Shareholder Loses Standing to Maintain Derivative Action After Merger

In Villari v. Mozilo (2012) 208 Cal. App. 4th 1470, the court held that under Delaware law a shareholder who was a plaintiff in a shareholder derivative action lost standing to maintain that action once a merger resulted in the shareholder ceasing to be a shareholder.

A shareholder filed a shareholder derivative complaint in August 2007 on behalf of Countrywide against several of its officers and directors and against Countrywide as a nominal defendant. Countrywide was acquired via merger by Bank of America in July 2008. Because both corporations were Delaware corporations, the court applied Delaware law under the “internal affairs” doctrine, which it said in a footnote was codified by Corporations Code § 2116. The application of Delaware law was not at issue.

Delaware has a “continuous ownership” rule, which requires a plaintiff in a shareholder derivative action to retain stock ownership for the duration of the litigation. A plaintiff who ceases to be a shareholder as a result of a merger, or for any other reason, loses standing to maintain the derivative action. The derivative claims become the property of the surviving corporation, which then has the sole right and standing to prosecute the action. The Delaware Supreme Court has stated in several opinions, however, that a former shareholder will retain standing to maintain a derivative action despite a merger if the sole purpose of the merger was to eliminate potential derivative claims. This is known as the fraud exception to the continuous ownership rule.

The trial court concluded, pursuant to the continuous ownership rule, that plaintiff had no standing to maintain shareholder derivative claims on behalf of Countrywide after its acquisition by Bank of America and merger into another corporation. This was based in part on Lewis v. Anderson (Del. 1984) 477 A.2d 1040, in which the Delaware Supreme Court that in the merger context there are two exceptions to the rule that only a current shareholder has standing to maintain an action that is derivative in nature: first, if the merger itself is the subject of a claim of fraud, being perpetrated merely to deprive shareholders of the standing to bring a derivative action; or second, if the merger is in reality merely a reorganization which does not affect plaintiff’s ownership in the business enterprise.

Plaintiff nonetheless contended that he had adequately alleged a factual basis for application of the fraud exception based on dicta contained in the opinion of the Delaware Supreme Court in Arkansas Teacher Retirement System v. Caiafa (Del. 2010) 996 A.2d 321.

Plaintiff contended that Arkansas Teacher broadened the fraud exception to Delaware’s continuous ownership rule so that the fraud exception would now apply not only where the sole purpose of a merger was to deprive shareholders of standing to maintain a derivative action, but also where the directors’ fraudulent conduct and breach of fiduciary duty prior to a merger impaired the corporation’s financial condition to such an extent that a merger became a practical necessity.

In the court’s view, that reading of Arkansas Teacher was untenable and contrary to well-settled Delaware law, and it affirmed the trial court’s dismissal.

Comment

California follows the “continuous ownership” rule, and although it does not have as well developed a body of case law on when a merger deprives a shareholder of standing, it is not likely that the result would have been different under California law.

What is odd is the court’s statement that the “internal affairs” doctrine was codified by Corporations Code § 2116. That section applies the law of the state of incorporation to determine the liablity of directors in certain instances. At best, it is only a partial codification of the judge-made internal affairs doctrine.