Supreme Court Permits New Shareholder Litigation Action

The California Supreme Court on April 7, 2003 held that a corporation that has issued misleading financial statements may be sued for damages by a shareholder who neither bought nor sold shares, but simply continued to hold company shares in reliance on those financial statements.

Unlike federal cases brought under SEC Rule 10b-5, which requires that a plaintiff must purchase or sell a security in order to bring a case, a California law “holder’s action” can be brought as a negligent misrepresentation state law tort case. The Court held that a “holder’s action” should be limited to stockholders who can make a bona fide showing of actual reliance upon the misrepresentations (unlike federal 10b-5 cases, in which reliance is presumed to exist based on “efficient” stock market pricing of shares).

The Court was aware that permitting “holder’s actions” could result in abusive and non-meritorious suits to force a settlement from a corporation and its officers. The Court held that “[b]ecause of the potential for false claims ... a complaint for negligent misrepresentation in a holder’s action should be pled with the same specificity required in a holder’s action for fraud .... In a holder’s action a plaintiff must allege specific reliance on the defendants’ representations: for example, that if the plaintiff had read a truthful account of the corporation’s financial status the plaintiff would have sold the stock, how many shares the plaintiff would have sold, and when the sale would have taken place. The plaintiff must allege actions, as distinguished from unspoken and unrecorded thoughts and decisions, that would indicate that the plaintiff actually relied on the misrepresentations.”

The Court further noted that plaintiffs who “cannot plead with sufficient specificity to show a bona fide claim of actual reliance ... cannot bring individual or class actions for fraud or misrepresentation. They may, however, be able to bring a corporate derivative action against the corporate officers and directors for harm caused to the corporation.”

The judges were divided on how -- or whether -- a shareholder who did not buy or sell a security could demonstrate damage for which a holder’s action could provide compensation.

Business Law Alert is a publication of the Business Department of Downey Brand LLP, a full-service law firm counseling California businesses since 1926.