Derivative Action Plaintiff Loses Standing--And Action Must Be Dismissed--If It Sells Its Ownership Interest

On December 6, 2017, the Second Department issued a decision in Jacobs v. Cartalemi, 2017 NY Slip Op. 08506, holding that a derivative action plaintiff loses standing--and the action must be dismissed--if it sells it ownership stake in the company on behalf of which the plaintiff is suing, explaining:

Members of a limited liability company (LLC) may bring derivative suits on the LLC's behalf. In a derivative suit, the remedy sought is for wrong done to the corporation; the primary cause of action belongs to the corporation; and recovery must enure to the benefit of the corporation. In the context of a corporation, the standing of the shareholder is based on the fact that he or she is defending his or her own interests as well as those of the corporation. Where the plaintiff voluntarily disposes of the stock, his or her rights as a shareholder cease, and his or her interest in the litigation is terminated. Being a stranger to the corporation, the former stockowner lacks standing to institute or continue the suit. The same is true in the context of an LLC. In order to maintain a derivative cause of action, a plaintiff must be a member of the LLC. Thus, the Supreme Court properly held that, once the plaintiff withdrew from WIC, he lost standing to maintain any derivative causes of action on behalf of the company, notwithstanding his possible right to a future payment for the value of his membership interest upon his withdrawal.

In light of the plaintiff's lack of standing to maintain derivative causes of action on behalf of WIC, the Supreme Court properly granted those branches of the defendants' motion which were for summary judgment dismissing the second, fourth, and fifth causes of action. Allegations of mismanagement or diversion of assets by officers or directors to their own enrichment, without more, plead a wrong to the corporation only, for which a shareholder may sue derivatively but not individually. The subject causes of action, which sought damages for breach of fiduciary duty and waste, and the imposition of a constructive trust, respectively, were all based on alleged wrongs that were committed against WIC and not the plaintiff individually.

For those same reasons, the Supreme Court should have granted that branch of the defendants' motion which was for summary judgment dismissing the first cause of action, which sought an accounting. The right to an accounting is premised upon the existence of a confidential or fiduciary relationship and a breach of the duty imposed by that relationship respecting property in which the party seeking the accounting has an interest. Here, the plaintiff's right to an accounting was based on his ability to prove that Cartalemi breached his fiduciary duty to WIC, a claim that is entirely derivative and which the plaintiff, having withdrawn as a member from WIC, no longer had standing to maintain.

(Internal quotations and citations omitted).

This decision touches on two areas of commercial litigation that are a significant part of our practice: derivative actions (where a shareholder brings an action on behalf of a corporation) and business divorce (a break-up between the owners of a closely-held business). Contact Schlam Stone & Dolan partner John Lundin at jlundin@schlamstone.com if you or a client have questions regarding either of these issues.