In a case of first impression, the Ninth Circuit Court of Appeals held that the continuous share ownership requirement of Rule 23.1 of the Federal Rules of Civil Procedure is procedural in nature and applies to shareholder derivative actions that are instituted in federal courts on the basis of diversity jurisdiction. Specifically, Rule 23.1 requires a plaintiff in a derivative action to own shares at the time the alleged wrongful transaction occurred and throughout the pendency of the action. The Ninth Circuit also delineated the circumstances under which an exception to Rule 23.1 may exist, whereby a party may have equitable standing to maintain a derivative claim despite not having actual possession of the shares.
Several investors, including the defendant, used plaintiff Kona Enterprises, Inc. ("Kona") as an investment vehicle to gain control of two companies (collectively, the "Companies"). To avoid foreclosure by a creditor, the defendant provided several letters of credit to the Companies and then, after rejecting other financing arrangements, bought the Companies' loans. After the Companies defaulted, the defendant foreclosed on the loans and seized all Companies' stock and assets pursuant to the stock pledge agreement that was executed in connection with the loans. Kona thereafter instituted a derivative suit against defendant in federal court, alleging claims for breach of fiduciary duty, breach of the covenant of good faith and fair dealing, and interference with corporate opportunity.
The United States District Court for the District of Hawaii held that Kona lacked standing to pursue its claims derivatively because it did not own shares at the time the suit was instituted, and hence failed to comply with Rule 23.1. On appeal to the Ninth Circuit, Kona asserted that Rule 23.1 was a substantive rule of law and therefore did not apply because the court's jurisdiction was premised on the diversity of the parties' citizenship, rather than the existence of a federal question. In diversity cases, Kona argued, federal courts follow federal law only with respect to procedure, and must apply state law to a party's claims. Moreover, Kona claimed that even if the continuous share ownership requirements of Rule 23.1 applied, it was entitled to maintain the action because it had "equitable" standing.
The Ninth Circuit affirmed the district court's decision, holding that Rule 23.1's continuous share ownership requirement is procedural in nature and thus applies to diversity suits. The court noted that Kona did not own stock at the time it instituted suit because the defendant had seized all of the Companies' stock before then. Thus, the court held that Kona lacked standing to maintain its derivative claims under Rule 23.1. The result would be the same even if the most liberal of state laws applied to Kona's claims, the court added, since such laws require share ownership at the time of the transaction complained of and at the time the suit is filed.
The Ninth Circuit then acknowledged that an equitable exception to Rule 23.1 exists, allowing standing where "a claimant has lost its share involuntarily through the same wrongful conduct which is the subject of the derivative claims." According to the court, this equitable exception could exist under two factual scenarios, neither of which applied to Kona.
- First, the court noted that equitable standing could exist where the plaintiff in the derivative action "'has an adequate interest in vigorously litigating the corporate claim' [and] where the success of the claim is inextricably linked to whether the plaintiff is successful in setting aside or rescinding the sale (or foreclosure) of" company shares. Because Kona did not seek to recover its shares in the Companies, rescind the stock pledge agreement, or contest the foreclosure, the court found that this exception did not apply.
- Second, the court stated that equitable standing could exist in the context of a merger, where the company on whose behalf the plaintiff is suing may have disappeared as a legal entity. Because no merger occurred, the court refused to grant equitable standing to Kona. *
Kona Enterprises, Inc. v. Estate of Bishop, 179 F.3d 767 (9th Cir. 1999).