Ninth Circuit Expands the Scope of Applicable Test for Adequacy of Representation by the Plaintiff in Shareholder Derivative Suits

By Jennifer Hadley Catero

In Bigfoot Ventures, Ltd. v. Knighton, et al., the U.S. Court of Appeals for the Ninth Circuit¹ recently clarified and expanded the scope of the factors appropriately considered in determining whether a plaintiff in a shareholder derivative suit is an adequate representative of a potential class as required by Rule 23.1, Fed.R.Civ.P.

Pertinent Background Facts

In 2019, Bigfoot Ventures commenced a shareholder derivative action on behalf of NextEngine, Inc. (NextEngine) against Mark S. Knighton (NextEngine’s CEO), ShapeTools, LLC, and NextEngine, alleging that the transfer of NextEngine’s inventory and revenue to ShapeTools (which had been formed by Knighton) was not intended to benefit NextEngine or its shareholders. Bigfoot Ventures, however, had a prior history with NextEngine. Specifically, between 2002 and 2005, Bigfoot Ventures entered into several promissory notes with NextEngine, pursuant to which BigFoot Ventures lent money to NextEngine secured by NextEngine’s patents. BigFoot Ventures subsequently commenced litigation against NextEngine to collect on the notes and multiple lawsuits ensued between Bigfoot Ventures and NextEngine concerning its investments in NextEngine and its patents.

NextEngine moved to dismiss the derivative suit arguing that Bigfoot was an inadequate representative pursuant to Rule 23.1, Fed.R.Civ.P. After supplemental briefing on the issue, the District Court for the Central District of California dismissed the derivative suit holding that Bigfoot Ventures was an inadequate representative of NextEngine’s shareholders. 

In Affirming the Dismissal, the Ninth Circuit Clarifies and Expands the Applicable Test   

On appeal, the panel affirmed the district court’s dismissal of the derivative action. In doing so, the panel first discussed the eight-factor Larson² test. The eight Larson factors for determining the adequacy of representation in shareholder derivative actions are:

(1) Indications that plaintiff is not the true party in interest; (2) the plaintiff’s unfamiliarity with the litigation and unwillingness to learn about the suit; (3) the degree of control exercised by the attorneys over the litigation; (4) the degree of support received by the plaintiff from other shareholders; (5) the lack of any personal commitment to the action on the part of the representative plaintiff; (6) the remedy sought by plaintiff in the derivative action; (7) the relative magnitude of plaintiff’s personal interests as compared to his interest in the derivative action itself; and (8) plaintiff’s vindictiveness toward the defendants.

Of key import, the court clarified that “it is not mandatory for a court to assess each and every one of the Larson factors when determining plaintiff adequacy in a shareholder derivative action” and that “what matters most . . .is the text of FRCP 23.1.” Rather than requiring a rigid application, these factors are “only intended to guide courts in assessing plaintiff adequacy under FRCP 23.1.” Even more notable, the court went on to confirm that the appropriate analysis may extend beyond the eight Larson factors. Specifically, courts “may consider other factors like outside entanglements” and can also “consider whatever other factors help them to assess whether a plaintiff” is an adequate representative in addition to the Larson factors.

Applying this reasoning to the Bigfoot case, the court affirmed that the district court properly considered the ongoing litigation between Bigfoot and NextEngine as “outside entanglements” that may “mak[e] it likely that the interests of the other stockholders will be disregarded in the management of the suit.” It found that it was likely Bigfoot would use the derivative action as leverage to advance its separate and distinct interest in acquiring the NextEngine patents in the promissory note litigation, which interest could be greater than its interest in asserting shareholder rights derivatively on behalf of NextEngine. Further, the other NextEngine shareholders did not support Bigfoot’s advancement of the derivative action inasmuch as three other shareholders submitted declarations “formally and emphatically” objecting to it. In light of the foregoing, consideration of these “entanglements” outside of the Larson factors was upheld as appropriate and the district court’s dismissal was affirmed.

Conclusion

The Bigfoot decision provides derivative defendants with more leeway in crafting arguments as to why a particular shareholder may not be an adequate representative of all shareholders in a derivative action. Such defendants should still consider the eight Larson factors as the touchstone of their opposition to the adequacy of a representative plaintiff in shareholder derivative actions but need not feel constrained to confine their adequacy challenges to only the eight Larson factors. Rather, “whatever other factors” may guide the court in determining adequacy can and should be raised in opposition to a representative plaintiff in a shareholder derivative action.