We’ve written from time to time, including here and here, about the need to allege pre-suit demand or demand futility where a shareholder seeks to sue derivatively on behalf of a corporation for whom the court has appointed a receiver. Pre-receivership, the board of directors is entitled to decide whether to bring a lawsuit on the corporation’s behalf. Under Section 626 (c) of the Business Corporation Law, a shareholder seeking to sue derivatively on behalf of the corporation must allege (i) pre-suit demand upon the board to commence a lawsuit on behalf of the corporation or (ii) that a demand upon the board of directors to commence suit would be “futile.”
Things change when a receiver is appointed. In an order appointing a receiver, the court typically gives to the receiver, and takes from the board, the power to decide whether to commence suit on the corporation’s behalf. In that situation, the putative shareholder derivative plaintiff must allege pre-suit demand or demand futility upon the receiver. The concept is straightforward, but putative derivative plaintiffs often overlook it.
Take, for example, a recent decision by Manhattan Commercial Division Justice Andrea J. Masley in Culligan Soft Water Co. v Clayton Dubilier & Rice, LLC, 2020 NY Slip Op 30828(U) [Sup Ct, NY County Mar. 19, 2020]. Culligan did not involve a closely-held business, but it did contain a particularly useful explanation of the applicable law in New York on the subject of alleging pre-suit demand upon a court-appointed receiver, or in that case, “liquidator,” including the subject of a pre-suit demand relating back to a prior-filed pleading.
The New York Derivative Lawsuit and the Bermuda Liquidation Proceeding
In 2012, a group of minority shareholders sued derivatively on behalf of Culligan, a Bermuda corporation in the business of providing “water treatment services and equipment, primarily through franchised dealers.” The plaintiffs alleged that a private equity firm entered into a leveraged buyout of Culligan, stripped the corporation of its assets, saddled it with enormous debt, and destroyed the company for its own profit. The plaintiffs brought claims against the corporation’s directors as well as certain outside advisors, including accounting and investment advisory firm KPMG. In their original complaint, the plaintiffs alleged a series of written pre-suit demands upon the board of directors, which the board allegedly either ignored or failed to act upon.
In 2013, while the shareholder derivative action was pending in New York, Culligan entered into a voluntary liquidation in Bermuda. In connection with the liquidation, the shareholders of Culligan adopted a resolution under Bermuda law appointing two members of KPMG as “liquidators” to wind up Culligan’s affairs. The Supreme Court of Bermuda later issued an order approving appointment of the liquidators.
In early 2019, following the dismissal of their third amended complaint “without prejudice to replead,” the shareholder derivative plaintiffs filed in New York a fourth amended complaint. Although the new pleading explicitly referred to the Bermuda liquidation proceeding, it did not allege a pre-suit demand upon the liquidators to file the fourth amended complaint, nor did it allege that such demand would be futile.
The Motion for Substitution, or in the Alternative, to Dismiss
The liquidators promptly filed a motion to substitute themselves as plaintiffs, or in the alternative, for dismissal of the fourth amended complaint, arguing in their memorandum of law that their appointment as liquidators bestowed upon them “sole authority to represent Culligan,” “displac[ed] the corporation’s board of directors,” and “divested the shareholders of any standing they might have had” to pursue their derivative claims. In their opposition memorandum of law, the plaintiffs argued, among other things, that they sufficiently alleged pre-suit demand in their original pleading, and that their allegations of pre-suit demand “related back” to the original pleading, excusing the requirement of making a subsequent demand upon the liquidators at the time of filing the fourth amended pleading.
Rulings on the Substitution Motion
Section 1017 of the New York Civil Practice Law and Rules provides, “If a receiver is appointed for a party, or a corporate party is dissolved, the court shall order substitution of the proper parties.” Applying this statute, the first question Justice Masley considered was whether a corporate liquidator appointed under Bermuda law is “akin to that of a receiver” under New York law. The Court ruled that the “powers granted to the Liquidators are similar to those of a bankruptcy trustee, in that such trustee’s duties include the liquidation of the property of the estate.” “Accordingly,” the court ruled,” no difference should exist between a receiver and the Liquidators for purposes of applying CPLR 1017.”
