In 2008, Vice Chancellor J. Travis Laster of the Delaware Court of Chancery — one of the many intellectual giants and gifted writers who’ve occupied seats on that bench — published an article in the Delaware Journal of Corporate Law entitled Goodbye to the Contemporaneous Ownership Requirement. The article argued that the contemporaneous ownership rule in shareholder derivative actions, embodied in DGCL Section 327 (“In any derivative suit instituted by a stockholder of a corporation, it shall be averred in the complaint that the plaintiff was a stockholder of the corporation at the time of the transaction of which such stockholder complains or that such stockholder’s stock thereafter devolved upon such stockholder by operation of law”) and likewise in New York’s BCL Section 626 (b), should be abolished as “unnecessary,” “incoherent,” “ill-suited to each of the purposes advanced to support it,” and “arbitrarily mandat[ing] the dismissal of potentially meritorious claims.”
At the risk of vastly over-simplifying VC Laster’s multi-pronged argument, the central point he made is that, as long as the derivative plaintiff is a shareholder upon commencing the action and for its duration, it’s meaningless whether the plaintiff owned shares at the time of the challenged corporate action because the claim belongs to the corporation and is being brought for the benefit of the corporation, not the shareholder.
In one of his subsequent opinions questioning the rule’s wisdom, Bamford v Penfold, L.P., VC Laster dropped an intriguing footnote referring to a “provocative article” published in 2010 by Professor of Law Lawrence Mitchell of The George Washington University entitled Gentleman’s Agreement: The Anti-Semitic Origins of Restrictions on Stockholder Litigation (available here). As the title suggests, Professor Mitchell’s thesis is that the statutory contemporaneous ownership rule and other restrictions on derivative actions including the security requirement for small shareholders, first enacted in New York in 1944 and in Delaware the following year, were promoted by the non-Jewish, corporate defense bar dominated by white-shoe law firms to stymie shareholder suits being brought by predominantly Jewish lawyers. From the footnote:
In 1944, the New York legislature adopted a suite of statutory limitations on derivative actions that included a security-for-expenses requirement and a contemporaneous ownership requirement. Professor Mitchell has argued that the legislation was influenced by the anti-Semitic prejudices of the predominantly non-Jewish defense bar and their reaction to the perceived prevalence with which predominantly Jewish lawyers represented plaintiffs in stockholder derivative actions challenging the corporate establishment. The New York initiative had widespread influence, as “[p]assage of the New York statute inspired a burst of heated attacks on the derivative suit as an abusive and corrupt device from supporters of business interests throughout the country.” Donna I. Dennis, Contrivance and Collusion: The Corporate Origins of Shareholder Derivative Litigation in the United States, 67 Rutgers U. L. Rev. 1479, 1520 (2015). Delaware notably did not adopt a security-for-expenses statute, but it seems likely that the 1945 enactment of Section 327 was spurred by the New York initiative.
Whatever its origins, VC Laster’s advocacy seeking to eliminate the contemporaneous ownership rule has not spurred its repeal by the Delaware legislature, hence Section 327 remains on the books. Which brings me to an interesting opinion handed down last week by Chancellor Kathaleen St. J. McCormick in SDF Funding LLC v Fry in which, after remarking that Section 327’s contemporaneous ownership requirement “is not universally beloved” and referring to VC Laster’s scholarship on the issue, she considered and ultimately rejected the argument of a putative derivative plaintiff who ran afoul of the rule, that he should be afforded “equitable standing” to prosecute the action.
In 1999, plaintiff Stuart Feldman acquired a minority stock interest in nominal defendant Flashpoint Technology, Inc. through his wholly-owned company, Chelsey Capital, LLC. In 2015, Feldman caused Chelsey to transfer its Flashpoint shares to another Feldman-owned entity, SDF Funding LLC. Beginning in 2015, Feldman made a series of Section 220 demands to inspect books and records concerning alleged related-party transactions involving Flashpoint’s founder/CEO, Stanley Fry, and his family members including loans, bonuses, lease payments, and usurped corporate opportunities. In 2017, Feldman and SDF as co-plaintiffs filed suit against the Frys and non-family members of Flashpoint’s board, alleging a series of derivative claims totaling $26 million, some of which involved transactions that predated 2015 when non-party Chelsey transferred its Flashpoint shares to SDF, and some post-dating the transfer.
