California limited liability company disputes | Courtroom war stories and lessons learned

LLC Derivative Claims — Sometimes It’s “Now or Never”

One substantial LLC membership right in California (and most other states) is the ability of members to file a “derivative” lawsuit.

If the LLC has suffered harm, but the LLC fails to sue (due to managerial inaction, indifference, or even culpability), a member can sue derivatively on behalf of the LLC.  A successful derivative claim results in recovery to the LLC, which usually leads to indirect recovery for its members through distributions or more valuable membership interests.

As with all other claims, however, a derivative claim must be brought timely.  Usually this means paying attention to any applicable statute of limitations, and filing the lawsuit before the limitations period expires.  But the “compulsory cross-complaint” rule can also present timing problems, as illustrated by a recent opinion from California’s Second Appellate District — Heshejin v. Rostami.

Facts: a tale of two lawsuits

According to the complaint, American Logistics International, LLC (ALI) and American Investment Group, LLC (AIG) formed a joint venture for the creation of a cold storage and fulfillment business, with capital raised through a combination of ALI’s EB-5 immigrant investors and a contribution from AIG.  Once financing became imperiled due to the federal immigration authorities’ denial of visa applications of many of ALI’s EB-5 investors, certain principals of AIG and related affiliates secretly signed documents restructuring the joint venture in a manner that would benefit AIG while divesting ALI of all benefits of the joint venture.

In the lawsuit at hand, plaintiffs (various individuals and trusts holding interests relating to ALI) filed derivative claims on behalf of ALI against AIG arising from the joint venture, including fraud, breach of fiduciary duty, and other claims.

But there had been a previous lawsuit in 2017 between ALI and AIG.  In that prior lawsuit, AIG sued ALI asserting claims arising from their joint venture relationship.  ALI’s manager and attorney filed an answer to the complaint, but failed to file a cross-complaint against AIG for its own joint venture-related claims, and did not disclose the lawsuit to ALI’s stakeholders.

In the current lawsuit, AIG filed a demurrer, arguing that ALI’s claims were barred by ALI’s failure to file a cross-complaint in the prior lawsuit.

Trial court: derivative claims dismissed due to compulsory cross-complaint rule

The trial court sustained AIG’s demurrer and dismissed the lawsuit.

The court held that the plaintiffs’ derivative claims on behalf of ALI were barred by the compulsory cross-complaint rule because ALI failed to assert those claims in a cross-complaint in the prior action.

Court of Appeal: affirmed

The Court of Appeal affirmed the trial court’s judgment based on the compulsory cross-complaint rule in Code of Civil Procedure section 426.30.

Under section 426.30(a), “if a party against whom a complaint has been filed and served fails to allege in a cross-complaint any related cause of action which (at the time of serving his answer to the complaint) he has against the plaintiff, such party may not thereafter in any other action assert against the plaintiff the related cause of action not pleaded.”  The rule “is designed to prevent piecemeal litigation.”

The plaintiffs tried to argue that section 426.30 did not apply to their lawsuit because they — as individuals — were not defendants in the prior action.  The court rejected that argument, holding that ALI was a defendant to the prior action but failed to file a cross-complaint, and the claims in the new action were asserted derivatively on behalf of ALI.

The court held:

Because ALI is barred from asserting the related causes of action against AIG in this action, so are plaintiffs.  A derivative cause of action belongs to the corporation, and the corporation is the true plaintiff. … Because the right of action belongs to the corporation, not its shareholders or members, it may be forfeited, waived, or adjudicated by the direct actions of the corporation.

Lesson

If a defendant has potential cross-claims relating to the plaintiff’s complaint, they must be asserted in that action through a cross-complaint under the compulsory cross-complaint rule.  It’s “now or never.”

Here, the court acknowledged that the rule might lead to inequitable results where an LLC’s members might not even be aware of the first lawsuit, due to manager neglect or misdirection.  But the compulsory cross-complaint rule still applied, because it would be equally unfair to AIG to allow the plaintiffs to assert claims that ALI failed to assert by a compulsory cross-complaint in the prior action, subjecting AIG to the type of piecemeal litigation that section 426.30 was designed to prevent.

This also highlights the critical importance for LLC members to ensure that the LLC’s manager is competent and trustworthy, and will keep the members informed regarding any pending lawsuits involving the LLC that might impact the members’ interests.