This complex case addresses several important issues pertaining to the professional liabilities of corporate lawyers, including the application of Civil Code section 1714.10’s procedural requirements to claims alleging a conspiracy between a lawyer and client to commit fraud. The case also holds, on public policy grounds, and as a matter of first impression in California, that a shareholder may bring a derivative action even after the corporation is dissolved, and that a corporation’s privilege does not terminate upon dissolution. The opinion also limits a trial court’s ability to dismiss a derivative action against attorney defendants under the McDermott, Will doctrine where claims against other defendants might result in either a waiver of the corporation’s privilege or further evidence supporting an exception to the privilege (such as crime-fraud). Finally, the opinion makes clear that those authorized to act on behalf of a dissolved corporation may assert the corporation’s attorney-client privilege during the winding-up of the corporation’s affairs.
This case involved the sale of assets by a company (“Motion Graphix”) to another company (“Get Flipped”) following the death of Motion Graphix’s founder and shareholder (“Corrales”). Corrales’ Estate sued Get Flipped and its founder (“Souther”), who was the only other shareholder for Motion Graphix, for conversion, breach of fiduciary duty and fraud in an individual action. The Estate also filed a separate derivative action on behalf of Motion Graphix against Souther, Get Flipped and Motion Graphix’s corporate counsel Katten Muchin Rosenman LLP and two of its attorneys Galimi and Thompson, (collectively “attorneys”) for professional negligence, breach of fiduciary duty and unjust enrichment arising from the asset sale.
When Motion Graphix was formed 51% of its stock was issued to Corrales, and 49% was issued to Souther. Following a dispute between Corrales and Souther, Corrales agreed to sell 80% of his shares to the company and resign from his positions as a director and officer. Corrales, on his own behalf, and Souther, on his own behalf and as CEO of the company, signed a ratification and release agreement drafted by Katten Muchin incorporating a term sheet which included a provision stating that Corrales would still retain a silent 20% ownership. It also stated that Souther would become majority partner and shareholder for the company when the document was signed by both parties. The term sheet was apparently prepared by Corrales or Souther, not the attorneys.
Following execution of the ratification, Corrales complained in an email to Galimi that certain obligations were not being complied with and appealed to Galimi to use his duty to Motion Graphix to have Souther address these issues. Galimi responded that his duty was to Motion Graphix, as counsel for Motion Graphix, and not to Corrales or Souther as individuals, and therefore he was not in a position to address disputes between the two. A couple of months later Corrales died and his shares in Motion Graphix passed to his Estate. A couple months thereafter Souther sent Galimi an email stating that Get Flipped should be incorporated as soon as possible. The email also acknowledged the possibility of a lawsuit by the Estate. Among the statements in the email was the following: “[s]o damn the torpedoes, let’s incorporate Get Flipped Inc. and sell the MG assets over and dissolve MG as quickly as possible.” The next month Souther incorporated Get Flipped. He was the sole shareholder, officer and director. About 8 months later, Galimi resigned from Katten Muchin and was replaced by Thompson. Three months later Souther, as President of Motion Graphix sent a letter to the Estate advising that a majority of the company’s shareholders had voted to sell the company’s assets to Get Flipped. A couple weeks after that Souther executed a Quitclaim Assignment transferring Motion Graphix’s assets to Get Flipped for $5,000. Almost a month later, another letter was sent to the Estate informing it that the Board of directors and holders of a majority of the outstanding shares of Motion Graphix had acted by written consent to approve the wind up and dissolution of the corporation. A couple weeks thereafter the company dissolved. The Katten Muchin firm represented Motion Graphix in connection with the asset sale.
Procedural History of the Individual Action
The Estate’s individual action was originally filed against Souther and Get Flipped. The complaint alleged that Corrales still held 51% of the shares of Motion Graphix when he died (which passed to the Estate), that the Estate never approved the sale of Motion Graphix’s assets or the company’s dissolution, that the fair market value of Motion Graphix’s intellectual property was between $8 and $12 million (compared to the $5,000 paid for Motion Graphix’s assets), and that Souther had orchestrated an unauthorized and fraudulent sale of the assets.
