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Two recent rulings in the California and Delaware supreme courts erect significant barriers to derivative lawsuits by shareholders, as in the California suit, or company directors who do not own shares, in the Delaware dispute. The California Supreme Court held that shareholders lose standing to bring derivative actions against directors and officers if they sell or divest company stock � even when it is the involuntary result of a merger. Grosset v. Wenaas, No. S139285 (Calif.). In the Delaware case, the state Supreme Court holding bars company directors who are not company shareholders from bringing derivative lawsuits against the company, except to prevent a complete failure of justice. Schoon v. Smith, No. 1753-N (Del.). Derivative lawsuits are generally filed by shareholders, or disgruntled corporate officials, on behalf of the corporation. They name some of its officers and directors for alleged wrongdoing that may have harmed the company. It is the company that recovers any damages, rather than shareholders. High risk for lawyers The Feb. 14 California decision throws up a financial barrier for plaintiffs’ lawyers working on contingency bases because they are far less likely to take on an expensive derivative lawsuit only to have it cut short by a company merger, according to George Shohet, a Venice, Calif., solo practitioner who represented shareholder Sik-Lin Huang, who replaced Richard Grosset. “Cases as complex as these can bankrupt you in a New York second,” Shohet said. “It indicates that it is going to make it riskier for plaintiffs’ lawyers to take on cases, and that has nothing to do with the merits,” he said. Defense attorney Robert W. Brownlie, an attorney in DLA Piper’s San Diego office who represented JNI Corp. officers, said that companies targeted for derivative lawsuits are frequent merger targets as well because the stock price also has been hurt. “In my practice I see it 30% to 40% of the time,” he said. The California ruling upholds dismissal of a derivative shareholder action originally filed by Grosset on behalf of JNI Corp. in San Diego. The suit was filed against nine JNI directors and officers accused of alleged mismanagement in 2001 prior to JNI’s merger with Applied Micro Circuits Corp. The court found that a continuous ownership requirement in state law created “no inequity” if a merger cuts off even expensive, protracted litigation. An exception would be a merger subject to a fraud claim. California’s high court joins nine other state courts and two federal appeals courts that found similar continuous-ownership requirements in derivative actions. Only one state, North Carolina, has arguably not followed that lead. Alford v. Shaw, 398 S.E.2d 445 (N.C. 1990). The Feb. 12 Delaware decision, which upheld the Delaware Court of Chancery’s dismissal of a director’s lawsuit, said that the state Legislature sets the rules. “Although the Delaware General Assembly has the prerogative to confer standing upon directors by statute, it has chosen not to do so,” Justice Henry duPont Ridgely wrote. “Because a stockholder derivative action is available to redress any breach of fiduciary duty, we decline to extend the doctrine of equitable standing to allow a director to bring a similar action.” Independent director Richard W. Schoon filed the breach of fiduciary duty claim against Troy Corp., a privately held Delaware corporation that makes high-performance industrial materials. Schoon claimed that Troy’s CEO and chairman was able to “dominate and control the board” because his stock ownership gave him the right to elect four of five directors. Schoon received the fifth board seat from privately held Steel Investment Co., which owns the majority of Troy’s Series B shares. Derivative standing Most of Delaware corporate law is common law. The decision clarifies the rights and duties of directors of Delaware corporations, said Michael Maimone, a partner in the Wilmington, Del., office of Boston-based Edwards Angell Palmer & Dodge. Maimone and lawyers from Wilmington-based Morris James represented the CEO/chairman and three other directors and officers, who were sued derivatively on behalf of the corporation. “Directors do not need derivative standing because stockholders are fully capable of bringing derivative suits,” Maimone said. Although the opinion’s language leaves the door open for the rare instance when a suit filed by nonshareholder director might be the only path to justice, “that crack is pretty small,” said Morris James attorney Michael A. Weidinger. The “complete failure of justice” standard is extreme, but his client respects the court’s decision, said Schoon’s lawyer, J. Travis Laster, a founding partner of Abrams & Laster in Wilmington, Del. “We think as a matter of public policy [independent] directors should be able to sue,” Laster said. “[The standard] suggests that a little bit of injustice or significant injustice would be OK, as long as there’s not a complete failure of justice.”

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