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In a landmark case decided last month, a California Court of Appeal ruled that shareholders lose their rights to maintain derivative lawsuits when they part with their shares during a merger. The court also concluded that shareholders' standing to bring derivative suits is an issue normally to be decided by the laws of the state in which the corporation is incorporated, even when the suit is filed in a different state. The case, Grosset v. Wenaas, 2005 DJDAR 12583, is a significant clarification of corporate law.
JNI Corporation is a San Diego-based manufacturer of computer products which is incorporated in Delaware. The plaintiff in Grosset claimed that officers and directors of JNI breached their fiduciary duties to JNI through insider trading and other alleged violations of federal securities laws. After the alleged breaches, JNI merged with Applied Micro Circuits Corporation (AMCC). During the merger, AMCC purchased all shares of JNI, including the plaintiff's shares. JNI moved to dismiss the Grosset suit on the grounds that the plaintiff lacked standing due to the sale of his stock during the merger. The trial court granted the motion, and the court of appeal affirmed.
To judge the propriety of the trial court's dismissal for lack of standing, the appeals court first had to decide whether to apply California or Delaware law to the standing issue. As a judicial rule of thumb, the "internal affairs" doctrine provides that disputes over internal corporate affairs should be settled according to the law of the state of incorporation. The court ruled that shareholder standing in derivative suits is subject to that doctrine, and therefore should be settled by applying Delaware law. Under Delaware law, standing to bring a shareholder derivative suit is proper only when the plaintiff owned stock from the time of the events giving rise to the suit through the end of litigation. Since the plaintiff sold his stock during JNI's merger with AMCC, the court held that he lost his standing to sue, making dismissal appropriate.
However, the court went further, holding that dismissal was proper for lack of standing even if California law controlled. California standing requirements, the court said, mirror Delaware's insofar as standing in shareholder derivative suits extends only to plaintiffs who held stock continuously from the time of the offending transaction through litigation's end. Since the plaintiff lost his JNI stock during the merger with AMCC, he no longer had standing to sue.
In reaching this conclusion, the court took a narrow view of California Corporations Code Section 800(b)(1), which requires derivative plaintiffs to allege only that they owned stock at the time of the offending transaction. The court read this statute as "merely a procedural pleading requirement" which did not alter the substantive and more restrictive standing hurdles.
The court also criticized a previous California decision which held that continuous stock ownership was not necessary in shareholder derivative suits. In Galliard v. Natomas Co. (1985), 173 Cal.App.3d 410, a different appellate court found that a derivative plaintiff need only have held stock at the time of the offending transaction through the date that suit was filed. The Grosset court, however, noted that the relaxed rule in Galliard runs counter to the rule in many states requiring continuous stock ownership throughout the entire litigation. Moreover, the court noted that because derivative plaintiffs sue on the corporation's behalf, it only makes sense that they should retain a proprietary interest in the corporation until the litigation concludes.
Thus, the Grosset decision makes clear that continuous ownership of stock is necessary to maintain a shareholder derivative suit on behalf of a California corporation. With few exceptions, plaintiffs lose their derivative standing when they sell their stock as part of a merger. Further, corporations doing business in California but incorporated in other states have been put on notice that California courts will likely apply the potentially more permissive standing requirements of the state of incorporation when shareholders file derivative actions.
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