The Estate thereafter amended the complaint to substitute Galimi and Katten Muchin for Doe defendants. Galimi filed a demurrer and motion for sanctions. Katten Muchin also filed a demurrer. The trial court sustained both demurrers without leave to amend but without prejudice to the Estate filing a petition under Civil Code section 1714.10(a). That section requires a court order before a plaintiff can file a complaint with a cause of action against an attorney for civil conspiracy with his or her client. The court found that although a conspiracy claim had not been expressly asserted in the complaint, it was clear that the Estate was inferring that attorneys acted as counsel for Souther and Get Flipped at the time of the transaction and had conspired with him.
The trial court thereafter granted Galimi’s motion for sanctions finding that Galimi had been copied on an email with two replies in February 2006 (the “damn the torpedoes” email), that he left Katten Muchin in November 2006 prior to the asset sale in February 2007, and that the Estate’s complaint did not provide a basis for holding Galimi liable for conspiracy to do anything alleged in the complaint or on any other theory of liability.
Prior to the granting of the sanctions motion, and after the sustaining of the demurrers, the Estate filed a petition for an order allowing it to file a first amended complaint that asserted a conspiracy claim against Galimi, Katten Muchin and Thompson (who had not previously been named). The petition was denied without prejudice because the Estate had failed to serve the attorneys.
Following the granting of Galimi’s sanctions motion the Estate again filed a petition and motion for leave to file a first amended complaint. The amended complaint not only sought to add a conspiracy claim but to also name the attorneys in causes of action for conversion, breach of fiduciary duty and fraud. The complaint asserted that Souther and Galimi had formulated a scheme to defraud the Estate by incorporating Get Flipped and selling Motion Graphix’s assets to it for a price grossly below market value, and in furtherance of that scheme sent a letter to the Estate falsely claiming that a majority of shareholders had approved the sale. The Estate further asserted that because the stock transfer was never completed, the Estate (who did not approve the sale) was the majority shareholder. The complaint further claimed that even if the stock transfer was effective, the sale violated two provisions of the Corporations Code. Finally, the complaint alleged that Thompson participated in the scheme after Galimi left Katten Muchin by drafting the letter stating that a majority of shareholders had approved the sale while knowing that the Estate was still the majority shareholder, or at least while knowing of the alleged Corporate Code violations.
The trial court thereafter denied the Estate’s petition and motion to file a first amended complaint. The court held that Civil Code section 1714.10 was applicable and the Estate had not pled either of the exceptions to the statute: (1) the attorney has an independent legal duty to the plaintiff, or (2) the attorney’s acts go beyond the performance of a professional duty in furtherance of the attorney’s financial gain. In that regard, the court noted that attorneys would only have an independent legal duty to Motion Graphix, not the Estate. The court then concluded that the Estate had not met its burden under 1714.10 of establishing a “reasonable probability” that it would prevail in the action. The court explained that Galimi’s receipt of the “damn the torpedoes” email from Souther did no establish participation in a conspiracy. As to Thompson, the court stated that no conspiratorial conduct was alleged aside from the fact that the asset sale occurred in the same month as the letter that Thompson drafted stating that a majority of shareholders had approved the sale. The court noted that the complaint’s allegation sounded more like a professional negligence claim than a conspiracy claim. The Estate immediately appealed as provided for under section 1714.10(d).
