8581598506_ef3d866be1_zHearing oral argument in Stevens v. McGuireWoods LLP in the final days of its May term, the Illinois Supreme Court appeared skeptical of the Appellate Court’s holding reviving former shareholders’ professional negligence claim against the defendant for loss of certain derivative claims. Our detailed summary of the underlying facts and lower courts holdings in Stevens Is here.

The plaintiffs in Stevens are former minority shareholders of a corporation. They hired a law firm to bring various claims against the corporation’s managers as well as the majority shareholder for misappropriation of trademarks and other intellectual property. The plaintiffs successfully moved to disqualify another law firm from representing the managers in the ongoing litigation.

In the summer of 2008, the trial court dismissed all claims against the managers, and three of nine claims against the owner. The plaintiffs retained new counsel, and filed two rounds of amended complaints. The second amended complaint purported to state claims “individually and on behalf of” the corporation against the disqualified law firm. The trial court granted the law firm’s motion to dismiss, holding that all claims were time barred. The court then addressed the merits of the claims, holding that the plaintiffs could not bring five of their claims against the firm in an individual capacity, and that plaintiffs had failed to adequately allege derivative standing with respect to several claims. In late 2011, the plaintiffs sued their own counsel for failing to sue the disqualified law firm in a timely manner. The trial court granted the defendants’ motion for summary judgment. The Appellate Court affirmed in part, but reversed with respect to the defendant’s failure to timely raise the derivative claims.

Counsel for the defendant began the argument. He argued that summary judgment was proper because the plaintiffs are seeking damages they never suffered. The Appellate Court’s decision effectively creates a new cause of action for a direct claim by former shareholders for loss of a company’s derivative claims. But under Illinois law, counsel argued, only current shareholders have a cause of action for derivative claims. Plaintiffs could have sued derivatively had they not sold their interests in the company, or the company could have sued itself, or the current shareholders could have sued. But one thing is certain, counsel argued – former shareholders cannot sue directly. Justice Thomas noted that counsel had spent much of his brief arguing a lack of compensable damages, but do the plaintiffs have a standing problem as well? Counsel responded that the defendant has called that a damages problem, but they’re two sides of the same coin. The plaintiffs have not been injured, counsel argued, and they have no standing. The only case the plaintiffs have cited is an 1897 decision, Brown v. DeYoung, but that’s a direct action case. There, counsel argued, the company had disclaimed any right of recovery. Without an injury to the plaintiffs, there cannot be liability. Counsel commented that the plaintiffs say they’re entitled to an indirect benefit in the price of their shares if the underlying claim had succeeded – but that’s not actionable. The plaintiffs’ claim fails, counsel argued, because the plaintiffs would be put in a dramatically better position that they ever would have been had they succeeded in the underlying case, since they never could have recovered anything in the underlying case.

Counsel for the plaintiffs followed. Counsel argued that although the defendant was hired to represent the plaintiffs, and told the plaintiffs they had individual and fiduciary claims, they failed to join the disqualified law firm. The defendant’s position was hypocritical, counsel argued. Justice Thomas asked if the defendant had brought the law firm claim in a timely manner and recovered damages, how much of that judgment would the plaintiffs have received – isn’t the answer zero? Counsel answered that in similar circumstances in Brown v. DeYoung, the Court said that the individuals should benefit, because giving the recovery to the entity would benefit the wrongdoer. That case predicted what was to come, counsel argued. According to Rule 7.01(d) of the American Law Institute’s Principles of Corporate Governance, in a closely held corporation, the court may in its discretion treat a derivative action as a direct action, and exempt it from restrictions on derivative litigation, as long as no third party interests are compromised. Justice Thomas noted that the plaintiffs had no ownership interest in the corporation. Counsel answered that the claims had arisen before the plaintiffs sold their interests. Justice Thomas said now the plaintiffs have no interest in the company, what possible interest do they have in determining whether the defendant properly handled derivative claims that belong exclusively to the corporation? Counsel responded that that is the point of Rule 7.01(d). The defendant represented the plaintiffs, not the company, counsel said. Counsel argued that defendants were arguing that their breach of fiduciary duty should have no consequences. Chief Justice Garman asked what specific damages the plaintiffs are claiming. Counsel responded that the plaintiffs were seeking the fees they paid the defendant, and would articulate a damages theory when the case goes to trial. Chief Justice Garman asked whether the plaintiffs would have damages if they still owned an interest in the company. Counsel answered that whether or not the plaintiffs have an interest in the company is a red herring. The claims arose before the plaintiffs sold their interests. That’s no impediment to proving the case. The Chief Justice asked whether the claims are derivative. Counsel said that’s the point of Rule 7.01(d). The cases cited by the defendant don’t trump the Supreme Court’s statement in 1897 in Brown v. DeYoung. In Brown, the Court treated the misappropriated money as a fund through which dividends should be declared. The plaintiffs would get a proportionate share of that fund. Justice Theis asked whether the suit within a suit was derivative or individual. Counsel answered that the plaintiffs seek to present derivative claims, and then a claim under Brown and Rule 7.01(d) for a share of the proceeds. Justice Theis pointed out that Brown is not a derivative action – so why is it relevant? Counsel answered that plaintiffs cited Brown in the context of actions by shareholders, and whether direct recovery is appropriate. Justice Thomas said that counsel says it’s a derivative suit, but the plaintiffs don’t have an ownership stake in the company – so what possible standing do the plaintiffs have? Counsel responded that the question is whether the plaintiffs could recover under Brown and Rule 7.01(d). Justice Thomas asked if the plaintiffs have no interest in the company, how do they have standing to raise that claim? Counsel answered that the trial would be based on whether the plaintiffs owned an interest in 2006-2007, when the claim arose, which they did.

Counsel for the defendant concluded with rebuttal, arguing that the plaintiffs have never before raised the notion of being entitled to recover fees. Fees are awarded when they are incurred as a natural and probable consequence of the conduct at issue, but here, counsel argued, the issue is waived. The only issue here is whether the plaintiffs can recover damages as individuals for the loss of a derivative claim, and the law is clear that they can’t. Brown is a direct action case, counsel argued, and not consistent with Illinois law. Nor is the Principles of Corporate Governance consistent with Illinois law; the legislature addressed that same point in the LCC Act and rejected the ALI’s view: the LLC Act says that the proceeds are remitted to the company. Justice Kilbride asked counsel how he characterized the rule in Brown. Counsel said that Brown doesn’t involve a parallel situation. There, the individual shareholders sued the majority shareholders. The court said that the company had disclaimed any right to the proceeds. The legislature could have adopted the ALI’s position from the Principles in the LLC Act, but it didn’t. Justice Thomas asked counsel to address the plaintiff’s argument that standing was not an issue, since the plaintiffs had an ownership interest at the time the claim arose. Counsel responded that that’s not Illinois law. The relevant question is whether the plaintiff is a shareholder on the day the claims are brought. By selling the shares after the claims arose, they relinquished the ability to bring a derivative claim. Besides, counsel argued, any value the claim might have had would be incorporated into the price of the shares. That’s the holding of Small v. Sussman, counsel argued.

We expect Stevens to be decided in three to four months.

Image courtesy of Flickr by H. Michael Miley (no changes).