Nonetheless, the Court denied the liquidators’ motion to be substituted as plaintiffs because the fourth amended complaint “contains a breach of fiduciary duty claim against KPMG,” making it “unclear” to the Court whether the liquidators’ relationship with KMPG raises a “possible conflict of interest” between the liquidators, in their capacity as prospective derivative plaintiffs, on the one hand, and Culligan, the entity on whose behalf they would be suing, on the other.
Rulings on the Dismissal Motion
The most interesting aspect of Culligan is the Court’s treatment of the plaintiffs’ relation back argument. As Justice Masley explained, “It is undisputed that demand futility was properly [alleged] with respect to the existing board at the time plaintiffs initiated the action [in 2012]. The parties, however, dispute as to whether to continue looking at the board or instead to the Liquidators for assessing demand and demand futility with respect to the [fourth amended complaint in 2019].”
As to the initial choice-of-law question, the Court noted that in a prior appeal the “Appellate Division held that New York law, not Bermuda law, governs plaintiffs’ standing to bring the shareholder derivative action” (citing Culligan Soft Water Co. v Clayton Dubillier & Rice LLC, 118 AD3d 422 [1st Dept 2014]).
Applying New York law to the issue of pre-suit demand, the court explained:
When, as here, a complaint is amended following a dismissal without prejudice, demand and demand futility must be assessed by reference to the board in place at the time the amended pleading is filed (see Korsinsky v Winkelreid, 143 AD3d 427, 427 [1st Dept 2016]; see Brody v Chemical Bank, 517 F2d 932, 934 [2d Cir 1975]). [T]he FAC [fourth amended complaint] does not relate back to 2012 for demand or demand futility purposes, as argued by plaintiffs, because the third amended complaint was not ‘validly in litigation’, since, as previously noted, it was dismissed by the trial court, and its dismissal was affirmed by the Appellate Division (see Korsinsky v Winkelreid, 143 AD3d at 427 [‘[a] complaint that is dismissed without prejudice but with express leave to amend is nevertheless a dismissed complaint’]).
Applying these principles, the Court held:
[T]he demand or demand futility needs to be measured in terms of the 2019 board, or in this case, the Liquidators who had already been appointed, at the time of the FAC. Accordingly, to avoid dismissal of the FAC, plaintiffs are required to show that they made a demand on the Liquidators or that it would have been futile to have made a demand on them. Here, the FAC is devoid of any allegations that such demand was made or excusing plaintiffs for not making the demand on the Liquidators. Therefore, the derivative claims asserted by plaintiffs on behalf of Culligan Ltd. are dismissed without prejudice for failure to make a demand on the Liquidators or plead demand futility regarding the Liquidators.
Follow the Rules
The following rules emerge from Culligan:
- First, where a corporate receiver is appointed prior to the filing of a shareholder derivative lawsuit, the putative plaintiff must always allege pre-suit demand or demand futility upon the receiver, which has authority (instead of its board) to decide whether to commence litigation on behalf of the corporation.
- Second, where a corporate receiver is appointed during the pendency of a shareholder derivative lawsuit, and a derivative plaintiff thereafter seeks to file an amended complaint, the plaintiff must allege pre-suit demand or demand futility upon the receiver, unless the prior pleading is “validly in litigation” at the time of the filing of the amended pleading, in which case the demand requirement potentially “relates back” to the prior pleading.
- Third, for a prior pleading to be “validly in litigation” for purposes of the relation-back rule, the prior pleading “can or has survived a motion to dismiss,” including an attack upon the sufficiency of the prior complaint’s allegations of pre-suit demand or demand futility (Braddock v Zimmerman, 906 A2d 776, 779 [Del 2006]).
Failure to adhere to these rules can result in an expensive loss for the putative shareholder derivate plaintiff.