The defendants moved for partial summary judgment based on lack of standing under Section 327’s contemporaneous ownership requirement. They argued that Feldman lacked standing altogether because he never owned Flashpoint stock directly and that SDF lacked standing insofar as it asserted derivative claims pre-dating 2015 when it became a shareholder. Plaintiffs essentially conceded both points under Section 327 but, in an attempt to salvage the pre-2015 claims, argued that under the doctrine of “equitable standing,” the court should “look through the LLCs” and grant derivative standing to Feldman personally as the sole owner of Chelsey and SDF.
The Court Declines to Grant Feldman Equitable Standing
Chancellor McCormick’s opinion denying Feldman equitable standing turned mainly on her reading of Schoon v Smith where the Delaware Supreme Court, in declining to extend the doctrine of equitable standing to allow a director to bring a derivative action against his fellow directors, held that the doctrine’s reach should be limited to “new exigencies” in order to “prevent a complete failure of justice on behalf of the corporation.” Acknowledging that the phrase “complete failure of justice” is “far from self-explanatory” and that “[t]he history of this court’s application of the equitable standing doctrine is no doubt inconsistent,” she framed the standard as follows:
The “complete failure of justice” standard focuses on the ability to access “judicial machinery” to remedy alleged harm to a corporation or its residual claimants. Delaware courts have extended the doctrine of equitable standing where alternative avenues of remedying harm to the corporation and its residual claimants are foreclosed. Delaware courts have declined to extend the doctrine of equitable standing where other avenues for invoking judicial machinery exist in theory because other potential plaintiffs would have standing to pursue the claims at issue.
. . . The injustice relevant to the “complete failure of justice” analysis looks to the rights of the corporation or residual claimants as a whole and not to any individual plaintiff. In that sense, the standard is best articulated in combination with the prepositional phrase added in Schoon: “on behalf of the corporation.” [Footnotes omitted.]
In Schoon, the court found a “complete failure of justice” absent and “no new exigencies that require an extension of equitable standing to Schoon, as a director” because the non-party stockholder who elected Schoon to the board had standing to pursue the same claims. Chancellor McCormick found Feldman similarly situated, writing:
This case, like Schoon, lacks any new exigency warranting an extension of the equitable standing doctrine. In Schoon, there were no structural impediments to the pursuit of derivative claims because stockholders had standing to enforce a corporate right. In this case, there are not structural impediments to the pursuit of derivative claims because stockholders other than Plaintiffs have standing to enforce a corporate right. At base, any ostensible injustice in declining Feldman standing would be to Feldman only. Accordingly, the court will not “look through” SDF to grant Feldman standing. [Footnotes omitted.]
Chancellor McCormick further commented that “[c]onsiderations unique to SDF’s status as a limited liability company” and the “core features” of LLCs including pass-through taxation, limited liability, and freedom of contract, “increase the court’s reluctance to extend the doctrine of equitable standing in this case,” adding:
As Feldman admitted in his deposition, Feldman embraced the benefits of the LLC as a business model. Thus, even if the court were to consider injustice to Feldman in declining Feldman standing, it is far from unjust to refuse Feldman’s request to cast aside the veils of Chelsey and SDF and allow him to serve as their equitable stand-in. [Footnote omitted.]
At least in New York, and I suspect in most jurisdictions, equitable standing is not a frequently litigated issue in shareholder derivative actions or other types of disputes among co-owners of closely held entities. Indeed, in the 14+ years of this blog’s existence, this is only the second post concerning equitable standing. The first was the Carlisle case in which none other than VC Laster, who also took a deep dive into Schoon, granted equitable standing to the plaintiff in an action seeking judicial dissolution of a deadlocked LLC.
The sole New York court decision from the modern era that I found concerning equitable standing in a shareholder derivative action, Swope v Quadra Realty Trust Inc., involved a plaintiff who lost his status as shareholder of a Maryland corporation as a result of a merger. The trial court granted the defendants’ dismissal motion, finding no equitable standing exception under Maryland law to that state’s contemporaneous ownership rule.
In the absence of binding New York case precedent, New York courts often seek guidance from the robust body of Delaware decisional law in matters involving shareholder suits and other types of disputes involving the internal affairs of corporations, LLCs, and partnerships. If and when a case is presented to a New York court in which a plaintiff, not among those expressly authorized to bring a derivative action under BCL Section 626 (b), seeks a grant of equitable standing, Chancellor McCormick’s decision in the SDF case likely will play a prominent role.