Business divorce cases more often than not include claims against the controlling owners for diversion or waste of company assets,  usurpation of corporate opportunity, taking excessive compensation and the like. The party directly harmed by the claimed misconduct is the company.

Under settled law, that means the claim belongs to the company and, at least in the first instance, is to be pursued or not in accordance with the business judgment of the board of directors or, in the case of an LLC, its managers. (For the sake of simplicity, I’ll use the word “board” to refer both to a corporation’s board of directors and the collective managers of an LLC whether or not denominated a board of managers, and I’ll use the word “controller” to refer to the individual board members.)

While the effects of the claimed misconduct may have no less of an impact on the non-controlling owner, the harm is indirect and therefore not amenable to a direct claim in the name and right of the non-controlling owner. Enter the derivative action, in which a shareholder or LLC member sues some or all the controllers for recovery on behalf of the company.

The derivative action as far as I know is authorized by statute and/or common law in every state. Shareholder derivative actions asserting claims on behalf of New York corporations are authorized by § 626 of the Business Corporation Law. Derivative actions brought by members on behalf of New York LLCs are authorized under common law as pronounced in 2010 by New York’s highest court in Tzolis v Wolff. By and large, New York courts post-Tzolis have applied the standards and requirements developed under § 626 to LLC derivative actions.

Business divorce cases litigated in New York courts often involve companies formed under Delaware law. In such cases, under New York choice-of-law rules, the court will apply Delaware law in deciding disputes concerning entity governance and other internal affairs, including derivative actions.

Under Delaware law, shareholder derivative actions are governed by Delaware General Corporation Law § 327 and Chancery Court Rule 23.1 while derivative actions by LLC members are governed by Delaware LLC Act §§ 18-1001 through 1004.

The Demand Requirement

Consistent with the board’s duty and right to manage the company’s business affairs, the above-referenced New York and Delaware statutes and court rules require that the complaint in a derivative action set forth “with particularity” the efforts of the plaintiff to obtain the action the plaintiff desires from the board or the reasons for not making such effort. In common parlance, the plaintiff’s complaint must allege demand or demand futility.

When demand is made upon the board to initiate a lawsuit against one or more controllers, and there’s no challenge to the board’s ability consistent with its fiduciary duties to consider the demand and to exercise properly its business judgment, the board’s decision not to pursue litigation, while technically not a bar to a subsequent derivative action, practically creates an insuperable barrier to the effort.

The same holds true when a board-appointed, independent special litigation committee recommends against pursuing the claims.

Most threshold challenges to derivative actions therefore stem from complaints alleging demand futility. In the seminal Delaware case, Aronson v Lewis, 473 A.2d 405 [1984], the Supreme Court held that plaintiffs in derivative actions must allege particularized facts which create a “reasonable doubt” that,

(1) the directors are disinterested and independent and (2) the challenged transaction was otherwise the product of a valid exercise of business judgment. Hence, the Court of Chancery must make two inquiries, one into the independence and disinterestedness of the directors and the other into the substantive nature of the challenged transaction and the board’s approval thereof.

In the leading New York case, Marx v Akers, 88 NY2d 189 [1996], the Court of Appeals noted criticism of what it called Aronson‘s “reasonable doubt threshold of Delaware’s two-fold approach to demand futility” and formulated its own three-part standard:

(1) Demand is excused because of futility when a complaint alleges with particularity that a majority of the board of directors is interested in the challenged transaction. Director interest may either be self-interest in the transaction at issue, or a loss of independence because a director with no direct interest in a transaction is “controlled” by a self-interested director. (2) Demand is excused because of futility when a complaint alleges with particularity that the board of directors did not fully inform themselves about the challenged transaction to the extent reasonably appropriate under the circumstances. The long-standing rule is that a director does not exempt himself from liability by failing to do more than passively rubber-stamp the decisions of the active managers. (3) Demand is excused because of futility when a complaint alleges with particularity that the challenged transaction was so egregious on its face that it could not have been the product of sound business judgment of the directors. [Citations and internal quotes omitted.]

The Particularity Pitfall

Many business divorce cases involve a small number of owners who are active in the business. In those cases, where the plaintiff’s derivative complaint alleges factually detailed acts of diversion, waste, self-dealing, etc., attributable to each of the other controllers constituting a majority of the board or, as in a two-owner, 50/50 company, having blocking power at the board level, demand futility normally does not present much of a pleading hurdle. In such cases, the courts usually will allow that the personal liability faced by the defendant controllers defeats their disinterestedness.

The potential pitfalls of pleading demand futility are more apt to snag the unwary plaintiff who pleads derivative claims involving a company with a sufficient number of outside controllers and/or inside controllers who are not accused of malfeasance, and whose disinterestedness and independence would enable them to decide by the requisite voting majority whether to pursue litigation in the company’s own name and right.

