Derivative Standing And The Difficulty In Distinguishing Between Direct And Derivative Claims

• Posted on: Mar 28 2018

It is well-settled that a plaintiff asserting a derivative claim seeks to recover for injury to the business entity. A plaintiff asserting a direct claim seeks redress for injury to himself/herself individually. Sometimes, the distinction between the two types of actions is not readily apparent. Yudell v. Gilbert, 99 A.D.3d 108, 113 (1st Dept. 2012).

In considering whether a claim is direct or derivative, courts look to the nature of the wrong and the person or entity to whom the relief should go. Tooley v. Donaldson, Lufkin & Jenrette, Inc., 845 A2d 1031, 1039 (Del. 2004). See also Yudell, 99 A.D.3d at 114; Higgins v. New York Stock Exch., Inc., 10 Misc. 3d 257, 264 (Sup. Ct. N.Y. County 2005) (citation omitted). Thus, for a shareholder’s injury to be direct it must be independent of any alleged injury to the corporation. The shareholder must demonstrate that the duty breached was owed to the stockholder and that he/she can prevail without showing an injury to the corporation. Tooley, 845 A2d at 1039.

Derivative claims that are improperly alleged as direct claims must be dismissed for lack of standing. Abrams v. Donati, 66 N.Y.2d 951, 953 (1985) (“[a] complaint the allegations of which confuse a shareholder’s derivative and individual rights will, therefore, be dismissed.”) (internal citations omitted).

New York Courts have held that, because derivative actions bind absent interest holders, they take on “the attributes of a class action” and a “plaintiff must therefore demonstrate that [he] will fairly and adequately represent the interests of the shareholders and the corporation, and that [he] is free of adverse personal interest or animus.” Steinberg v. Steinberg, 106 Misc. 2d 720, 721 (Sup. Ct. N.Y. County 1980) (citation omitted); see also Gilbert v. Kalikow, 272 A.D.2d 63, 63 (1st Dept. 2000) (“[D]erivative causes of action were properly dismissed on the ground that plaintiff has failed to demonstrate that he will fairly and adequately represent the interests of the [limited partnership].”).

As noted in a recent article posted by this Blog (here), these standing requirements are strictly enforced.

Earlier this month, the Appellate Division, First Department, considered the foregoing in a case involving the business breakup of two managing partners of a general partnership. Pokoik v. Norsel Realties, 2018 NY Slip Op. 01534 (1st Dept. Mar. 8, 2018) (here).

Pokoik v. Norsel Realties

Background

Leon Pokoik (“Pokoik”), among others, commenced the action in 2014, asserting direct and derivative claims against, among others, Norsel Realties (“Norsel”), Michael Steinberg (“Steinberg”) and Jay Lieberman (“Lieberman”) for breaches of fiduciary duty in connection with their management of a closely held real estate business.

Norsel, a New York partnership, owns the land under an office building located on Madison Avenue in midtown Manhattan (the “Property”). Defendants Norsel, 575 Realties, Inc. (“575 Realties”) and 575 Associates, LLC (“575 Associates”), an affiliated operating company of 575 Realties, are owned by the Steinberg and Pokoik families, and their children. 575 Realties leases the Property from Norsel, and net leases the Property to 575 Associates.

The dispute centered on the ground rent agreed to between Norsel and 575 Realties for the Property. Plaintiffs claimed that the rent was improperly calculated, notwithstanding the fact that it was based on two independent appraisals. The rental terms for the applicable extension periods of the ground lease were approved by 90% of Norsel’s partners. Pokoik and his family hold approximately 11% of the partnership interests in Norsel and slightly different percentages in their affiliates.

In July 2015, Justice Oing dismissed the initial complaint based solely on the application of the business judgment rule. By order dated April 12, 2016, the Appellate Division, First Department affirmed Justice Oing’s order in part and reversed it in part (Pokoik v. Norsel Realties, 138 A.D.3d 493 (1st Dept 2016) (here). The First Department affirmed the dismissal with prejudice as to the defendant business entities on the ground that there was no allegation that any of those entities owed Plaintiffs a fiduciary duty, or that those entities engaged in any misconduct. The First Department, however, reversed and remanded the remaining claims against Norsel and the individual defendants (Steinberg and Lieberman), finding that the complaint was sufficient with respect to these defendants to overcome the presumptive application of the business judgment rule in view of the limited record at that stage of the proceeding. Notably, the First Department did not address the issue of whether Plaintiffs’ alleged conflicts of interest prevented them from fairly and adequately representing Norsel’s interests.

Plaintiffs subsequently filed an amended complaint in which they named thirty-nine additional defendants, including all of the approving partners, as well as eleven individuals, who either were never partners, or were no longer partners when the new ground rent was approved.

As to all defendants, Plaintiffs alleged that “by arranging and/or agreeing” to the ground rent, each of the defendant mangers/general partners breached their fiduciary duties under New York law.

