One of the most frequently encountered preliminary skirmishes in shareholder litigation involving closely held business entities focuses on whether the plaintiff’s claims are properly classified and brought either as direct claims for individual relief or as derivative claims for recovery on behalf of the entity. This duality — direct or derivative — has major consequences at the pleading stage and beyond.

Yet, as the Appellate Division, First Department, recently observed in Yudell v. Gilbert, where it expressly adopted Delaware’s formulation for distinguishing between the two based primarily on who suffers the alleged harm, “[s]ometimes whether the nature of the claim is direct or derivative is not readily apparent.”

The line between direct and derivative gets especially blurry when the only two shareholders involved are the aggrieved plaintiff and the defendant whose alleged misconduct results in the wholesale transfer of the corporation’s assets to the defendant or the defendant’s affiliate. Such cases may give rise to direct claims that, in other contexts, might be classified as derivative.

Take, for example, the case of Barmash v. Perlman, 2013 NY Slip Op 31518(U) (Sup Ct NY County July 3, 2013), decided earlier this month by Manhattan Commercial Division Justice Melvin L. Schweitzer. In Barmash, Justice Schweitzer denied a motion to dismiss a complaint brought by a minority shareholder where the claimed breaches by the controlling shareholder, constituting what the court labeled the “de facto liquidation” of the corporation, resulted in harm to the corporation to be pursued derivatively, but also caused injury “uniquely and individually” to the plaintiff minority shareholder permitting direct recovery. 

Barmash involves a New York-based Delaware corporation called Energy Scorecards, Inc. (“ESC”) formed in 2010 to develop and market software used by real property owners to monitor and control energy and water usage in compliance with municipal regulations.  The plaintiff, Jean Barmash, is a software developer who developed the monitoring software which he transferred to ESC in exchange for a 25% stock interest. According to the complaint (read here), the software is ESC’s sole asset and is a trade secret. The other, 75% shareholder is an energy management company known as Bright Power, Inc. whose majority owner is Jeffrey Perlman.

It wasn’t long before Barmash and Perlman had a falling out. Barmash resigned as ESC’s Chief Technology Officer and Perlman removed Barmash from ESC’s Board of Directors. In his complaint filed in early 2013, Barmash alleged that Bright Power appropriated ESC’s software by marketing itself as the owner of the software, usurping contracts and corporate opportunities that rightfully belonged to ESC, competing against ESC, and failing to compensate ESC with proper licensing fees. Barmash also alleged that Perlman threatened and pressured him to sell his stake in ESC to Bright Power for an unfairly low price.

Barmash’s complaint alleged a series of claims against Perlman and Bright Power. Those against Perlman were pleaded as derivative claims. Those against Bright Power were asserted as direct claims.

Defendants’ Motion to Dismiss

Perlman and Bright Power moved to dismiss the complaint. Their memorandum of law (read here) launched a multi-faceted attack on the adequacy of the pleading under applicable Delaware law. As to the derivative claims against Perlman, they argued that Barmash for various reasons could not adequately represent ESC’s interests as a derivative plaintiff. As to the direct claims against Bright Power, they argued that the claims are all derivative because any damages resulting from the alleged wrongful actions would flow to ESC and not to Barmash directly.

Barmash’s opposing memorandum of law (read here) countered that Barmash was an appropriate representative to assert derivative claims on ECS’s behalf. As to his direct claims against Bright Power, Barmash argued that as the majority shareholder that dominated and controlled ESC’s decisions, Bright Power owed fiduciary duties directly to Barmash which it breached by expropriating to itself ESC’s intellectual properties and corporate opportunities causing harm directly and disproportionately only to Barmash.

The Court’s Ruling

Justice Schweitzer rejected defendants’ primary contention that Barmash was not an adequate representative of ESC for purposes of asserting derivative claims against Perlman. In so ruling, Justice Schweitzer carefully reviewed each of the factors set forth in Youngman v. Tahmoush, 457 A.2d 376 (Del Ch 1983), concluding that defendants failed to show the requisite “serious conflict of interest” needed to disqualify plaintiff.

