A "derivative" suit is one brought on behalf of an entity by a partner or shareholder to enforce a claim against its officers, managers, or third-parties for harm caused to the entity. 

The Arizona Court of Appeals was recently asked to examine the requirements for maintaining a derivative action in the context of a limited partnership.  Specifically, the question before the Court was whether a plaintiff who files a derivative action must continue to possess an ownership interest in the entity on whose behalf it sues throughout the litigation?   See Judson C. Ball Revocable Trust v. Phoenix Orchard Group I and II, 1 CA-CV 17-0642, decided Oct. 2, 2018.

In that case, the Plaintiff, a limited partner, brought a derivative action for damages against the general partner and others.   However, because the Plaintiff had also sued the partnership separately for rescission of its interest and had tendered back its shares as part of that separate action, and because its tender had been accepted by the partnership, the Plaintiff no longer had a limited partnership interest in the entity on whose behalf it filed suit.  Thus, the partnership intervened and moved to dismiss the Plaintiff's derivative suit for lack of standing, and its motion to dismiss was granted by the trial court.

On appeal, the Plaintiff argued that the express language of the statute does not contain any requirement of continuous ownership.  Indeed, Arizona's derivative statute applicable to limited partnerships provides only that in a derivative action, the plaintiff shall be a partner at the time of bringing the action and:

1. Shall have been a partner at the time of the transaction of which he complains;

or

2. His status as a partner shall have devolved upon him by operation of law or pursuant to the terms of the partnership agreement from a person who was a partner at the time of the transaction.

See A.R.S. 29-357.

However, the Intervenors pointed out that, although the express language of the statute requires only contemporaneous ownership, a majority of courts around the country with statutes similar to Arizona's have held that a plaintiff's continuous ownership of stock throughout the litigation is necessary to prosecute a derivative action.  See Grosset v. Wenaas, 42 Cal. 4th 1100, 1118, 175 P.3d 1184 (2008) FN9.  The main reasoning for this is that one who no longer possesses any ownership interest has little incentive to vigorously prosecute the litigation. 

Finding this reasoning to be persuasive, the Arizona Court of Appeals sided with the majority in adopting the “continuous ownership” rule, which requires that a plaintiff in a derivative action must continue to possess an interest in the entity on whose behalf it sues throughout the litigation.  

We adopt the continuous ownership rule and hold that, to maintain standing in a derivative action, the plaintiff must not only possess an ownership interest when commencing suit but must also continue to maintain its ownership interest throughout the litigation.  Because the Trust no longer possesses any ownership interest in POG, we conclude, as did the trial court, that the Trust lacks standing to maintain the derivative action.

In doing so, the Court also pointed to the Arizona Rule of Civil Procedure pertaining to derivative actions, Rule 23.1, which provides:

The Complaint must:

1. be verified;

2. allege facts sufficient to show that the plaintiff has standing to maintain the derivative action; and

3. allege facts sufficient to show that the plaintiff satisfies all statutory and other requirements under the law for maintaining the derivative action.

According to the Court, the rule's “acknowledgement of requirements other than those imposed by statute affords room for application of well-reasoned common law principles where appropriate.”  Thus, one of the “other requirements” under Rule 23.1 for maintaining a derivative action in Arizona is now the common law requirement of continuous ownership. 

Note: Although the case involved a limited partnership, the rule applies to all corporate derivative actions.  In addition, exceptions to the rule have been recognized in cases where the Plaintiff has been wrongfully deprived of standing.  For example, where the loss of ownership results from a corporate merger claimed to be fraudulent.