Two recent decisions by New York appellate panels, both involving Delaware  illustrate the point.

Glaubach v Slifkin

Glaubach v Slifkin, 171 AD3d 1019, 2019 NY Slip Op 02854 [2d Dept Apr. 17, 2019], involves a highly contentious, multi-jurisdictional battle over a Long Island-based provider of home healthcare services organized as a Delaware corporation. My partner Matt Donovan previously wrote on this blog about a post-trial ruling by the Delaware Chancery Court in a lawsuit against Felix Glaubach by the other owner (Robert Marx) and outside directors for breach of fiduciary duty stemming from a real estate transaction and a bizarre campaign of letter-writing harassment against Marx, the other directors, and their spouses.

The parties switched positions in the New York case, with Glaubach asserting derivative claims against the others allegedly for taking unauthorized compensation hidden as reimbursement of educational expense that they did not actually incur. The lower court denied the defendants’ dismissal motion challenging the adequacy of the complaint’s allegations of demand futility. The defendants appealed to the Appellate Division, Second Department, which reversed the lower court’s ruling and dismissed the claims.

In their briefs, the defendants argued that Glaubach’s complaint did not include particularized allegations showing bad faith or self-interest sufficient to overcome the statutory exculpation of the liability for breach of the duty of care under § 102(b)(7) of the Delaware General Corporation Law. The appellate panel apparently agreed, citing Glaubach’s failure to plead demand futility with sufficient particularity along with other deficiencies. The court wrote:

Here, the plaintiff alleged in the amended complaint that, at a board meeting and in certain letters and emails, he demanded that the corporation’s board of directors take action with respect to the allegations in the amended complaint. However, the board meeting minutes, letters, and emails that the plaintiff submitted in opposition to the motion to dismiss conclusively demonstrated that he did not demand that the board take any specific action, such as by filing suit. The plaintiff also failed to allege particularized facts indicating that such a demand would be futile. Moreover, even if the plaintiff had made a specific demand with respect to the causes of action relating to the payments characterized as reimbursement of educational expenses, these causes of action were premature, as the audit committee, which was appointed by the board of directors to investigate these allegations less than two months prior to the commencement of this action, had not completed its investigation. [Citations omitted.]

Madison Sullivan Partners LLC v PMG Sullivan St., LLC

Madison Sullivan Partners LLC v PMG Sullivan St., LLC, 2019 NY Slip Op 04460 [1st Dept June 6, 2019], involved a dispute between 50/50 owners of a real estate venture organized as a Delaware LLC. The plaintiff asserted derivative claims against the defendant allegedly for causing $30 million in construction delays and cost overruns, and that defendants’ actions constituted bad faith, intentional wrongdoing, and gross negligence. The complaint alleged that a pre-suit demand on the defendants would have been futile. The lower court dismissed the derivative claims for failure to plead particularized facts showing demand futility.

On appeal, the plaintiff contended that demand futility was adequately pleaded because the defendant 50% corporate shareholder or its affiliate potentially was liable for the derivative claims. The defendants argued that Glaubach’s allegations failed to satisfy the Delaware standard requiring that the plaintiff plead particularized facts showing that the 50% shareholder could not have properly exercised its independent and disinterested business judgment in responding to a demand to act because of a “substantial likelihood,” not just a mere threat of individual liability.

In its unanimous decision affirming the lower court’s order of dismissal, the appellate panel wrote that “under Delaware law, which governs the instant demand futility analysis, the allegations in the complaint are insufficient to show demand futility because they lack the requisite particularized facts establishing that defendants faced a ‘substantial likelihood’ of personal liability,” citing the Delaware Supreme Court’s ruling in Rales v Blasband, 634 A2d 927, 934-936 [Del 1993].

The above synopses barely scratch the surface of the complexities surrounding the demand/demand futility issue which, over the decades, has generated a vast body of case law. Most of the credit goes to the Delaware Chancery Court which has the advantage, if you can call it that, of deciding far more shareholder derivative lawsuits than New York courts involving public companies whose boards almost invariably include a material number of outside directors.

But even in cases involving closely held business entities, whether organized under Delaware of New York law, it is essential that counsel on both sides of any case involving derivative claims carefully consider whether the complaint’s  allegations in support of demand futility are stated with sufficient particularity. On the plaintiff’s side, do not take for granted the sufficiency of allegations that the named defendants may face liability. On the defendant’s side, look for conclusory, non-particularized allegations of lack of controller disinterestedness or independence, or of a controller’s failure to adequately inform himself or herself of matters before the board.