A petitioner for judicial dissolution of a close corporation often sees fit to bring a separate, companion action against the controlling shareholder, or against another 50% shareholder, asserting derivative claims on the corporation’s behalf to recover sums allegedly misappropriated or seeking damages for diversion of corporate opportunity. Under bedrock corporate law applicable to private and public corporations alike, the complaint in a derivative action must allege either that the plaintiff made a prior demand upon the corporation’s board of directors to bring the action, and that the board declined to do so, or that making such demand would have been futile because a majority of the board is disabled by conflict or otherwise. Demand futility is usually satisfied easily in the close corporation setting where the alleged wrongdoer either controls the board or has blocking power as a co-equal director.
But what happens when a close corporation shareholder starts a derivative action after the court already has appointed a receiver in a prior-commenced proceeding for judicial dissolution? Can demand futility be alleged on the theory that the board retains authority to file suit in the corporation’s name, or does the authority pass to the receiver to whom demand must be made in the board’s stead?
The answers are provided in a recent decision by Nassau County Commercial Division Justice Timothy S. Driscoll in Koenig v. Koenig, 2010 NY Slip Op 32617(U) (Sup Ct Nassau County Sept. 17, 2010), and in an unreported prior ruling in the same case dated April 6, 2010.
Koenig involves a fight between two brothers who were 50/50 shareholders in a company called Mel Sobel Microscopes Ltd. that serviced, repaired and sold microscopes. In July 2009, Fred Sobel filed a petition seeking judicial dissolution based on deadlock under Section 1104(a)(3) of the Business Corporation Law. In September 2009, Fred and his brother Steven agreed to the appointment of a receiver and to proceed with the dissolution. In early October 2009, the court ordered appointment of a temporary receiver with the powers, among others, to conduct an audit of the company’s business and to take “any action [he] deems necessary to preserve, protect or recover the corporation’s assets.”
In late October 2009, Steven filed a derivative action against his brother Fred and others accusing them of misappropriating over $1 million of corporate funds for personal use beginning in 2005. The complaint also claimed that, immediately after the brothers consented to dissolution, Fred formed a new company called New York Microscope Co., Inc. to which Fred allegedly transferred the old company’s customer list, website and other intangible property. Nodding to the demand requirement for derivative claims, Steven’s complaint alleged that demand upon Fred would have been futile because of Fred’s alleged participation in the wrongful acts that form the basis of the derivative claims.
The derivative action defendants moved to dismiss Steven’s complaint on various grounds including lack of standing based on his failure to allege prior demand upon the receiver. In his unreported decision dated April 6, 2010, Justice Driscoll notes there is “significant hornbook jurisprudence regarding the appropriateness of a derivative action when the Court has appointed a receiver,” and goes on to quote the following passage from 20 Carmody-Wait 2d §121:166 (2005):
A stockholder is entitled to bring an action in behalf of a corporation notwithstanding the fact that a receiver has been appointed for the corporation. However, it is generally held that the action cannot be maintained without the permission of the court which appointed the receiver. Moreover, before bringing an action in the right of, or for the benefit of, the corporation in receivership the stockholder must show a demand upon the receiver to bring the action, unless the circumstances were such that a demand would have been futile.
Justice Driscoll then restates the rule and cites additional authority, as follows:
Unless a demand would have been futile, the better practice is for the stockholder to make a demand upon the receiver to bring suit and then move for leave to bring suit, on notice to the receiver. See Craig v. James, 71 AD 238 (1st Dept 1902) (plaintiff, as a stockholder, would be invested with cause of action on failure of receivers to bring action to redress wrong alleged in complaint).
How did the rule apply in Koenig? Initially, in his April 2010 ruling, Justice Driscoll denied the dismissal motions, notwithstanding the plaintiff’s failure to demonstrate that demand upon the receiver would have been futile, because the defendants never served their dismissal motions upon the receiver “or offered any evidence that the Receiver would have a legally cognizable objection to Plaintiff’s bringing this action.”
On a subsequent defense motion for reconsideration, however, this time supported by an affidavit from the receiver, Justice Driscoll in his most recent September 2010 decision dismissed the complaint without prejudice based on plaintiff’s failure to make a demand upon the receiver. The receiver’s affidavit disagreed that a demand would have been futile, stating as summarized in the court’s decision:
Had Steven or his attorney provided the Receiver with the proposed allegations and evidence supporting those claims, the Receiver would have examined those and responded to Steven and his counsel. Had he received a demand, the Receiver would have provided the shareholders and the Court with an analysis of the claims, and the Receiver would also have made efforts to mediate the dispute in an effort to preserve the Company’s assets.
The Receiver’s affidavit also contended that the complaint itself was no substitute for a formal demand in that it lacked adequate support for the allegations of misconduct, and that the court should permit discovery to proceed prior to any such formal demand. The receiver further suggested that the possibility of settlement in the dissolution proceeding may render the derivative action unnecessary, thereby saving the company the costs of defending that action.
Justice Driscoll’s decision states that the receiver’s affidavit “provides persuasive support” for the defendants’ contention that plaintiff lacks standing for failure to make a prior demand on the receiver. Justice Driscoll’s order also adopts the receiver’s suggestion to preclude plaintiff from making a demand pending further discovery proceedings in the dissolution case.
The Koenig case is somewhat unusual because, more often than not, and unlike in Koenig, the shareholder seeking dissolution is the same shareholder asserting derivative claims and thus is in a position to control the timing of the derivative action vis-a-vis any decision to seek the appointment of a receiver. Also, in the usual scenario involving a dissolution petition by an oppressed minority shareholder, such a petitioner has the alternative option to assert “surcharge” claims against the controlling shareholder under BCL § 1104-a(d) for corporate waste, diversion, etc., thereby bypassing altogether the demand requirement and other rules governing derivative actions.