If you ask me to name the most common skirmishes over the adequacy of pleadings at the outset of business divorce litigation, at or near the top of the list are motions to dismiss a dissident owner’s direct claims that should have been brought derivatively, or derivative claims that should have been brought directly, or claims pleaded as both direct and derivative.
The frequency of such motion practice contrasts with the simplicity of the two-factor test devised by the courts for determining whether a claim is direct or derivative. As stated by the Appellate Division, First Department in Yudell v Gilbert, borrowing from the Delaware Supreme Court’s Tooley formulation, the determination depends on “(1) who suffered the alleged harm (the corporation or the stockholders); and (2) who would receive the benefit of any recovery or other remedy (the corporation or the stockholders individually).”
The test sounds easy to apply, and in most cases it is, especially when the alleged wrongful conduct by a controller involves misuse or waste of company funds or other financial impropriety that affects the nonculpable owners indirectly and on a shared basis by devaluing their equity interests. While the nonculpable owners of a closely held business may be victimized in a very real sense by the controller’s alleged misconduct, the direct injury is to the company for which the company is entitled to any recovery. Stated differently, the claim is company property, the prosecution of which normally depends on the business judgment of those holding the company’s managerial reins, and therefore can only be asserted by the non-managerial owners as a derivative claim after making demand upon the company managers or establishing that demand would be futile.
Let’s look at some recent examples of derivative and direct claims that went astray.
A “Quintessential” Derivative Claim. Last October, in Sajust, LLC v Mendelow, the Appellate Division, First Department affirmed the Manhattan Commercial Division’s dismissal of a complaint by an LLC member asserting direct claims for losses to her capital account against the allegedly disloyal manager of a Madoff feeder fund that, following Madoff’s implosion, recovered from the Trustee only a small portion of the fund’s investments. The complaint also alleged a direct claim for losses to the plaintiff’s capital account from the Trustee’s denial of a credit for “fictitious profits” on investments that had been “rolled over” from another fund. Quoting from Yudell and other precedent, the Appellate Division found that
- the plaintiff’s capital account was “akin to the value of shares in a corporation”;
- “the lost value of an investment in a corporation is quintessentially a derivative claim by a shareholder”;
- the claim was derivative “even if the diminution in value [of the capital account] derives from a breach of fiduciary duty”; and
- “even though plaintiff alleges an individual harm, the loss of a portion of the rollover amount, such claim cannot separately stand on its own because it is embedded in [the fund’s] harm, the loss of the entire rollover amount.”
Company-Funded Legal Fees: Derivative, Not Direct. Just last week, the Appellate Division, Second Department in Weinstein v Levine applied the direct-derivative dichotomy to an issue that frequently arises in business divorce litigation when the defendants who control the company checkbook use company funds to pay their personal legal fees. In a post-trial decision, the lower court threw out the plaintiff 50% LLC member’s claims for fraud and unjust enrichment. The Appellate Division, while affirming the dismissal of the claims, disagreed with the lower court’s award in plaintiff’s favor of about $107,000 representing funds diverted from the LLC to pay the fees of the defendants’ attorneys. Here’s what the court wrote:
Although the [defendants], on appeal, do not challenge the court’s determination that those funds should not have been diverted from SMAX to pay their litigation expenses, they correctly contend that this award to [plaintiff] individually was improper, as the diversion of these funds from SMAX only injured [plaintiff] derivatively, and that the proper remedy would be for the funds to be returned to SMAX to be distributed in the dissolution proceeding.
At least in this case, due to the pending dissolution proceeding, it appears the plaintiff still has a chance to recover his 50% of the diverted funds, assuming the company’s liquidation.
With Unpaid Company Creditors, All the More Reason to Police Direct Claims. The Manhattan Commercial Division’s decision last month in Mascarenhas v Paam Group Inc. involves an Indian restaurant named Nirvana on Lexington Avenue around the corner from my Manhattan office that, as far as I knew, has been shut down for some time due to the drastic impact of the COVID pandemic on retail and hospitality businesses in the midtown office district. It seems Nirvana also is not living up to its name as the subject of what the court describes as a “bitter dispute between business partners” in which a 50% shareholder asserted direct claims against the corporation, his business partner, and another corporation owned by his partner seeking to recover his investment, his 50% share of profits allegedly in the millions, and accusing his partner of various and sundry fiduciary breaches and of locking him out of the business. Not surprisingly, the court granted the defendants’ motion to dismiss the plaintiff’s direct cause of action seeking damages for breach of fiduciary duty, holding that the claim needed to be brought derivatively because “the alleged harm is to the corporation, not plaintiff, and the corporation would benefit from the recovery of [defendant’s] alleged misappropriated funds.” The court also emphasized that “crucially, on one issue, plaintiff and defendants agree: [the corporation] has unpaid creditors” and that “as such, there may be creditors with claims superior to plaintiff which precludes direct recovery by plaintiff.”
