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Can Derivative Claims be Pursued for a Dissolved or Cancelled LLC?

Today’s post focuses on a thorny issue arising from the LLC Jungle — can derivative claims be pursued on behalf of a dissolved or cancelled LLC?

In short, the answer is “yes” — but there are nuances to be aware of.

What is a derivative claim?

A derivative claim is a claim brought by an LLC member (or a stakeholder of any other type of entity, such as a corporation or partnership) attempting to recover for harm inflicted directly on the entity.  A typical derivative claim might involve misappropriation or diversion of the entity’s assets.  While the misappropriation might cause indirect harm to the entity’s stakeholders, the direct and primary harm is to the entity itself.

To bring a derivative claim on behalf of an LLC, the member must first usually establish that he/she either asked the LLC (through its manager) to institute the claim itself, or that such a demand would be “futile.”

Recovery on a derivative claim goes to the entity, and then potentially flows to the stakeholders.

California law allows derivative claims to be pursued for a dissolved entity

Under well-established California law, the dissolution of an entity does not necessarily defeat a stakeholder’s ability to pursue a derivative claim.  As long as the plaintiff maintains an ownership interest in the entity, a derivative claim is usually possible.

Courts have rejected the argument that dissolution automatically eliminates the stakeholders’ interest in the entity.  Courts have noted that even after dissolution, the entity continues its legal existence for certain limited purposes, including prosecuting and defending lawsuits.  Entity stakeholders, likewise, continue to exist and have rights and liabilities with respect to the dissolved entity.  See, e.g., Favila v. Katten Muchin Rosenman LLP.

California’s Revised Uniform LLC Act also acknowledges that after dissolution and cancellation, the LLC continues to exist for some purposes, including winding up and being sued.  (See California Corporations Code section 17707.06 and 17707.07.)

If the entity has been not just dissolved, but cancelled, additional measures might be required

When an LLC has not just been dissolved, but also cancelled and wound up (the so-called “last stop” in the entity’s lifespan), an additional step might be required for a derivative action.

In a recent unpublished (non-precedential) opinion filed by the New York Supreme Court — Hopkins v. Ackerman — the court dismissed the plaintiffs’ derivative claims asserted on behalf of a dissolved and cancelled LLC.  The court held that the plaintiffs lacked standing to assert the derivative claim because they never tried to “nullify or revoke” the cancellation on the grounds that the cancellation was improper.

That holding is consistent with several other opinions issued by New York courts.  One court put it this way: “Plaintiff was required to bring her derivative claims … after or in conjunction with a successful action seeking the nullification of the certificate of cancellation[.]”  (See Otto v. Otto.)

Delaware courts have ruled similarly.  (See, e.g., Metro Communication Corp. BVI v. Advanced Mobilecomm Technologies Inc.; see also Matthew v. Laudamiel [unpublished – holding after dissolution and cancellation of LLC, derivative claims can be pursued “after reviving the LLC by obtaining revocation of its certificate of cancellation“].)

While California law has apparently not squarely addressed the issue, it’s hard to imagine that California courts would not apply the same rationale as the New York and Delaware cases.  Under California Government Code section 12261, a court can reinstate a wrongfully cancelled LLC when the certificate of cancellation contains “materially false and fraudulent information[.]”

After reinstatement of a wrongfully cancelled LLC, pursuant to California Corporations Code section 17704.07(d), the party who wrongfully cancelled the entity (usually its manager) will be rendered an economic interest holder only, with no rights to participate in management of the LLC.

Lesson

Dissolution of an LLC doesn’t necessarily prevent a member from asserting a derivative claim on behalf of the LLC.

When an LLC has been dissolved and cancelled, a member seeking to assert a derivative claim might also have to pursue nullification of the certificate of cancellation and reinstatement of the LLC.

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