Procedural History of the Derivative Action
While the Estate’s petition for leave to file an amended complaint was pending in the individual action, the Estate filed a separate action against attorneys for legal malpractice and breach of fiduciary duty. Attorneys demurred on the grounds that they owed no duty to Corrales or the Estate. The Estate thereafter amended the complaint to allege a shareholder derivative action and added a claim for unjust enrichment. The derivative action also named Souther and Get Flipped and asserted causes of action against them for breach of fiduciary duty, conversion and fraud. The attorneys’ subsequent demurrer was sustained with leave to amend on grounds that the Estate lacked standing to bring a derivative action on behalf of a dissolved corporation under Corporations Code section 800(b) which requires a shareholder to own stock during the pendency of the litigation (the “continuous ownership” requirement). The trial court held that the Estate ceased being a shareholder when the dissolution of Motion Graphix occurred. The trial court further held that even if the Estate had standing to prosecute the derivative action it was nevertheless precluded from pursuing the action against outside corporate counsel in the absence of a waiver of Motion Graphix’s lawyer-client privilege, citing McDermott, Will & Emery v. Superior Court (2000) 83 Cal.App.4th 378, 381. The court further rejected the Estate’s argument that the privilege ceased to exist upon Motion Graphix’s dissolution or that it was lost by virtue of the crime-fraud exception, relying on an earlier privilege ruling it made in the individual action with regard to a motion to compel in which the court determined that Get Flipped acquired substantially all of Motion Graphix’s assets and, as such, acquired Motion Graphix’s attorney client privilege, and that the Estate had not shown the crime-fraud exception applied. The Estate did not amend the complaint. Subsequently, pursuant to an ex parte application by the attorneys, the court dismissed the derivative action as to the attorneys, but the action proceeded as to the other defendants. The Estate filed a timely notice of appeal.
The appellate court analyzed each of the appeals, in turn, and issued a single decision encompassing both appeals.
The Individual Action (Application of Civil Code section 1714.10)
The appellate court addressed the trial court’s ruling on 1714.10 by first noting that the statute was enacted as part of the same legislation that created the special motion to strike for cases arising from constitutionally protected petitioning and speech activity (CCP section 425.16, the “Anti-SLAPP” statute), and was intended to “screen out meritless cases at an early stage” by requiring a plaintiff to demonstrate a probability of success on the merits. The court explained that the legislation was a reaction to an appellate court decision in Wolfrich Corp. v. United Services Automobile Assn. (1983) 149 Cal.App.3d 1206, which had held that although an insurance company’s attorneys could not be sued directly for violating the Insurance Code, they could be sued for conspiring with their client to commit unfair or deceptive acts or practices prohibited by the Code.
The court then analyzed the impact of the California Supreme Court’s decision in Doctors’ Co. v. Superior Court (1989) 49 Cal.3d 39. Doctors disapproved Wolfrich, holding that a conspiracy claim could not be maintained against an attorney retained by an insurance company to assist in the defense of an insured against a third party claim. In reaching this holding the Court in Doctors relied on the “agent’s immunity rule” which provides that a cause of action for civil conspiracy may not arise if the alleged conspirator, though a participant in the agreement underlying the injury, was not personally bound by the duty violated by the wrongdoing and was acting only as the agent or employee of the party who did have the duty.
The appellate court noted that section 1714.10 was thereafter amended (in light of the decision in Doctors) to apply only to situations in which it was alleged an attorney had engaged in a conspiracy with his or her client “arising from any attempt to contest or compromise a claim” and created two exceptions to the procedural requirements of the statute where: (1) the attorney has an “independent legal duty” to the plaintiff, or (2) the attorney’s acts go “beyond the performance of a professional duty to serve the client” and involve a conspiracy to violate a legal duty in furtherance of the attorney’s financial gain. The court also noted that an attorney’s “independent legal duty to the plaintiff” includes “the duty to abstain from injuring the plaintiff through express misrepresentations.”
Given this backdrop, the appellate court explained that if a plaintiff seeks to assert a conspiracy claim against an attorney based on a violation of duty owed by the client, but not the attorney, and the attorney was acting within the scope of his or her professional responsibilities, the claim has no merit substantively (under the decision in Doctors) and will not satisfy the procedural requirements of section 1714.10. However, if a plaintiff seeks to plead a conspiracy claim against an attorney based on fraud or virtually any other common law tort theory, the “exceptions” to 1714.10 will apply and the procedural requirements of the statute (e.g., requiring the plaintiff to establish a “reasonable probability” of prevailing on the action) will not apply.
