Second Circuit Holds that Issuer May be Substituted as Plaintiff in Pending 16(b) Action Following Acquisition of Issuer in Cash Merger

In a 2 to 1 vote, a Second Circuit panel has reversed a SDNY decision holding that, when an issuer is acquired in a cash merger while a shareholder-initiated 16(b) action is pending, the court loses jurisdiction over the case and therefore may not entertain a motion to substitute the issuer as plaintiff. See Klein v. Cadian Capital Management, LP. The majority decision, if it stands, offers a way for an acquiror to continue a 16(b) action following a cash merger, even though, under the Supreme Court’s holding in Gollust v. Mendel, the shareholder plaintiff’s loss of a financial interest in the case means the case no longer involves a “case or controversy” under the U.S. Constitution. (Gollust involved a stock merger, and the Court held in that case that a plaintiff continues to have a financial interest in 16(b) litigation post-merger through its ownership of stock in the acquiror.)

The facts of Klein are discussed in an earlier blog. In short, a shareholder of Qlik Technologies brought a 16(b) action against a group of ten percent owners, but a private equity firm acquired Qlik in a cash merger while the case was pending, causing the shareholder to lose her financial interest in the outcome of the litigation. Qlik itself, however, had a continuing economic interest in the case, so Qlik retained the shareholder’s counsel to file a motion to substitute Qlik as plaintiff. The defendants opposed the motion on the ground (among others) that, once the merger closed, the court lost subject matter jurisdiction over the claim and therefore did not have jurisdiction to entertain the motion. The plaintiff countered by citing FRCP 17(a)(1), which provides that an action must be prosecuted in the name of the real party in interest, and Rule 17(a)(3), which prohibits a court from dismissing an action for failure to comply with (a)(1) until a reasonable time has been allowed for the real party in interest to be substituted as plaintiff. The purpose of (a)(3), courts have said, is to prevent an injustice when an “honest mistake” was made in determining in whose name an action should be brought.

The district court concluded that a shareholder plaintiff loses “standing” to pursue a 16(b) claim following a cash merger, and therefore the court no longer has subject matter jurisdiction over the case to substitute a new plaintiff. The district court also noted that naming Klein (rather than Qlik) as plaintiff did not result from an “honest mistake,” but instead resulted from Qlik’s conscious decision not to bring the action in its own name.

On appeal, the majority drew a distinction between “standing” and “mootness” and said that a plaintiff’s standing is relevant only at the time of commencement of the action. If the plaintiff loses a financial interest in the litigation, the court said, the case then becomes moot. If a case becomes moot, the court may utilize Rule 17(a)(3) to substitute a “real party in interest” so long as doing so does not change the substance of the action and does not reflect bad faith on the part of the plaintiff or unfairness to the defendant. Those factors alone establish an “honest mistake.”

The dissent, in turn, said that when a case become moot, it is no longer a case or controversy, and therefore the court no longer has jurisdiction to substitute a plaintiff (subject to certain exceptions applicable to class actions). The dissent also said that the “honest mistake” required by Rule 17(a)(3) requires a mistake in identifying the real party in interest, which, as the district court noted, did not occur here.

Thanks to Glenn Ostrager, who was on the appellate brief for the plaintiff, for bringing the Second Circuit’s decision to my attention.