second Department reversed, holding that Sakow did not satisfy the standing requirements of BCL § 626(b). In doing so, the Court stated:

Here, upon renewal, the Supreme Court erred in determining that Sakow was entitled to an award of an attorney’s fee under Business Corporation Law § 626(e). At the time this action was commenced, Sakow was not a holder of shares or of voting trust certificates of Mawash, and he did not have a beneficial interest in such shares or certificates. Accordingly, Sakow did not have standing to commence a derivative action. While Sakow contends that, as nominee of the Trust, he could have commenced a derivative action on Mawash’s behalf, that was not the capacity in which he initiated the instant action. Since Sakow failed to satisfy the standing requirements for a derivative action, he was not entitled to an award of an attorney’s fee.

Internal quotations and citations omitted.

Takeaway

The policy behind BCL § 626(b) is sensible. It is designed to prevent plaintiffs from buying into a lawsuit or commencing a derivative action by simply purchasing shares after the alleged wrong has occurred. See, e.g., Independent Investor Protective League v. Time, Inc., 50 N.Y.2d 259, 263 (1980). Although there are exceptions to the rule, the law has long required plaintiffs bringing a derivative action to have a stake in the corporation on whose behalf the action is commenced.  After all, if the plaintiff is not a shareholder of the corporation, then he/she has no right to vindicate the corporation’s rights and obtain a judgment on its behalf. In Sakow, the Second Department reinforced this common-sense policy.