With these principles in mind, the appellate court held that under Doctors an attorney has an “independent legal duty” not to defraud individuals engaged in business transactions with his or her client, and since the Estate sought leave to amend to plead a conspiracy claim against the attorneys based on Souther’s allegedly fraudulent scheme to transfer Motion Graphix’s assets at a grossly undervalued price, the requirements of section 1714.10 were not applicable and the trial court therefore erred in requiring the Estate to establish a probability of prevailing on its conspiracy claim before allowing it to file its first amended complaint.
The appellate court next noted that even where the requirements of 1714.10 are not applicable, a court can nevertheless properly deny a petition under 1714.10 if the pleading on its face fails to state a viable cause of action against the attorney and the deficiency cannot be remedied by amendment (placing the court in essentially the same position it would be in ruling on a demurrer and deciding whether to grant leave to amend). The court then proceeded to analyze whether the proposed amended complaint pled with sufficient specificity a viable cause of action for fraud.
The appellate court concluded that the allegations that Souther and Galimi had agreed to defraud the Estate by incorporating Get Flipped and then selling Motion Graphix’s assets to it for below market value and dissolving Motion Graphix, coupled with the allegedly express misrepresentations to the Estate in letters asserting that majority shareholders had voted to approve the asset sale and dissolve the company, along with Thompson’s alleged knowledge that the Estate was still the majority shareholder of Motion Graphix, and the assertion that the alleged misrepresentations were made with the intent to induce the Estate’s reliance so as not to try and block the asset sale, were “minimally adequate” for a claim of conspiracy to commit fraud against the attorneys. They alleged “how, when, where, to whom, and by what means” the alleged conspiracy took place and sufficiently alleged the elements of the tort.
The court further noted that whether Galimi had left Katten Muchin before the alleged express misrepresentations were made, or Thompson was not involved at the outset of the purportedly fraudulent scheme, was irrelevant because both attorneys would be responsible for all acts done as part of the alleged conspiracy if they knowingly agreed to commit fraud and intended to aid its commission.
The Derivative Action (Standing Upon Corporate Dissolution and Related Issues)
Turning to the dismissal of the derivative action as to the attorneys, the appellate court rejected the trial court’s ruling that the Estate lacked standing to maintain a derivative action on behalf of Graphix Motion even though the company had been dissolved. The court noted that although dissolved, the corporation continued to exist for the purpose of winding up its affairs, including prosecuting and defending actions by or against it and enabling it to collect and discharge obligations, dispose of and convey its property, and collect and divide its assets. Accordingly, as a shareholder of the dissolved corporation the Estate was entitled to pursue a derivative action on the corporation’s behalf provided the other requirements for such an action were met.
The court emphasized that the shareholders of a dissolved corporation do not cease to exist as shareholders or lose all of their interest in the corporation, or responsibility for, the affairs of the corporation upon its dissolution. The court explained that because a derivative claim belongs to the corporation, and not the shareholder, standing for the shareholder to assert the claim is only justified by the stockholder relationship which provides the stockholder with an interest in and incentive to seek redress for injury to the corporation. Where the relationship ceases, the shareholder has no standing to assert the claim because he or she no longer has a financial interest in any recovery pursued for the benefit of the corporation (the shareholder “has no dog in the hunt” so to speak). The court rejected the contention, however, that the dissolution of Motion Graphix divested the Estate (as a shareholder) of any ownership in the company. Such a proposition, the court concluded, would be at odds with the statutory scheme governing dissolutions. Just as a dissolved corporation continues to exist for purposes including prosecuting and defending actions by or against the corporation, the shareholders continue to exist and to have rights and potential liabilities with respect to the dissolved corporation. “As a matter of public policy, since the shareholders may be responsible for postdissolution claims against the corporation, there is no reason to deny them the right to bring a derivative action, which may benefit them postdissolution, as long as the requirements of the corporation code are met.”
