When an LLC suffers primary harm that also indirectly harms the LLC’s members, the cause of action generally belongs to the LLC, not its members. Only if the LLC (through its duly authorized management) fails to pursue the claim after proper demand can its members sue derivatively on behalf of the LLC.
To have standing to assert a derivative claim, a plaintiff must prove both contemporaneous membership (membership at the time of the challenged transaction or succeeding to the interest of such a member) and continuous membership (membership throughout the litigation of the derivative claim).
An opinion recently published by California’s First Appellate District – Sirott v. Superior Court – describes these derivative standing requirements in greater detail.
Facts: a derivative plaintiff with contemporaneous, but not continuous membership
The Sirott case featured a business dispute among medical doctors involved with 400 Taylor Holdings, LLC (“Taylor LLC”). Taylor LLC owned a medical office building in Pleasant Hill, California. As of 2008, the members of Taylor LLC were Dr. Matthew Sirott (25%), Dr. Robert Robles (25%), and EBO LLC (50%). EBO LLC’s equal 50/50 members were Dr. Bimal Patel and Dr. John Ganey.
In the fall of 2016, a dispute erupted over the leasing of a vacant space in Taylor LLC’s building. Patel proposed leasing the space to a medical practice to which Patel belonged – the East Bay Medical Oncology/Hematology Medical Associates, Inc. (“EBMOH”). Sirott objected to the proposal, voicing concern that the proposed lease would interfere with another tenant – the California Radiation Treatment Center, LLC – which was owned in part by Sirott and Robles. EBMOH was rejected as a tenant and the space was leased instead to the medical practice of Sirott and Robles.
In 2017, EBO (then still a 50% member of Taylor LLC) sued Sirott and Robles, alleging derivative claims for breach of fiduciary duty and other claims relating to the refusal to lease the vacant space in Taylor LLC’s building to EBMOH.
Meanwhile, while the litigation remained in progress, Taylor LLC decided to sell its medical building. Before the sale, for tax purposes the parties entered into an agreement under which Taylor LLC (without dissolving) distributed its interest in the building to Patel, Ganey, Sirott, and Robles as tenants in common. At the same time, EBO also transferred its 50% membership interest in Taylor LLC to EBO’s owners, Patel and Ganey as individuals.
As such, after the sale of the property, Patel, Ganey, Sirott, and Robles each held a 25% membership interest in Taylor LLC, and EBO no longer owned an interest.
Trial court: EBO allowed to maintain derivative claims despite no longer owning a membership interest
After Covid-19 delays and a newly amended complaint, the defendants filed a demurrer arguing that EBO lacked standing to maintain the derivative claims because it was no longer a member of Taylor LLC.
The trial court allowed EBO to file a motion for standing under Corporations Code section 17709.02, and then granted EBO’s motion. The trial court expressed its belief that section 17709.02 gave the court discretion to allow a member of an LLC “who does not meet the requirements of contemporaneous and continuous ownership to maintain its action.”
The defendants filed a petition for writ of mandate, seeking immediate review by the Court of Appeal.
Court of Appeal: EBO lacked standing to maintain derivative claims
The Court of Appeal disagreed with the trial court, ruling that EBO lacked standing to maintain the derivative claims “because it is no longer a member of Taylor LLC.”
The court held: “section 17709.02 requires a party to have both contemporaneous and continuous membership” in an LLC to have standing to bring derivative claims and “the statute confers discretion on a court to excuse only the former requirement.”
Here, EBO met the contemporaneous membership requirement because it was a member of Taylor LLC from 2009 until 2019, and all of the challenged conduct occurred during that time period. However, EBO did not meet the continuous membership requirement because in 2019 it relinquished its membership interest in Taylor LLC to Patel and Ganey.
The court acknowledged that trial courts retain discretion under section 17709.02(a) to permit a derivative action by any “member” who does not meet the standing requirements. But that discretion is reserved only for a “member,” not simply a “plaintiff.” The court concluded: “These passages presuppose that the court’s discretion extends to current members of the LLC, not to plaintiffs who are no longer members.”
Thus, under the statute, a trial court might be able to excuse a current member’s failure to satisfy the contemporaneous membership requirement based on certain circumstances enumerated in the statute (e.g., when the plaintiff acquired the interest before there was disclosure of the defendant’s wrongdoing). But the statute does not allow a trial court to excuse a former member’s failure to satisfy the continuous membership requirement.
The Sirott opinion concluded by noting some potential wiggle room regarding an equitable exception to the continuous ownership requirement – for example, “if a merger itself is used to wrongfully deprive a plaintiff of standing, or if the merger is merely a reorganization that does not affect the plaintiff’s ownership interest.” The court noted an earlier opinion from 2009 in which the plaintiff had been “wrongfully deprived” of its membership interest.
Here, however, nothing suggested that EBO would be entitled to similar relief, as the complaint did not allege any wrongdoing in connection with EBO’s voluntary distribution of its interests in Taylor LLC to Patel and Ganey. The opinion left further consideration of that issue to the trial court.
Lesson
Under the Sirott opinion, in order to maintain a derivative action, a plaintiff generally must show both contemporaneous and continuous membership. The statutory motion allowing a trial court to excuse noncompliance applies only to the contemporaneous membership requirement.
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