24 Jun Decision Reaffirms California Law Regarding Derivative Litigation Conflicts
The decision in Ontiveros v. Constable, D066412 (Cal. Ct. App. 4th Dist. Feb. 18, 2016), which was ordered published on March 14, 2016, reaffirms prior California case law concerning the inherent conflict in representing a corporation and a shareholder in a shareholder derivative lawsuit. The plaintiff is a 40% shareholder in a closely held corporation. Concerned about the management of the company, plaintiff sued the 60% shareholder derivatively for various contract and tort claims as well as the corporation seeking involuntary dissolution. Counsel for the corporation appeared in the lawsuit on behalf of both the company and the defendant shareholder. The plaintiff filed a motion to disqualify counsel from representing both the defendant shareholder and the company, which was granted by the trial court.
On appeal, the court affirmed the disqualification as to the company, reasoning that well-established California law precluded counsel from representing both a company and a shareholder against derivative claims sounding in fraud, The court reversed with respect to counsel’s representation of the shareholder adopting the reasoning in prior decisions which recognize that in small companies, there is often little distinction between the company and the managing shareholder/member when it comes to counsel’s duty of confidentiality. As the defendant shareholder was “undeniably the sole repository of that information,” the court reasoned that permitting corporate counsel to continue in the representation of the shareholder did not impact counsel’s duty of confidentiality to the company.
In short, California law recognizes that the technical distinction in small companies between the legal entity and its managing shareholder or member is immaterial when it comes to corporate counsel’s duty of confidentiality to the company. In reality, the managing shareholder or member is the company when it comes to interacting with counsel. Thus, while California law precludes corporate counsel from representing both the company and the managing shareholder/member in shareholder derivative litigation, counsel cannot be disqualified from representing one or the other. In these situations, it is generally the case that corporate counsel will continue to represent the managing shareholder/member, while separate counsel is retained to represent the company. Doing so when derivative litigation is filed avoids the inevitable motion to disqualify.
Fernald Law Group regularly represents clients in derivative litigation involving small and medium-sized companies.