The court further explained that recognizing the right of a shareholder of a dissolved corporation to maintain a derivative action in no way undermines the “continuous ownership” requirement for derivative actions, which is intended to ensure that a derivative plaintiff who is only indirectly benefited by the assertion of the action has a sufficient interest and incentive to vigorously pursue the lawsuit. In contrast to a shareholder who voluntarily sells or involuntarily losses through a merger his shares of stock, and no longer has even an indirect interest in any recovery pursued for the corporation’s benefit, and who retains no proprietary interest in the corporation, the shareholder of a dissolved corporation retains his or her indirect interest in any recovery pursued for the corporation’s benefit – to the extent the action is successful and results in a monetary award, the asset will be distributed to the shareholders of record at the time of dissolution as a belated realization of the corporation’s assets, thus the shareholder continues to have “a dog in the hunt.”
The appellate court next turned to the trial court’s ruling that even if the Estate had standing it was barred from pursuing the derivative action against Motion Graphix’s outside counsel absent a waiver or exception to the attorney-client privilege. The court acknowledged that under the decision in McDermott, Will a shareholder in a derivative actions stands in the shoes of the corporation but the corporation, not the shareholder, remains the holder of the privilege and is the only party who can waive the privilege. Thus the filing of a derivative action against outside counsel does not result in a waiver of the corporation’s attorney-client privilege. The court further acknowledge that in McDermott, Will the court held that the derivative action was barred because it was not clear “how an attorney [could] mount a defense in a shareholder derivative action alleging breach of duty to the corporate client, where, by the very nature of such an action, the attorney is foreclosed, in the absence of any waiver by the corporation, from disclosing the very communications which are alleged to constitute a breach of that duty.” This problem, however, is eliminated, the court noted, if the lawyer-client privilege has been waived by the privilege holder or no longer exists. Resolving whether McDermott, Will barred the Estate’s derivative action thus depended on the resolution of three difficult questions regarding privilege in the context of an asset sale followed immediately by a corporate dissolution.
First, did Get Flipped acquire Motion Graphix’s privilege when it acquired the company’s assets? Under Evidence Code section 953(d) the successor to a corporation “that is no longer in existence” becomes the holder of the extinct corporation’s lawyer-client privilege. However, in the absence of a “merger or transfer of control” of the corporation holding the privilege, the sale of the corporation’s assets generally does not also transfer the privilege. The trial court’s conclusion that privilege transferred to Get Flipped with the sale of Motion Graphix’s assets was therefore “incorrect.” Accordingly, the fact that Get Flipped had not waived the privilege would not resolve the issue of whether McDermott, Will barred the derivative action.
Second, if Get Flipped did not acquire the privilege from Motion Graphix (through the asset sale) did the privilege nevertheless cease to exist upon Motion Graphix’s dissolution? The appellate court held that it did not, noting that – as discussed in the context of the standing issue – a dissolved corporation continues to exist for various purposes. Thus persons authorized to act on the dissolved corporation’s behalf during the winding-up process should be able to assert the privilege, at least until all matters involving the company have been fully resolved and no further proceedings are contemplated. To hold otherwise would be to eviscerate the corporation’s ability to effectively prosecute or defend actions, and would unfairly disadvantage shareholders who may be responsible for their own pro rata portion of any claims.
Third, does the crime-fraud exception apply so as to moot the problem identified in McDermott, Will? The appellate court began its analysis of this question by noting that under Evidence Code section 956 a party challenging a claim of attorney-client privilege must make a prima facie showing that the services of the attorney were sought or obtained to aid someone in committing a crime or fraud. However, the statute does not require a completed crime or fraud, and the exception applies to attorney communications sought to enable the client to plan to commit a fraud, whether the fraud is successful or not. The appellate court noted that the trial court was entitled to, in effect, “incorporate by reference” its’ prior ruling on the crime-fraud exception in the discovery dispute from the individual action into its ruling on whether the existence of the privilege barred prosecution of the derivative action. However, the court rejected attorneys’ contention that the prior ruling was “binding” on the trial court or the appellate court in the derivative action under the doctrine of collateral estoppel. The discovery ruling in the individual action was not “final.” It was made in connection with the Estate’s claims against Souther, not the attorneys. An appellate challenge to that order could be made only after the action was final with respect to those claims. Accordingly, the Estate had no standing to challenge any aspect of the discovery ruling in its appeal from the section 1714.10 order in the individual action.
