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Family Feud Highlights Hurdles to Derivative Actions Against Close Corporation Directors

Posted in Derivative Actions, Family-Owned Businesses

From time to time I read about or am involved in a business divorce case that shows all the signs of an irreparable breach between opposing 50/50 shareholder factions but, for any number of reasons including buy-out leverage, is brought as a plenary action asserting claims for diversion of assets or other financial abuse rather than as a corporate dissolution proceeding.

The claims in such a plenary action usually allege injury to the corporation and thus, under New York’s Business Corporation Law (BCL), must be brought as derivative claims seeking recovery on the corporation’s behalf. There are several BCL provisions with special requirements that come into play when suing derivatively.

A decision earlier this month by Suffolk County Commercial Division Justice Elizabeth H. Emerson (pictured) in Gillette v. Sembler, 2012 NY Slip Op 50188(U) (Sup Ct Suffolk County Feb. 3, 2012), highlights some of the hurdles to be overcome at the pleading stage in such a case. Gillette also features a particularly interesting discussion of the demand requirement for derivative claims arising from an unusual alignment of parties and board control.

Gillette involves a family-owned business called South Shore Dredging Co. (“Dredging”) that owns a five-acre parcel of waterfront property on Long Island used as a boatyard and marina. Dredging is owned in equal 25% shares by four siblings whom I’ll refer to as S1 through S4. The suit was brought by S1 and S2 against S3, S3′s wife, and a company separately owned by S3 called South Shore Boat Yard, Inc. (“Boat Yard”). S4 was not made a party to the suit.

S1 and S2 alleged that S3 misappropriated Dredging’s assets and corporate opportunities for the benefit of Boat Yard; that Boat Yard was using Dredging’s real property without paying fair rental value; that S3 had collected for himself rents from tenants of Dredging’s property; that S3 was paying himself and his wife compensation from Dredging that was not authorized by the board of directors; and that S3 had denied S1 and S2 access to Dredging’s books and records.

As became significant to the court’s decision, the parties disagreed over the composition of Dredging’s board of directors. S1 and S2 alleged that all four siblings, including non-party S4, were officers and directors. S1 and S2 also alleged that S3 was “in the process” of buying S4′s shares. S3 alleged that the board had only three members consisting of himself, S1 and S2. S3 denied that he purchased S4′s shares and asserted that the corporate records continue to show S4 as a 25% shareholder.

The complaint asserted shareholder derivative claims under BCL §§626, 719 and 720. Section 626 does not establish liability for officer or director misconduct. Rather, it sets forth stock ownership and pre-suit demand requirements for derivative lawsuits, and it also contains provisions governing settlement of derivative lawsuits and recovery of attorney’s fees. Section 719 imposes joint and several liability on directors who vote for or concur in certain enumerated actions such as making shareholder distributions when the corporation is insolvent or post-dissolution without adequately providing for creditor liabilities. Section 720 authorizes an action against corporate directors and officers for a broader array of misconduct, including:

  • to compel an accounting for “neglect of, or failure to perform, or other violation of his duties in the management and disposition of corporate assets  committed to his charge” and for the “acquisition  by himself, transfer to others, loss or waste of corporate assets due to any neglect of, or failure to perform, or other violation of his duties”;
  • to set aside ”an unlawful conveyance, assignment or transfer of corporate assets, where the transferee knew of its unlawfulness”; and
  • to enjoin a “proposed unlawful conveyance, assignment  or  transfer of corporate assets, where there is sufficient evidence that it will be made.”

S3 and the other defendants moved to dismiss the complaint based on the plaintiffs’ failure to make pre-suit demand upon Dredging’s board of directors as required by BCL §626(c). The pre-suit demand requirement stems from the principle acknowledged by New York’s highest court in Auerbach v. Bennett, 47 NY2d 619, 631 (1979), that ”[d]erivative claims against corporate directors belong to the corporation itself.”

Justice Emerson’s decision contains a useful summary of New York law concerning the demand requirement including the three circumstances under which demand will be excused as futile, as outlined by the New York Court of Appeals in Marx v. Akers, 88 NY2d 189 (1996). S1 and S2 contended that S3 was an “interested director” thereby rendering demand futile but, as Justice Emerson points out, S3 “is only one director and does not constitute a majority of the board of directors.” Justice Emerson also notes that, assuming a three-member board, and further assuming S3 boycotted the directors meeting, attendance at the meeting by S1 and S2 would constitute a quorum enabling them to approve commencement of a lawsuit by the corporation against S3.

S1 and S2 argued (apparently accepting for argument’s sake S3′s assertion of a three-member board) that a demand is not required since they represent a majority of the board, citing the trial court’s decision in Bouhayer v. Georgalis, 169 Misc.2d 779 (Sup Ct Queens County 1996). The court in Bouhayer excused demand in a derivative suit for fraud, conversion and waste brought by a majority of the board’s directors against the minority, as “serv[ing] no useful purpose, since [if the court dismissed the suit] all that the plaintiffs need do is meet, vote and recommence the action” as a direct action in the corporation’s name. Justice Emerson declined to follow Bouhayer, stating that it has not been followed by other courts and that it is contrary to the demand-futility test established in Marx v. Akers.

The outcome is no different, Justice Emerson finds, even assuming a four-member board inclusive of S4. As the court explains:

On the other hand, if [S4] is a director of South Shore Dredging, as [S3] contends, the plaintiffs would have to show that [S4] is dominated or controlled by [S3] and that the board is deadlocked. The plaintiffs have made no such showing. Allegations of wrongdoing and control must be made with particularity and conclusory allegations are insufficient to circumvent the requirement of a demand. The plaintiffs simply allege that [S3] is in the process of buying [S4's] shares. Such conclusory allegations, without more, are insufficient to establish domination or control of [S4] by [S3]. Accordingly, the complaint is dismissed insofar as it asserts claims derivatively under Business Corporation Law §626.  [Citation omitted.]

The defendants also moved to dismiss the plaintiffs’ causes of action under BCL §§719 and 720 for failure to plead a valid claim. Justice Emerson’s decision agrees with defendants that the allegations of financial misconduct do not fall within the narrow categories of claims specified in BCL §719, and she accordingly dismisses the plaintiffs’ claims to the extent brought under that statute.

The plaintiffs fare better under §720. Justice Emerson finds that the complaint’s allegations of defendants’ trespass, conversion, waste and misappropriation of Dredging’s assets adequately plead claims for an accounting and other relief available for director and officer misconduct under §720, and that these claims sounding in breach of fiduciary duty are alleged with sufficient particularity to satisfy §3016 of the Civil Practice Law and Rules.

Why, you may ask, are the plaintiffs in Gillette permitted to pursue claims under §720 for recovery on behalf of Dredging even though they did not satisfy the pre-suit demand requirement? It’s because §720(b) expressly authorizes suit by an officer or director, as well as by a receiver, trustee in bankruptcy, creditor or shareholder. It’s typical in suits between owners of close corporations, where the parties also serve as officers and directors, for the plaintiffs to sue in dual capacities, i.e., as shareholders and as officers/directors, to avoid any dispute over their standing and to take advantage of the express remedies in §720, and also to take advantage of the potential award for counsel fees available in shareholder derivative suits brought under BCL §626.