Derivative Actions In Washington
The derivative action is the source of increasing consternation throughout the legal industry. Today’s post brings a little insight into the fundamentals of a derivative action in Washington.
What is it?
A derivative action permits a shareholder or member the right to sue third parties on behalf of the entity. The purpose behind the derivative suit is described by former Washington State Supreme Court Justice Fred Dore:
Ordinarily, a shareholder cannot sue for wrongs done to a corporation, because the corporation is viewed as a separate entity, and the shareholder’s interest is too remote to meet the standing requirements. However, because of the possibility of abuse by the officers and directors of a corporation, a narrow exception has been created for shareholders to bring derivative suits on behalf of the corporation.
Gustafson v. Gustafson, 47 Wn. App. 272, 276, 734 P.2d 949 (1987).
Suppose an LLC owns real property and leases that real property to a tenant that is owned by one of the members. When the tenant defaults in the lease, the LLC may be reluctant to sue the tenant / member, but those members of the LLC that are independent of the tenant have a sincere interest in enforcing the lease. As a result, the derivative action gives the independent members of the LLC the right to cause the LLC to sue the tenant to enforce the lease.
Statutory Creation
As Justice Dore notes, the “narrow exception” known as the derivative action is, in fact, created by statute. Article X of Washington’s LLC Act (RCW 25.15.386-.401) authorizes derivative actions in Washington LLCs, and RCW 23B.07.400 of Washington’s Business Corporations Act authorizes derivative actions in Washington corporations.
In the same manner, when business entity statutes are silent as to the right to assert a derivative action, there is no right at all. Courts interpreted the Washington Nonprofit Corporations Act to bar derivative actions by nonprofit corporation members as the Act is silent on the topic of derivative actions. See Mohandessi v. Urban Venture LLC, 13 Wn. App. 2d 681, 697, 468 P.3d 622 (2020) (“The WNCA … does not authorize members to bring derivative actions on behalf of the nonprofit corporation against third parties.”); see also Lundberg ex rel. Orient Found. v. Coleman, 115 Wn. App. 172, 176, 60 P.3d 595 (2002) (rejecting plaintiffs’ argument that nonprofit members have an equitable common law right to bring derivative actions).
Requirements
While statutes create a right to bring a derivative action, there are still certain threshold requirements necessary to sustain such an action. Standing is one of these most important aspects. The Washington Supreme Court noted that “[s]tanding to bring a stockholder derivative claim requires a proprietary interest in the corporation whose right is asserted.” Haberman v. Wash. Pub. Power Supply Sys., 109 Wn.2d 107, 149, 744 P.2d 254 (1987). Also, in a corporate setting, a plaintiff’s interest as a shareholder must continue through the litigation. Sound Infiniti, Inc. v. Snyder, 145 Wn. App. 333, 350, 186 P.3d 1107 (2008), aff’d, 169 Wn.2d 199, 237 P.3d 241 (2010) (for an in-depth discussion of this case, see here). The same rule applies to members of LLCs, where a plaintiff’s interest as a member must continue through the litigation. Northwest Wholesale, Inc. v. Pac Organic Fruit, LLC, 184 Wn.2d 176, 185-186, 357 P.3d 650 (2015) (holding that under Washington’s LLC Act, a member who petitioned for bankruptcy lost his member status upon petitioning and therefore forfeited any right to bring a derivative action on behalf of the LLC).
Washington Superior Court Rule 23.1 also adds (and supplements) to the rules discussed in the cases:
In a derivative action brought by one or more shareholders or members to enforce a right of a corporation or of an unincorporated association, the corporation or association having failed to enforce a right which may properly be asserted by it, the complaint shall be verified and shall allege (a) that the plaintiff was a shareholder or member at the time of the transaction of which the plaintiff complains or that the plaintiff’s share or membership thereafter devolved on the plaintiff by operation of law, and (b) that the action is not a collusive one to confer jurisdiction on a court of this state which it would not otherwise have. The complaint shall also allege with particularity the efforts, if any, made by the plaintiff to obtain the action the plaintiff desires from the directors or comparable authority and, if necessary, from the shareholders or members, and the reasons for the plaintiff’s failure to obtain the action or for not making the effort. The derivative action may not be maintained if it appears that the plaintiff does not fairly and adequately represent the interests of the shareholders or members similarly situated in enforcing the right of the corporation or association. The action shall not be dismissed or compromised without the approval of the court, and notice of the proposed dismissal or compromise shall be given to shareholders or members in such manner as the court directs.
Interestingly, a person holding only a transferable interest in an LLC does not have the right to sue derivatively, because that person is not a member.
Derivative Suits and LLCs
Some have critiqued the right to sue derivatively in the context of LLCs. One of the most prominent LLC scholars, Larry Ribstein, once criticized derivative actions for LLCs as “an example of lawmakers applying rules across business entities without adequately thinking through which rules belong in a coherent business association statute.” See here. Ribstein argued that derivative suits were meant for shareholders of publicly traded corporations, not closely held LLCs. Nevertheless, the right to sue derivatively is an important right held by shareholder / members.
Tune in to this blog next Wednesday at noon for a discussion on some of the pre-requisites and procedural requirements to follow in order to bring a derivative action.