More on the “Continuous Ownership” Requirement for LLC Derivative Claim Standing
If an LLC has been harmed but the LLC’s management fails to act to pursue a remedy, a member of the LLC can file a derivative claim on the LLC’s behalf. To have standing to assert a derivative claim, a plaintiff must prove both contemporaneous ownership (owning a membership interest in the LLC at the time of the challenged transaction or succeeding to the interest of such a member) and continuous ownership (owning a membership in the LLC throughout the litigation of the derivative claim).
The rationale for the continuous ownership requirement, expressed in terms of a corporate shareholder derivative suit, was explained in one case as follows:
Because a derivative claim does not belong to the stockholder asserting it, standing to maintain such a claim is justified only by the stockholder relationship and the indirect benefits made possible thereby, which furnish the stockholder with an interest and incentive to seek redress for injury to the corporation. Once this relationship ceases to exist, the derivative plaintiff lacks standing because he or she no longer has a financial interest in any recovery pursued for the benefit of the corporation.
A case recently filed by California’s First Appellate District — EBO Properties North, LLC v. Sirott — sheds further light on the “continuous ownership” requirement. While the EBO opinion is unpublished and therefore not binding precedent, it still provides a useful guidepost.
Facts: a doctor LLC brawl
The opinion recited the following facts:
The main LLC at issue — on whose behalf derivative claims were ultimately asserted — was 400 Taylor Holdings, LLC. Taylor Holdings owned a medical office building in Pleasant Hill, California.
In 2008, Taylor Holdings was composed of the following members: EBO Properties North, LLC (“EBO”) (50%); Matthew Sirott (25%); and Robert Robles (25%). EBO was owned half by Bimal Patel and half by John Ganey — doctors who belonged to the same medical practice, East Bay Medical Oncology/Hematology Medical Associates, Inc. (“EBMOH”). Sirott and Robles were doctors in a different medical practice, Diablo Valley Oncology and Hematology Group (“DVO”).
Taylor Holdings leased space in its medical office building to another medical group that was owned partially by Sirott and Robles. In 2016, Patel proposed that Taylor Holdings lease a vacant space in the medical office building to EBMOH – the group in which Patel and Ganey practiced. Sirott refused to entertain the proposal. EBMOH was forced to seek another space to lease. The vacant space was eventually leased to DVO – the group to which Sirott and Robles belonged, allegedly on less advantageous terms to Taylor Holdings than the proposed lease to EBMOH.
Patel, Ganey, and EBO (Plaintiffs) sued Sirott and Robles. The claims included a derivative claim by EBO asserted on behalf of Taylor Holdings, alleging Sirott and Robles breached fiduciary duties they owed to Taylor Holdings in refusing to approve the lease.
The Transfer Agreements
During the litigation the parties considered an offer to sell Taylor Holdings’ medical building. In an effort to minimize taxes on gains, they structured the deal as a “drop and swap” in which first the ownership of the building would be conveyed from Taylor Holdings to the individual beneficial owners and held that way for a period of time before closing the sale to the third party. (See prior post here for more on the “drop and swap.”)
To facilitate the drop and swap, the parties entered into a series of agreements in June 2019:
- Under the EBO Distribution Agreement, EBO transferred its 50% membership interest in Taylor Holdings to EBO’s beneficial owners, Patel and Ganey. As such, Patel and Ganey each became 25% owners of Taylor Holdings. The agreement provided that EBO was not yet dissolved, and the agreement was expressly conditioned on written consents from Taylor Holdings and on all parties’ signing of the Taylor Holdings Distribution Agreement.
- Under the Taylor Holdings Distribution Agreement, Taylor Holdings distributed its ownership of the medical office building equally to Patel, Ganey, Sirott (his trust), and Robles. The agreement was expressly conditioned on EBO’s adoption of the EBO Distribution Agreement.
- The parties also entered into a Tenancy in Common Agreement governing their management of the medical office building until they closed the sale to the third party.
- Last, the parties entered into a No Prejudice Agreement, which clarified that the purpose of the Transfer Agreements was, to put it simply, to provide a path for the parties to cease their relationship by facilitating a sale of the property via the tax-minimizing drop and swap process. The agreement stated that the transaction “will not prejudice any Party with respect to any claims or defenses such Party may have (or claim to have) in conjunction” with the litigation, “with all Parties reserving all rights and remedies[.]”
As a result of the Transfer Agreements, as of June 2019 EBO no longer held a membership interest in Taylor Holdings. Thus, the derivative standing problem arose: at the time of the alleged harm to Taylor Holdings (the 2016 lease refusal), EBO was a member of Taylor Holdings, while Patel and Ganey individually were not. As such, Patel and Ganey could not satisfy the contemporaneous ownership requirement; only EBO could. But by June 2019, EBO was no longer a member of Taylor Holdings, while Patel and Ganey were.
