The derivative lawsuit is commonly defined as a lawsuit brought by a shareholder of a corporation against the directors, management, or controlling shareholders of the corporation seeking recovery on the corporation’s behalf for breach of duty involving self-dealing, looting, waste or other wrongful conduct causing injury to the corporation. Derivative lawsuits also can be brought on behalf of alternative entities, including limited partnerships (LP) and limited liability companies (LLC).

Since the claims belong to the corporation (or LP or LLC) the governing statutes and decisional law, applicable to public and private companies alike, impose standing criteria for would-be derivative plaintiffs, including the contemporaneous and continuous ownership requirements. In addition, the claim’s proponent must plead and prove either (a) the making of a pre-suit demand upon the corporation’s directors to bring the suit directly in the corporation’s name and right or (b) that such demand would have been futile and therefore is excused. Litigation over the plaintiff’s satisfaction of the demand requirement more often than not centers on demand futility.

Because many New York-based businesses are formed in Delaware, and because the ability to seek judicial dissolution of a Delaware entity in a New York court is virtually non-existent, when litigation among co-owners of privately-owned Delaware entities takes place in New York, such cases typically feature derivative claims, the standing requirements for which are governed by Delaware law including a large and well-developed body of Delaware case law concerning demand futility.

In the last two months, the Manhattan-based Appellate Division, First Department, handed down three decisions in derivative lawsuits examining challenges to satisfaction of the demand futility requirement: one involving a Delaware corporation, another involving Delaware LPs and LLCs, and the third involving a New York LLC. While none of them addresses claims seeking judicial dissolution, it is the exceptional dissolution petition that doesn’t include a derivative claim against the other owner alleging misappropriation of company assets or business opportunity. It’s therefore important for business divorce practitioners to stay current on the state of the law concerning the standing requirements for derivative claims.

Otto v. Otto: Demand Excused

Last month’s decision in Otto v. Otto, 2013 NY Slip Op 06990 (1st Dept Oct. 29, 2013), involves essentially an accounting dispute between Maria Otto and her deceased husband Richard’s son from a prior marriage, Jonathan Otto, over 14 dissolved New York and Delaware real estate holding companies organized as LPs and LLCs. After Richard’s death in 1999, Jonathan allegedly sold all of the properties but failed to pay to Maria her pro rata portion of income distributions and of the sale proceeds based on her 10% equity interest, and allegedly breached fiduciary duties owed to the companies by selling the properties for less than fair market value and paying excessive management fees to related companies (read here Maria’s Second Amended Complaint).

The complaint alleged that Maria made pre-suit demands upon Jonathan as the controlling partner or manager of 10 of the 14 holding companies. The four other companies were Delaware LPs.

The lower court denied Jonathan’s multi-faceted motion to dismiss the Second Amended Complaint. As to Jonathan’s contention that the complaint failed to allege pre-suit demand or demand futility as to the four Delaware LPs, the lower court found, in an oral bench ruling, that Maria’s allegations:

set forth a sufficient basis for me to conclude at this stage, the pleading stage, that a demand would have been futile, particularly given the fact that Jonathan Otto is . . . the stepson . . . [a]nd that there is quite a bit of acrimony going back and forth, that any demand that would have been made would have been disregarded at this juncture. (Transcript pp. 35-36; read here.)

Jonathan appealed to the Appellate Division, First Department, which last month affirmed in most parts the lower court’s order including with respect to demand futility, as to which the court wrote:

Both New York and Delaware law require a plaintiff bringing a derivative action on behalf of a limited liability company or limited partnership to plead that demand was made or that demand was futile (see Del. Code Ann. tit. 6, §§ 17-1003, 18-1003; NY Partnership Law § 115-a). The motion court’s finding that demand was futile with respect to four of the limited partnerships is supported by the complaint’s specific allegations that defendant Jonathan Otto, the controlling owner in the defendant entities, was interested in the sale transaction (see Wandel v Eisenberg, 60 AD3d 77, 79-80 [1st Dept 2009]).

The Otto decision is noteworthy in two other respects. First, the court disagreed with the lower court’s finding that Maria had legal capacity to assert derivative claims on behalf of the dissolved Delaware LPs and LLCs for which certificates of cancellation had been filed, stating that, under Delaware law, such derivative claims could only be brought after or in conjunction with a successful action seeking the certificates’ nullification. Second, the court agreed with the lower court’s refusal to dismiss Maria’s claims asserted against three dissolved Delaware corporations controlled by Jonathan. “Under Delaware law,” the court wrote, “for the purpose of prosecuting suits, dissolved corporations exist for the term of three years from the expiration or dissolution.”