The appellate court next explained that a demurrer based on McDermott, Will, unlike most pleading motions, asks a trial court to speculate about matters in the future (can the lawyer-defendant adequately defend the case if privileged information cannot be disclosed), rather than to evaluate the legal sufficiency of the complaint actually before it. The court therefore concluded that where a demurrer to a derivative complaint against outside counsel would otherwise be overruled but for the McDermott, Will doctrine, and there appears to be a realistic possibility that litigation of the remainder of the action against corporate insiders will result in a waiver of the corporation’s privilege or produce additional evidence supporting an exception to privilege, the trial court should not sustain the demurrer and dismiss the action. Instead, the appropriate course of action is to “conditionally stay” further proceedings against outside counsel, including discovery as to the causes of action against them, and defer consideration of any demurrer or judgment on the pleadings based on the lawyer’s inability to defend because of the privilege. To do otherwise, the court reasoned, would be unfair to the derivative plaintiff and is unnecessary to preserve the privilege, since the attorneys’ client might later decide to willingly waive its privilege to permit other defendants to defend themselves in the same lawsuit, or evidence might be later developed in the lawsuit against the allegedly culpable corporate insiders that would establish the applicability of the crime-fraud exception. Accordingly, a conditional stay should stay in place until the derivative plaintiff can demonstrate the privilege has been waived or establish the crime-fraud exception or, alternatively, until the litigation between the derivative plaintiff and other defendants has been finally resolved by settlement or judgment, without a waiver or other basis for disregarding the privilege, at which time the trial court can determine whether to sustain a demurrer or grant judgment on the pleadings based on McDermott, Will.
Finally, the appellate court rejected a number of other arguments the attorneys made in their demurrer, but which were not ruled on by the trial court. First, the court found that the fact the allegedly illegal asset sale and dissolution took place several months after Galimi left Katten Muchin did not bar his potential liability. The Estate adequately alleged that he had participated in advising Souther to sell Motion Graphix’s assets for insufficient consideration and without the shareholder approval required under the Corporations Code, and these allegations were sufficient to state claims for legal malpractice and breach of fiduciary duty.
Second, the claims in the derivative action against the attorneys were not barred by res judicata. A direct claim by the Estate against the attorneys for a conspiracy with Souther to defraud it “is entirely separate and distinct from the derivative claims for legal malpractice and breach of fiduciary duty being pursued on behalf of Motion Graphix.” The individual fraud claim and the derivative malpractice claim involve different primary rights, and there had been no final judgment entered in the individual action.
Third, the statute of limitations did not defeat the Estate’s derivative claims for legal malpractice and breach of fiduciary duty. Unlike the delayed discovery rule in tort actions, which enlarges a plaintiff’s time to file suit and which must be affirmatively pled by the plaintiff, the burden of pleading and proving the plaintiff’s actual or constructive discovery of defendant’s wrongdoing under the alternate one-year-from-discovery limitation on attorney malpractice actions falls on the defendant. Accordingly, to sustain a demurrer based on the alternative one-year-from-discovery limitation, it must appear clearly and affirmatively upon the face of the complaint that the right of action is necessarily barred – which means the complaint must allege every fact which the defendant would be required to prove if he were to plead the bar of the applicable statue of limitations as an affirmative defense. Although the Estate knew of the purportedly illegal asset sale to Get Flipped in February 2007 and the subsequent decision to dissolve Motion Graphix in March 2007, the Estate alleged that it did not know the attorneys had assisted in the transactions and did not learn of Katten Muchin’s involvement, and thus its malpractice, until Souther’s and Thompson’s depositions were taken in the individual action in February and April 2008. Thus, while its derivative claims against Souther for breach of fiduciary duty to Motion Graphix may have accrued by late March 2007, its claim that outside counsel failed to perform competently did not.
The appellate court reversed the trial court’s order denying the petition for leave to file an amended complaint in the individual action as well as the judgment of dismissal in the derivative action, and remanded both matters for proceedings not inconsistent with its opinion.