Direct Claim Brought as Derivative. The preceding three cases illustrate the more common instance of a derivative claim improperly asserted as a direct claim. Last month’s decision in Jacobsen v 474 3rd Owners Corp. features the reverse: a direct claim improperly pleaded as a derivative claim. The plaintiff, a 25% shareholder of a residential cooperative corporation, alleged various improper acts by his fellow board members including failing to conduct regular meetings, acting through an executive committee thereby excluding plaintiff from decision-making, and failing to provide financial statements. The Brooklyn Commercial Division’s decision, in addition to finding that the defendant board members’ actions were protected by the business judgment rule, found that the alleged injuries “only affect” the plaintiff and that “the entirety of the complaint as well as the accompanying materials demonstrate this lawsuit concerns personal claims Mr. Jacobsen maintains against the board of directors. Those claims may be real, however, they are surely not derivative in nature.” Was the prospect of recovering legal fees under BCL § 626(e) as demanded in the plaintiff’s complaint a factor in styling the claims as derivative? We’ll never know, although if it was, it’s difficult to understand since the complaint doesn’t allege or seek any money damages to the corporation out of which the legal fees would have to be paid.
Intermingled Direct and Derivative Claims. Here’s another no-no: courts routinely dismiss claims that intermingle direct and derivative claims in the same cause of action. This often occurs very simply when the cause of action as drafted culminates with an allegation that begins, “By reason of the foregoing . . . ” and then proceeds in the same sentence to allege both the company’s and the individual plaintiff’s entitlement to recover damages, which is then echoed at the bottom of the complaint in its ad damnum demand. Here’s how the Appellate Division, First Department handled such a case in a decision last year in Billig v Schwartz:
While it is somewhat unclear as to whether the motion court granted plaintiffs’ motion to amend, the issue is not determinative. There remain pleading deficiencies on the face of the proposed amended complaint, which are dismissible for the independent reason that the individual and derivative claims asserted by plaintiffs are intermingled. The intermingling of direct and derivative claims into single causes of action warrants dismissal of the complaint without prejudice. [Citations omitted.]
Death of the Dual-Natured Claim. In Gentile v Rossette, decided in 2006 only two years after Tooley, the Delaware Supreme Court carved out a narrow exception to the Tooley test for what came to known as the dual-natured claim, described by the court as “a species of corporate overpayment claim” that was “both derivative and direct in character,” 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; and (2) the exchange causes an increase in the percentage of the outstanding shares owned by the controlling shareholder and a corresponding dilution of the minority shareholders’ voting power. Over the years Gentile had a bumpy ride in Chancery Court, leading the Delaware Supreme Court in its 2016 El Paso ruling to construe Gentile narrowly, limiting it to the unique circumstances of that case. After further Gentile turbulence in Chancery Court, last September in Brookfield Asset Management, Inc. v Rosson, in a rare instance of the Delaware Supreme Court overruling its own precedent, the court dealt Gentile the coup de grâce, concluding that it suffered from intractable doctrinal and practical problems. Over the years a number of New York courts have allowed dual-natured claims to proceed on the authority of Gentile in disputes involving Delaware entities, including recent decisions by the Appellate Division here and here. That will now come to an end, likely pushing claims that pre-Brookfield would have qualified as dual-natured into the purely derivative classification.
Pay Close Attention, Practitioners! In the great majority of fact patterns in business divorce cases involving claims of financial chicanery by controllers, the directly injured party is the company and the claim therefore should be brought derivatively — even when there are only two, 50/50 owners. An obvious exception is a direct claim for improper distributions. Practitioners are well advised when drafting the complaint or petition to analyze carefully the facts and their client’s potential claims through the lens of the two-factor test for derivative versus direct claims. Failure to do so may cost the case precious time and the client precious dollars litigating a dismissal motion that does nothing to advance the merits of the case.