SHAREHOLDER WHO SELLS STOCK IN CORPORATION LOSES STANDING TO SUE DERIVATIVELY

• Posted on: Dec 13 2017

Standing to sue derivatively requires stock ownership in the corporation at the time the lawsuit is filed and at the time of the wrongful occurrence. As noted in a recent article posted by this Blog (here), these standing requirements are strictly enforced.

Now comes another decision from the New York Appellate Division, Second Department, that reiterates the point that the absence of standing is the death knell of a shareholder’s derivative action. Jacobs v. Cartalemi, 2017 N.Y. Slip Op. 08506 (2d Dept. Dec. 6, 2017). (Here.)

Jacobs v. Cartalemi

William Jacobs (“Jacobs”) and Charles Cartalemi (“Cartalemi”) were the members of the Westchester Industrial Complex, LLC (“WIC”). At the time Jacobs commenced the action, Jacobs held a 20% membership interest in WIC and Cartalemi held the remaining 80% interest.

Jacobs brought the action on September 27, 2012, both individually and derivatively against Cartalemi and WIC, alleging five causes of action: accounting, breach of fiduciary duty, appointment of a receiver, constructive trust, and waste of corporate assets. Jacobs alleged, among other things, that since 2006, Cartalemi had improperly increased his salary and paid his family members excess wages, used space on WIC’s property for his personal use and failed to pay WIC a fair rental price, and mismanaged and misappropriated funds from WIC.

During the pendency of the action, Jacobs withdrew his ownership interest in WIC effective December 1, 2015. By notice of motion dated February 5, 2016, Cartalemi and WIC moved for summary judgment dismissing the complaint, contending that Jacobs no longer had standing to maintain any of his causes of action, which were all derivative in nature. Jacobs opposed the motion, contending, inter alia, that until such time as he was paid for his membership interest, he remained the equitable and beneficial owner of a 20% interest in WIC, and, therefore, was entitled to assert derivative claims. He also contended that, in any event, he could still maintain each of his causes of action as individual ones.

On June 27, 2016, the motion court granted the defendants’ motion for summary judgment dismissing the causes of action for breach of fiduciary duty, imposition of a constructive trust and waste of corporate assets, and denied the motion with regard to the causes of action for an accounting and the appointment of a receiver.

Jacobs appealed the portion of the order granting the defendants’ motion for summary judgment. Cartalemi and WIC cross-appealed from the portion of the order which denied dismissal of the causes of action for an accounting and the appointment of a receiver.

The Second Department affirmed the dismissal of the causes of action for breach of fiduciary duty, imposition of a constructive trust and waste of corporate assets, and reversed the decision declining to dismiss the causes of action for an accounting and the appointment of a receiver. It did so because Jacobs lacked standing to assert the derivative claims:

In the context of a corporation, the standing of the shareholder is based on the fact that . . . he is defending his own interests as well as those of the corporation. Where the plaintiff voluntarily disposes of the stock, his rights as a shareholder cease, and his interest in the litigation is terminated. Being a stranger to the corporation, the former stockowner lacks standing to institute or continue the suit. The same is true in the context of an LLC. … Thus, the Supreme Court properly held that, once the plaintiff withdrew from WIC, he lost standing to maintain any derivative causes of action on behalf of the company, notwithstanding his possible right to a future payment for the value of his membership interest upon his withdrawal.

Internal quotation marks and citations omitted.

For the same reasons, the Court held that the motion court should have dismissed the first cause of action, which sought an accounting. “Here, the plaintiff’s right to an accounting was based on his ability to prove that Cartalemi breached his fiduciary duty to WIC, a claim that is entirely derivative and which the plaintiff, having withdrawn as a member from WIC, no longer had standing to maintain.” (Citations omitted.)

As to the cause of action seeking the appointment of a receiver, the Court found that the motion court should have granted the motion for summary judgment because Jacobs improperly asserted it as a “form of ultimate relief that can be awarded in a plenary action,” rather than as a “limited … provisional remedy … or as an aid in post-judgment enforcement.”  

Takeaway:

Since February 2008, members of a limited liability company (“LLC”) have been permitted to bring a derivative action on behalf of their company. Tzolis v. Wolff, 10 N.Y.3d 100, 102 (2008). In order to do so, the plaintiff must be a member of the LLC. See Herman v. Herman, 122 A.D.3d 506, 507 (1st Dept. 2014); Billings v. Bridgepoint Partners, LLC, 21 Misc. 3d 535, 540 (Sup. Ct., Erie County (2008). The reason for this requirement “is based on the fact that . . . [the plaintiff] is defending his [or her] own interests as well as those of the corporation.” Tenney v. Rosenthal, 6 N.Y.2d 204, 211 (1959); see also Indep. Inv. Protective League v. Time, Inc., 50 N.Y.2d 259, 263(1980). Therefore, a plaintiff who voluntarily disposes of his/her stock cannot defend the corporation’s rights because he/she no longer has an interest in the company. And, without ownership in the company, the courts consider the plaintiff to be nothing more than “a stranger to the corporation,” lacking the necessary “standing to institute or continue the suit.” Indep. Inv. Protective League, 50 N.Y.2d at 263-264. In Jacobs, these principles informed the Court’s decision and dictated the outcome of the appeal.