Prior Appeal
A year and a half after the Transfer Agreements, Defendants challenged EBO’s standing to maintain its derivative claims on behalf of Taylor Holdings. Defendants argued that EBO lacked standing because it was no longer a member of Taylor Holdings and therefore could not meet the continuous ownership requirement set forth in Corporations Code section 17709.02.
The trial court allowed EBO to file a motion for standing under section 17709.02(a)(1). EBO did so, arguing that it would be inequitable for the court to rule that EBO lacked standing. The trial court granted the motion in part, allowing EBO to maintain the derivative claims.
Defendants sought writ relief from the Court of Appeal. In an opinion addressed in a prior post here, the Court of Appeal held that the statutory provision on which EBO’s motion for standing relied (section 17709.02(a)(1)) pertains only to the contemporaneous ownership requirement. But the opinion also recognized that equitable considerations could provide an exception to the continuous ownership requirement. The Court of Appeal left to the trial court the determination of whether equitable considerations provided an exception to the continuous ownership requirement under the facts of the case.
Trial court after remand: summary judgement for Defendants and against EBO
Defendants moved for summary judgment, again arguing that EBO lacked standing to assert the derivative claim on behalf of Taylor Holdings because it could not satisfy the continuous ownership requirement. Defendants essentially argued that they played no role in EBO’s decision to transfer its 50% membership interest in Taylor Holdings to EBO’s beneficial owners, Patel and Ganey.
The trial court granted the motion. The court held that EBO did not show any equitable considerations supporting an exception to the continuous ownership requirement because it failed to show that Defendants “engaged in any wrongdoing involving EBO’s distribution of its interest” in Taylor Holdings to Patel and Ganey.
EBO appealed.
Court of Appeal: reversed; facts showed equitable considerations justifying an exception to the continuous ownership requirement
The Court of Appeal reversed, holding that the facts showed “the continuous ownership requirement should be equitably relaxed, allowing EBO to proceed with the derivative claims.”
The court first confirmed that while the specific equitable exception factors listed in section 17709.02(a)(1) applied only to the contemporaneous ownership requirement, under controlling authority from the California Supreme Court equitable considerations could also provide an exception to the continuous ownership requirement where “a plaintiff is being wrongfully deprived of, or not actually losing, its interest in the” business.
The court rejected Defendants’ argument that standing was “jurisdictional” and therefore must be strictly construed. “Thus, as we see it, the ‘jurisdictional’ nature of standing in this context is akin to the ‘jurisdictional’ nature of statutes of limitations or other statutory deadlines, most of which are subject to equitable exceptions such as equitable tolling and equitable estoppel. … The same is true of the two statutory requirements a plaintiff must ordinarily meet to pursue a derivative claim on behalf of a limited liability company — both can be excused where there is an equitable basis for doing so.”
The court held that the trial court took an unduly narrow view of what types of equitable circumstances would justify an exception to the continuous ownership requirement by requiring EBO to show that it lost its membership interest due to Defendants’ wrongdoing. The court held: “But this is clearly not the only way an equitable basis for excusing the continuous ownership requirement can be established.”
Here, the equitable basis for excusing the continuous ownership requirement was demonstrated by the evidence of the parties’ Transfer Agreements. “Specifically, we agree with EBO that what happened here was effectively a reorganization which kept the same interested parties involved in Taylor Holdings, from the time of the challenged lease decision throughout this litigation.”
Normally, a derivative plaintiff who cannot satisfy the continuous ownership requirement will lack standing because they have no “dog in the hunt” as to what happens to the LLC. But here, “not only do Patel and Ganey indisputably have a ‘dog in the hunt,’ they have an identical dog in the hunt—i.e., collectively a 50 percent interest in Taylor Holdings and individually a 50 percent interest in EBO.”
The court summarized:
In short, the reorganization—from EBO to Patel and Ganey—had zero significance in terms of who effectively owned, and actually participated in, the limited liability company. For purposes of who can appropriately prosecute a derivative claim, it is a distinction without a difference. Thus, the circumstances that occurred here are wholly unlike those that occur in the larger corporate environment, where loss of shares generally means loss of interest in the economic wellbeing of the company.
The court concluded: “we have no difficulty concluding the reorganization here was of a kind creating equitable considerations calling for EBO to be excused from the continuous ownership requirement.”
Lesson
Under the unpublished EBO opinion, equitable considerations can warrant excusing the continuous ownership requirement for LLC derivative actions.