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BCL § 626(c): Demand Futility

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  • Posted on: Jan 24 2022

By: Jeffrey M. Haber

Derivative actions are often brought by shareholders of a corporation (or limited liability company) to vindicate the entity’s rights.1 Although shareholders are given the right to bring such lawsuits, they are not, however, favored because “they ask courts to second-guess the business judgment of the individuals charged with managing the company.”2 Notwithstanding, “derivative actions serve the important purpose of protecting corporations and minority shareholders against officers and directors who, in discharging their official responsibilities, place other interests ahead of those of the corporation.”3

The tension between the foregoing interests is tempered by the requirement that a shareholder demand with particularity that the board of directors (or majority owners) take action to address the alleged wrongdoing or explain why such demand would have been futile.4 As explained by the Court of Appeals, “[t]he reason for the demand requirement rests on ‘basic principles of corporate control that the management of the corporation is entrusted to its board of directors, who have primary responsibility for acting in the name of the corporation and who are often in a position to correct alleged abuses without resort to the courts.’”5 “The demand requirement thus relieves courts of unduly intruding into matters of corporate governance by first allowing the directors themselves to address the alleged abuses. The requirement also provides boards with reasonable protection from harassment on matters clearly within their discretion, and it discourages ‘strike suits’ commenced by shareholders for personal rather than corporate benefit.”6 

“Demand is futile, and excused, when the directors [or managing members] are incapable of making an impartial decision as to whether to bring suit.”7 In New York, the demand requirement is excused where a plaintiff pleads “with particularity that (1) a majority of the directors [or managing members] are interested in the transaction, or (2) the directors [managing members] failed to inform themselves to a degree reasonably necessary about the transaction, or (3) the directors [or managing members] failed to exercise their business judgment in approving the transaction.”8 If any of these circumstances are met, the failure to file a pre-suit demand will be excused.9 

It is important to note that excusing a pre-suit demand is the exception and, therefore, “should not be permitted to swallow the rule” that a pre-litigation demand is required.10 Thus, if a plaintiff fails to plead with particularity that service of a pre-litigation demand should be excused, the complaint must be dismissed.11 

“[A] director may be interested under either of two scenarios: self-interest in a transaction or loss of independence due to the control of an interested director.”12 “The bare claim that the directors … should be viewed as interested because they are ‘substantially likely to be held liable’ for their actions is not enough” to find interestedness.13 Indeed, simply naming each current or former director “in a lawsuit, without more, is insufficient to establish that they are conflicted and demand is futile.”14 

Likewise, the assertion that certain directors controlled the amount of compensation other directors would have received is inadequate, especially in the absence of an allegation that the compensation the directors received was excessive.15 

Although a pre-suit demand can be excused because the directors failed to exercise their business judgment in approving the transaction, demonstrating such a failure can be difficult. Indeed, “it is the ‘rare case[ ] [in which] a transaction may be so egregious on its face that board approval cannot meet the test of business judgment.’”16 

“The business judgment rule is a common-law doctrine by which courts exercise restraint and defer to good faith decisions made by boards of directors in business settings.”17 The rule does not, however, protect directors who “passively rubber-stamp[] the acts of active corporate managers.”18 The complaint must “allege facts, such as self-dealing, fraud or bad faith” to show that the subject transaction “could not have been the product of sound business judgment.”19 Thus, “[s]o long as the corporation’s directors have not breached their fiduciary obligation to the corporation, the exercise of [their powers] for the common and general interests of the corporation may not be questioned, although the results show that what they did was unwise or inexpedient.”20 

The foregoing principles were recently considered by the Appellate Division, Second Department in Recine v. Recine, 2022 N.Y. Slip Op. 00324 (2d Dept. Jan. 19, 2022).

Recine involved an action to recover damages for breach of fiduciary duty against defendants Luciano Recine, Salimar Christina Recine (collectively, “Recine Defendants”), and Recine Properties, LLC. Plaintiff, John Recine, and his siblings, the “Recine Defendants”, were the managing members of Defendant Recine Properties, LLC (the “Company”). The Company is a limited liability company that was formed for the purpose of acquiring, holding, and disposing of certain real property in Rockaway Beach (the “Property”). 