Turning to defendants’ argument that the direct claims against Bright Power could only be brought derivatively, Justice Schweitzer initially observed that:

In order to determine if a claim is direct or derivative, the court must look to “the nature of the wrong and to whom the relief should go.” Tooley v Donaldson, Lufkin & Jenrette, Inc., 845 A2d 1031, 1039 (Del 2004). To make this determination, the court must examine the “body of the complaint, not the plaintiff’s designation or stated intention.” Agostino v Hicks, 845 A2d 1110, 1121 (Del Ch 2004) (cited in Tooley, 845 A2d at 1036).

Next, Justice Schweitzer noted that “[c]ertain breaches of fiduciary duty may give rise to both direct and derivative causes of action,” citing Grimes v. Donald, 673 A.2d 1207, 1212 (Del 1996). For example, he continued, the “paradigmatic” dual-character case is where a controlling stockholder causes the corporation to issue excessive shares of its stock in exchange for assets of the controlling stockholder that have a lesser value, which also dilutes the minority shareholder’s percentage. In such cases, he explained,

[t]he corporation is harmed because of the overpayment and has a claim to compel the restoration of the value of the overpayment; that claim is derivative. Yet the minority shareholders suffer a separate, unique, and independent harm from the corporation due to “an extraction from the public shareholders, and a redistribution to the controlling shareholder, of a portion of the economic value and voting power embodied in the minority interest.” [Citations omitted.]

Barmash, of course, did not involve a dilutive stock issuance scheme. Justice Schweitzer found a closer fit in Rhodes v. Silkroad Equity, LLC, 2007 WL 2058736 (Del Ch July 11, 2007),  where the plaintiffs alleged that the defendants purposely took actions against the corporation’s interests in order to lower its value and drive out the plaintiffs at a bargain price. In that case, the court held that it could not “view the transactions [that decreased the value of the corporation] as ‘confined to an equal dilution of the economic value of each of the corporation’s outstanding shares ‘” because “those alleged to have benefitted directly from the Defendants’ misdeeds are [the defendants themselves] or entities controlled by them.”

Justice Schweitzer concluded that “the rationale underlying the decision in Rhodes applies to the present case.” As he explained:

Barmash alleges that [Bright Power], ESC’s controlling shareholder, advertised itself as be the owner of ESC’s software, used ESC’s software without paying for it, and used ESC’s software to create opportunities for itself that rightfully should have flowed to ESC. All of the alleged breaches by [Bright Power] and Perlman “directly benefitted” them at ESC’s expense. Therefore, these transactions “cannot be viewed as confined to an equal dilution of the economic value of each of the corporation’s outstanding shares.” Barmash claims that these breaches were committed at least in part to pressure him to sell his shares at an unfair price, an allegation which the court in Rhodes relied upon when holding that the plaintiffs could bring their claims directly against the defendants.

It is even clearer that the underlying set of facts possesses the requisite dual character when one looks beyond Barmash’s “designations” to the “body of the complaint.” Viewed as a whole, the breaches that Barmash alleges–[Bright Power’s]  false claim of ownership of ESC’s software, the defendants’ waste of corporate assets, their misappropriation of confidential business information and diversion of corporate opportunities–have the “true substantive effect” of liquidating ESC of its sole corporate asset, its software, for a price substantially below its market value. This de facto liquidation results in an injury to both ESC (which can be pursued derivatively) and Barmash (which can be pursued directly).  

Barmash raises interesting and difficult questions concerning the contours separating direct and derivative claims in shareholder disputes of this sort. The complaint nowhere alleges that ESC ceased doing business or became insolvent as a result of defendants’ actions or otherwise. Indeed, ESC still maintains a website advertising its services. Nor does the complaint allege that the defendants succeeded in forcing Barmash to sell his shares at a discount, as occurred in the Rhodes case cited by Justice Schweitzer.

How extensive, therefore, must the alleged usurpation of the corporation’s business and assets be in order to assert a direct claim for injury to a shareholder? Would the result have been different if ESC had one or two other minority shareholders? Or might there be a more fitting analysis, such as that employed in the Madcat case that I blogged about here, in which the court permits a direct suit against a controlling shareholder by the only other, injured shareholder to avoid unnecessary circuity and hardship, and because insisting on a derivative suit would compel such a plaintiff to follow a meaningless legal procedure in complete disregard of the realities of the situation?