Monday, April 21, 2008

Important decision for small business

In Jennings v. Kay Jennings Family Limited Partnership, issued last week, the Virginia Supreme Court took on for the first time the meaning of the requirements to bring a derivative action under Va. Code 50-73.62.

That section says: "A limited partner may bring an action in the right of a limited partnership to recover a judgment in its favor to the same extent that a stockholder may bring an action for a derivative suit under the Stock Corporation Act, Chapter 9 (§ 13.1-601 et seq.) of Title 13.1. Such action may be brought if general partners with authority to do so have refused to bring the action or if an effort to cause those general partners to bring the action is not likely to succeed. The derivative action may not be maintained if it appears that the plaintiff does not fairly and adequately represent the interests of the limited partners and the partnership in enforcing the right of the partnership."

In the Corporation Act, the relevant statute, Va. Code 13.1-672.1, provides: "A. A shareholder shall not commence or maintain a derivative proceeding unless the shareholder:

1. Was a shareholder of the corporation at the time of the act or omission complained of;

2. Became a shareholder through transfer by operation of law from one who was a shareholder at that time; or

3. Became a shareholder before public disclosure and without knowledge of the act or omission complained of; and

4. Fairly and adequately represents the interests of the corporation in enforcing the right of the corporation."

At the request of both sides, the Court in Jennings looked to the discussion of the federal rule dealing with derivative actions, FRCP 23.1, as discussed in Davis v. Comed, Inc., 619 F.2d 588 (6th Cir. 1980), and like cases - and so it did, which in itself is interesting.

The trial court's decision to deny standing was affirmed, because of the would-be plaintiff's adverse economic interests, even though not directly related to the claim at issue, and because the other owners opposed the litigation, even though the other owners were few. The Supreme Court rejected the plaintiff/appellant's arguments against the way these factors were analyzed.

I think this decision will apply to corporation cases under Va. Code 13.1-672.1, although that Code section contains an additional substantive element, that the shareholder "[b]ecame a shareholder before public disclosure and without knowledge of the act or omission complained of." This provision is not in FRCP 23.1, and not to my knowledge in any version of the Model Business Corporation Act.

The significance of this decision, viewed through the prism of the latest cases where I am dealing with these issues, is that the shareholder who breaks off to go and compete against his old company should not be allowed to use derivative actions as a weapon of competition. The innocents who are not out stealing the business from the company would not be similarly disqualified from standing to proceed with the derivative action.

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