Plaintiff commenced the action, individually and derivatively, against the Recine Defendants and the Company, among others, to recover damages for breach of fiduciary duty, misappropriation and conversion, and unjust enrichment, and for an accounting, injunctive relief, and removal of the Recine Defendants as the managing members. Plaintiff alleged that the Recine Defendants sold the Property, the Company’s sole asset, without his knowledge or consent, thereafter intended to divert or diverted a portion of the proceeds for the benefit of their separate business interests, and refused his requests for information and documentation regarding the sale and the disposition of the proceeds.

Plaintiff moved, inter alia, to preliminarily enjoin the transfer and use of the sale proceeds. The Recine Defendants moved to dismiss pursuant to CPLR § 3211(a). The motion court, inter alia, (1) granted Plaintiff’s motion to preliminarily enjoin the Recine Defendants from disbursing, transferring, encumbering, or assigning the net proceeds of the sale of the property in a manner other than distribution of an equal share to each member, pursuant to the operating agreement; and (2) denied the Recine Defendants’ motion to dismiss the complaint. The Recine Defendants appealed.

The Second Department reversed the motion court’s order with respect to Plaintiff’s motion and affirmed the denial of the Recine Defendants’ motion. We discuss the latter holding.

The Court held that Plaintiff properly alleged demand futility. The Court found that Luciano Recine and Salimar Christina Recine constituted a majority of the managing members of the Company and were interested in the challenged transaction. As such, held the Court, “demand to initiate suit against themselves would have been futile.”21

The Court also held that the motion court properly denied the Recine Defendants’ motion to dismiss the breach of fiduciary duty, misappropriation and conversion, unjust enrichment, and accounting causes of action. The Court found that the Plaintiff alleged (as supplemented by his affidavit) sufficient facts to support the causes of action alleged.22  


Jeffrey M. Haber is a partner and co-founder of Freiberger Haber LLP.

This article is for informational purposes and is not intended to be and should not be taken as legal advice.

Footnotes

  1. Bansbach v. Zinn, 1 N.Y.3d 1, 8 (2003), rearg. denied, 1 N.Y.3d 593 (2004); Marx v. Akers, 88 N.Y.2d 189, 193 (1996).
  2. Bansbach, 1 N.Y.3d at 8.  
  3. Id.
  4. BCL § 626 (c) (providing that the derivative complaint “shall set forth 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”).
  5. Bansbach, 1 N.Y.3d at 9 (quoting, Barr v. Wackman, 36 N.Y.2d 371, 378 (1975)) (citation omitted).
  6. Id. (citing, Marx, 88 N.Y.2d at 194).
  7. Id.
  8. Marx, 88 N.Y.2d at 198.
  9.  Id. at 200-201.
  10. Matter of Omnicom Grp. Inc. S’holder Deriv. Litig., 43 A.D.3d 766, 768 (1st Dept. 2007) (citing, Marx, 88 N.Y.2d at 200).
  11. See Retirement Plan for Gen. Empls. of the City of N. Miami Beach v. McGraw, 158 A.D.3d 494, 495 (1st Dept. 2018).
  12. Matter of Comverse Tech., Inc. Deriv. Litig., 56 A.D.3d 49, 54 (1st Dept. 2008).
  13. Wandel v. Eisenberg, 60 A.D.3d 77, 80 (1st Dept. 2009).
  14. Lerner v. Immelt, 523 Fed. Appx 824, 827 (2d Cir. 2013) (citations omitted); accord, Bildstein v. Atwater, 222 A.D.2d 545, 546 (2d Dept. 1995).
  15. Walsh v. Wwebnet, Inc., 116 A.D.3d 845, 848 (2d Dept. 2014).
  16. Stein v. Immelt, 472 Fed. Appx. 64, 66 (2d Cir. 2012) (quoting, Wandel, 60 A.D.3d at 82).
  17. 40 W. 67th St. Corp. v. Pullman, 100 N.Y.2d 147, 153 (2003) (citation omitted).  
  18. Comverse, 56 A.D.3d at 56 (citing, Barr, 36 N.Y.2d at 381).
  19. Goldstein v. Bass, 138 A.D.3d 556, 557 (1st Dept. 2016).
  20. Matter of Levandusky v. One Fifth Ave. Apt. Corp., 75 N.Y.2d 530, 538 (1990) (internal quotation marks and citation omitted).
  21. Slip Op. at *2 (citations omitted).
  22.  Id. at *3 (citations omitted).
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