“A plaintiff asserting a derivative claim seeks to recover for injury to the business entity. A plaintiff asserting a direct claim seeks redress for injury to him or herself individually. Sometimes whether the nature of the claim is direct or derivative is not readily apparent.”

The preceding quotation, from a signed opinion by Justice Karla Moskowitz (pictured) writing for a unanimous panel of the Appellate Division, First Department, in Yudell v. Gilbert, 2012 NY Slip Op 05896 (1st Dept Aug. 7, 2012), captures the essence of a thorny issue that can arise in lawsuits brought by shareholders, LLC members and partners asserting fiduciary breach and other claims against controlling persons of the business entities and sometimes against persons outside the entity.

There are, as Justice Moskowitz also observed, a number of standard scenarios — e.g., involving shareholders who suffer solely through depreciation in the value of their stock, or who allege mismanagement or diversion of corporate assets and opportunities — which clearly fall in the category of derivative claims. At the other end of the spectrum are claims clearly identifiable as direct claims seeking individual redress, such as discriminatory shareholder distributions. But in the middle is an endless supply of unique fact patterns where the line separating direct from derivative can get blurry.

Why does it matter? For one, derivative claims belong to the business entity, which is why there exist both statutory and common law rules requiring a plaintiff suing derivatively to allege in the complaint with particularity the plaintiff’s pre-suit efforts to secure initiation of the action by the controlling board or other governing body, or that doing so would have been futile. For another, there are situations where a plaintiff may have standing to litigate direct but not derivative claims, such as following a freeze-out merger. The recharacterization of a direct claim as derivative therefore may be fatal to a complaint that either does not allege at all, or does not allege adequately, pre-suit demand or demand futility.

Delaware’s Tooley Formulation

In her opinion in Yudell, Justice Moskowitz acknowledged that “New York has lacked a clear approach for determining this difference” between direct and derivative claims and that, ‘[i]nstead, our jurisprudence consists of case by case analyses, that are sometimes difficult to apply to new fact patterns.” As it often does in the field of business law, the court looked to Delaware law for guidance, and found it in a 2004 decision by the Delaware Supreme Court in Tooley v. Donaldson, Lufkin & Jenrette, Inc., 845 A2d 1031, where that court wrote, as quoted in Yudell:

A court should look to the nature of the wrong and to whom the relief should go. The stockholder’s claimed direct injury must be independent of any alleged injury to the corporation. The stockholder must demonstrate that the duty breached was owed to the stockholder and that he or she can prevail without showing an injury to the corporation.

Under the Tooley formulation, Justice Moskowitz added, the two, essential considerations are:

(1) who suffered the alleged harm (the corporation or the stockholders); and (2) who would receive the benefit of any recovery or other remedy (the corporation or the stockholders individually).

Calling this a “common sense approach,” Justice Moskowitz next turned to its application in the Yudell case.

Application in Yudell

The complaint in Yudell (read here) was brought by trustees of one of three members of a joint venture (JV) that owned and operated a Long Island shopping center against the other two members, the shopping center’s managing agent, Jerrold Gilbert, who also was trustee of one of the defendant members, and the JV as a nominal defendant. The plaintiff claimed that Gilbert failed to properly bill and collect rent, tax escalation reimbursement and common area maintenance charges; gave improper rent concessions; and failed to preserve legal claims of the JV against certain tenants.

The complaint’s multiple causes of action, although not explicitly denominated as such, purported to bring both direct and derivative claims sounding in breach of fiduciary duty and breach of the JV agreement. Plaintiff demanded an award of damages and an accounting “to the Plaintiff and the other venture partners for all money received and disbursed” in connection with the management of the shopping center.

With respect to pre-suit demand, the complaint alleged demand futility, stating that “[i]n view of the acts, practices and courses of conduct on the part of the defendants as alleged herein, a demand upon the [other] joint venture partners . . . to take action against the individual defendants would be futile.”

The lower court’s decision (read here) without discussion characterized all of the claims as derivative. The lower court proceeded to dismiss the complaint for failure to plead that the other JV partners were self-interested in any of the specific transactions challenged in the complaint, or to allege any other facts justifying the plaintiff’s failure to make a pre-suit demand.

On appeal, the plaintiff argued that its third cause of action for breach of fiduciary duty was a direct claim and therefore should not have been dismissed for failure to plead pre-suit demand. Justice Moskowitz’s opinion applying the Tooley test rejected plaintiff’s position, stating that:

plaintiffs’ claim for breach of fiduciary duty is derivative, because any pecuniary loss plaintiffs suffered derives from a breach of duty and harm to the business entity, BHA. Plaintiffs’ allegations of breach of fiduciary duty involve failure to collect rent, back taxes and common charges that tenants would have owed to BHA. Paragraph 17 of the complaint highlights the derivative nature of plaintiffs’ claims when it refers to: “Gilbert’s failure to preserve BHA’s rights to collect the unpaid tax obligations, CAM [common area maintenance] and rent . . .” It is only through loss to BHA that plaintiffs suffer a loss at all. Although plaintiffs may own a minority interest in the joint venture, all members suffer losses from the failure to collect rents and other obligations owed the joint venture. Moreover, Tooley suggests that we consider looking at who would receive the benefit of any recovery or other remedy, the joint venture or the members individually. Accordingly, here, any recovery would represent the value of lost rent, CAM charges and the like that inure to the benefit of the joint venture. Only if and when the joint venture receives this compensation would plaintiffs then be entitled to receive their proportionate share. Thus, plaintiffs’ claims are derivative.

Even if some of the plaintiff’s claims were direct, Justice Moskowitz added, dismissal would still be warranted because such claims “are embedded in an otherwise derivative claim for partnership waste and mismanagement” in violation of pleading rules requiring the explicit denomination and separation of derivative and direct claims. Justice Moskowitz also agreed with the lower court that the complaint fails to allege grounds for excusing pre-suit demand.

Pleading Demand Futility

There’s an interesting side note to Yudell that was highlighted in a recent decision by Nassau County Commercial Division Justice Timothy Driscoll in Kahn v. Ran, 2012 NY Slip Op 31620(U) (Sup Ct Nassau County June 12, 2012), where the court dismissed derivative claims for not alleging with adequate particularity the futility of a demand on the subject corporation’s board of directors. Whereas in Yudell the court adopted Delaware’s formulation for identifying derivative versus direct claims, in Kahn Justice Driscoll noted that New York cases have rejected Delaware’s standard for pleading demand futility insofar as Delaware views directors as “interested” simply because they are substantially likely to be held liable for their actions. Justice Driscoll cites Wandel v. Eisenberg, 60 AD3d 77 (1st Dept 2009), and the seminal New York case on the subject of the demand requirement, Marx v. Akers, 88 NY2d 189 (1996), in which New York’s highest court set forth the three circumstances that, when adequately alleged, will excuse pre-suit demand:

  • a majority of the board is interested in the challenged transaction;
  • the directors failed to inform themselves to a degree reasonably necessary about the transaction; or
  • the directors failed to execute their business judgment in approving the transaction.

All of which tells the smart litigator contemplating an owner’s action against the controlling members of a business entity, treat the requirements for bringing derivative claims as a minefield, and step accordingly.