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    The Lawletter Blog

    CORPORATIONS:  The Nature of a Shareholder-Derivative Action

    Posted by Paul A. Ferrer on Tue, Mar 5, 2024 @ 13:03 PM

    The Lawletter Vol. 49 No. 1

    Paul Ferrer—Senior Attorney

                    The Virginia Supreme Court’s July 2023 decision in Monroe v. Monroe, 889 S.E.2d 646 (Va. 2023), turned on the trial court’s lack of jurisdiction to enter a sanctions order more than 21 days after the trial court had entered its final order dismissing the case. See Va. S. Ct. R. 1:1. For corporate attorneys, however, the case is more notable for Justice Kelsey’s admirably lucid discussion of the nature of a shareholder-derivative action and the status of the plaintiff seeking to maintain such an action.

                Lisa Monroe and Joseph Monroe were the married co-owners of MEPCO Materials, Inc., with 51% and 49% ownership interests, respectively. A week after Joseph filed for divorce, he, as the sole director at that time, caused MEPCO to file a civil action against Lisa for conversion and breach of fiduciary duty, alleging that she had used MEPCO funds for personal use. The following year, Joseph resigned from his position. Because he could no longer speak directly for MEPCO, he sought to convert the action against Lisa—which alleged classic claims that devolved to the benefit of the corporation and both of its shareholders, and not just to Joseph individually—to a shareholder-derivative action, that is, “an equitable proceeding in which a shareholder asserts, on behalf of the corporation, a claim that belongs to the corporation rather than the shareholder.” Monroe, 889 S.E.2d at 650 (quoting Little v. Cooke, 274 Va. 697, 709, 652 S.E.2d 129, 136 (2007)). Under the Virginia Stock Corporation Act, however, a shareholder “shall not commence or maintain a derivative proceeding unless the shareholder,” among other things, “[f]airly and adequately represents the interests of the corporation in enforcing the right of the corporation.” Va. Code Ann. § 13.1-672.1(A)(3). Justice Kelsey referred to this as a “statutory standing requirement that the putative representative must satisfy from the beginning to the end of the derivative action.” Monroe, 889 S.E.2d at 650.

                A shareholder with standing “can still lose on the merits by failing to prove that the corporation had a valid claim against the allegedly liable insider.” Id. But things can get worse for the shareholder (or his attorney) than just losing the derivative action. If it is determined that the shareholder “commenced or maintained” the derivative action “arbitrarily, vexatiously, or not in good faith,” then “the plaintiff or the plaintiff’s attorney [may be ordered] to pay the corporation’s or any defendant’s expenses incurred in defending the proceeding.” Va. Code Ann. § 13.1-672.5(2). In that event, the shareholder effectively loses his status, retroactively, as the corporation’s representative for purposes of maintaining the derivative action. As Justice Kelsey explained it:

    In a shareholder-derivative action, the shareholder initiating the action is seeking judicial approval of his representative capacity, not relying upon a previous recognition of such capacity by court order, statute, or common law. The typical caption of a complaint filed by a shareholder in a derivative action may be optimistically styled, “John Doe, Derivatively on behalf of XYZ, Inc.” But in substance it really means, “John Doe, Individually,” seeking a judicial declaration that he be allowed to represent XYZ, Inc. against its will and thereby be deemed to appear in court as “John Doe, Derivatively on behalf of XYZ, Inc.” If the shareholder succeeds in acquiring his sought-after representative status, courts in derivative actions will treat him as a “nominal plaintiff” because he is there in name only. But if he fails to persuade the court that he can fairly and competently represent the corporation, the shareholder never becomes a nominal plaintiff. He remains simply an unsuccessful shareholder-plaintiff in his individual capacity.

    Monroe, 889 S.E.2d at 651. Summing up, Justice Kelsey stated that “a shareholder initiating a derivative action, no matter the caption of the complaint, does so as a putative, not actual, representative of the corporation.” Id. The shareholder becomes a “de jure representative” of the corporation by establishing that he fairly and adequately represents the corporation’s interests, but he forfeits that status if and when the court concludes that he commenced or maintained the action arbitrarily, vexatiously, or not in good faith. Id.

                That is precisely what happened to Joseph, when the trial court ruled that he filed the action against Lisa for his own benefit rather than to benefit the corporation. However, the trial court entered its order awarding attorney’s fees against Joseph more than three months after the final order dismissing the case, well outside of the 21-day window in which a trial court maintains jurisdiction under Virginia law. Accordingly, the Virginia Supreme Court reversed the order granting sanctions. Id. at 653. While that it is a standard application of Virginia law, the case remains notable for Justice Kelsey’s discussion of shareholder-derivative actions, which is a model for judicial writing.

    Topics: corporations, shareholder dirivative action

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