Central Laborers’ Pension Fund v. Blankfein: Demand Not Excused

The next case involving derivative claims and demand futility stems from investment bank Goldman Sachs Group, Inc.’s (GSG) 2009 annual compensation and benefits that, when announced in January 2010, amounted to 35.8% of net revenues, down almost 13% from 2008. Before the results were announced however, in December 2009, a union pension fund brought a derivative suit predicting that GSG was likely to earmark around 50% of net revenues for that purpose, as in prior years, which for various reasons including “accounting trickery” the union claimed was “excessive.” After the actual results were announced in January 2010, the pension fund declared that its lawsuit had attained its objective, that it would voluntarily discontinue the action, and that it was applying for $5 million in legal fees as a “successful” derivative claimant under § 626 of the New York Business Corporation Law (BCL).

Before the lower court, GSG argued that, regardless whether the reduced 2009 compensation level was or wasn’t caused by the pension fund’s lawsuit, under Delaware’s “meritorious when filed” rule – GSG is a Delaware corporation – the pension fund had to show that its complaint asserted legally sufficient claims, and that it could not do so because the complaint did not allege pre-suit demand upon GSG’s board, and did not sufficiently allege demand futility.

In its September 2011 decision (read here), the lower court adopted GSG’s rationale and construed BCL § 626(e) to require an applicant for a fee award to show compliance with that statute’s predicate provisions including § 626(c)’s requirement that the complaint allege “with particularity the efforts of the plaintiff to secure the initiation of such action by the board or the reasons for not making such effort.” To establish demand futility under governing Delaware law, the court continued, the factual allegations must demonstrate either a “reasonable doubt” that “the directors are disinterested and independent,” or that “the challenged transaction was otherwise the product of a valid business judgment” (citing Aronson v. Lewis, 473 A.2d 805, 814 [Del. 1984], overruled on other grounds by Brehm v. Eisner, 746 A.2d 244 [Del. 2000]).

The lower court held that neither prong of the Aronson test was met. First, the complaint’s allegations of corporate waste and “blind adherence” to past policy did not raise a substantial doubt as to the good faith judgment of the GSG Board in reaching its decision concerning firm compensation. Second, none of the pension fund’s objections to the Board members’ disinterestedness and independence, including the threat of individual liability, receipt of substantial directors’ fees, and holdings in companies that do business with GSG, sufficed to show they were “beholden to any particular corporate influence.”

The pension fund appealed the lower court’s denial of its fee application. In a unanimous, signed opinion by Associate Justice David Friedman in Central Laborers’ Pension Fund v. Blankfein, 2013 NY Slip Op 05857 (1st Dept Sept. 17, 2013), the First Department affirmed the lower court’s order and held that, as a matter of statutory construction and sound policy, a derivative plaintiff’s entitlement to seek a fee award under BCL § 626(e) must satisfy “all of the standing requirements set forth in the remainder of the statute, including the requirement of pre-suit demand on the board.” As Justice Friedman wrote:

Absent a showing that the demand requirement has been complied with or excused, a derivative plaintiff has no justification for acting on behalf of the corporation. Under such circumstances, denying that plaintiff compensation from the corporation for any benefit allegedly conferred by the litigation does not constitute unjust enrichment, and the denial of fees fully accords with the doctrine of substantial benefit.

Interestingly, as the opinion notes, the pension fund’s appellate brief did not challenge the lower court’s finding that the complaint failed to plead particularized facts showing demand futility under Delaware law, and the appellate court therefore deemed “abandoned” any challenge on appeal to that determination.

The Najjar Group, LLC v. West 56th Hotel LLC: Demand Not Excused

It is not unusual for a managing member of an LLC itself to be organized as an LLC. The third, highlighted case involving derivative claims underscores the importance of alleging in support of demand futility that a controlling interest in the managing member, and not just one of its members who alone cannot exert control power, has an interest in the challenged transaction or otherwise is disabled from exercising a valid business judgment.

In The Najjar Group, LLC v. West 56th Hotel LLC, 2013 NY Slip Op 07123 (1st Dept Oct. 31, 2013), the First Department affirmed the lower court’s order dismissing a complaint (read here) brought by the 20% member of a New York LLC seeking judicial dissolution and asserting a series of derivative claims against the 80% managing member relating to disputes over the operation and finances of a Manhattan hotel. The lower court held, and the First Department agreed, that the plaintiff’s claims for breach of the operating agreement, conversion and breach of fiduciary duty, although styled as derivative claims, in actuality sought to vindicate the plaintiff’s individual rights and thus were precluded by adverse determination in prior litigation brought by the same plaintiff asserting direct claims.

The appellate court also upheld the lower court’s finding, even assuming the claims were derivative, that the complaint failed adequately to allege that a pre-suit demand would have been futile. The court noted that the managing member of the LLC was itself an LLC owned by three individuals, only one of whom allegedly controlled certain entities that operated another hotel to which the subject hotel’s funds allegedly were diverted. Plaintiff’s complaint “failed to specify how the other individual defendants were involved” and thus “failed to allege that a majority of the individuals controlling the managing member, defendant West 56th Hotel LLC, were interested in the challenged transaction.”