The amended complaint also contained a cause of action against all defendants, relating to the transfer of the Property from Norsel to Norsel LLC, a newly formed single­member limited liability company, the sole member of which is Norsel. Plaintiffs alleged that, after they filed their initial complaint, Steinberg, Lieberman and possibly other defendants arranged for Norsel to transfer its interests in the Property to Norsel LLC, which transfer was conducted without their knowledge or consent. Plaintiffs alleged that this transfer was made so as to defeat the terms of Norsel’s partnership agreement. Plaintiffs further alleged that Norsel’s managers refused their demands to protect Norsel and its partners against the transfer. As a result, Plaintiffs sought to set aside and void the deed transferring Norsel’s interest in the Property to Norsel LLC, the assumption of the ground lease, and all other instruments in connection therewith.

Defendants moved to dismiss the amended complaint, primarily arguing that Plaintiffs lacked standing to assert their direct and derivative claims. In that regard, they argued that Plaintiffs’ claims were all derivative in nature, and that as such, they lacked standing to assert the claims because of Plaintiffs’ “conflicts of interest,” which prevented them from “fairly and adequately” representing the partnership.

Justice Oing held (here) that Plaintiffs lacked standing to bring the claims asserted in the amended complaint directly, finding that the alleged injuries were suffered by Norsel:

Here, a review of all of plaintiffs’ claims in a light most favorable to them unequivocally demonstrates that they are based on alleged injuries to Norsel purportedly caused by the decisions to adopt an apparently below­market ground lease rent, and to transfer its interest in the Property to Norsel LLC, as well as the transfer of the ground lease from Norsel Realties to Norsel LLC. In fact, plaintiffs allege that the acts underlying the amended complaint were directed at Norsel as an entity, repeatedly asserting that such acts were “not in the best interests of Norsel,” and that “Norsel Realties as a whole is damaged $131,000,000.” Plaintiffs also rely on the purported injury to Norsel as the basis for their individual claims in which they assert that they have been injured in an amount equal to their ownership percentage multiplied by the $131,000,000 allegedly loss to Norsel. Under these circumstances, plaintiffs’ direct claims, which are based on allegations that their interests in Norsel have been diminished through the adoption of the ground rent at issue, are inherently derivative claims. Plaintiffs’ remaining allegations that defendants mismanaged Norsel for their own benefit, i.e., by transferring ownership to Norsel LLC, are similarly derivative in nature. Accordingly, to the extent that plaintiffs attempt to bring direct claims against Norsel or its partners, they do not have standing to do so because the claims asserted in the amended complaint are strictly derivative in nature — the claims and damages alleged result from purported injuries to Norsel. [Citations to Amended Complaint omitted.]

Having determined that the claims were derivative in nature, Justice Oing turned to the question of whether Plaintiffs had standing to represent the partnership’s interests. Justice Oing found that, for a number of reasons, Plaintiffs did not “fairly and adequately represent the interests” of the partnership because they were not “free of adverse personal interest or animus.” Citations omitted.

As an initial matter, the court found that because Plaintiffs sued all of Norsel’s partners, there were no beneficiaries of the action. “This presents a prototypical conflict of interest,” said Justice Oing.

The court also found that Plaintiffs had an “inherent conflict of interest” because of their 12.788% ownership interest in 575 Associates. Since 575 Associates net leases the Property from 575 Realties, the court found that the “plaintiffs are attempting to double dip — they are simultaneously receiving funds from 575 Associates in the form rental income while suing Norsel over the same ground rent.”

The court further found that Plaintiffs were harming Norsel rather than benefitting the partnership, finding that they did not “have any genuine concern for Norsel or its related entities.”

In addition, plaintiffs do not appear to have any genuine concern for Norsel or its related entities. While plaintiffs seek to extract monetary damages from their partners based upon their extremely high property appraisals, they do not request any relief, such as the revision of the subject ground lease rent or court oversight of the appraisal process, that would benefit Norsel. Indeed, plaintiffs ignore the fact that their $20 million proposed annual rent, an almost 90% increase, would make business operations more difficult for 575 Associates which, in turn, would jeopardize Norsel itself.

Last, but not least, Justice Oing found that Leon Pokoik, the lead plaintiff in the action, was not “free from personal animus” when it came to his business partners. According to the court, Pokoik’s “litigious nature” demonstrated that he was using the litigation as “a weapon” “to gain leverage in the other disputes” with his business partners and family. “Having named all of the Norsel partners with whom plaintiffs disagree as defendants in this action, and given Leon Pokoik’s demonstrated animus,” concluded the court, “plaintiffs’ self-interest is palpably obvious to the point that they are unable to show that they will adequately represent the interest of these defendants.” [Citations omitted.]

The Court granted Defendants’ motion and dismissed the amended complaint in its entirety. Plaintiffs appealed.

First Department Ruling

The Court unanimously modified the decision, vacating the dismissal of the individual defendants, reversing the dismissal of Plaintiffs’ first three of the causes of action and affirming the remainder of the motion court’s decision.

Relevant to the motion court’s finding that Pokoik was not “free from personal animus,” the Court disagreed, finding that the record was devoid of “any indication of an especially acrimonious relationship between the parties.”

We perceive no conflict of interest that would prevent plaintiffs from fairly representing Norsel’s interests. In a separate derivative action by plaintiff Leon Pokoik against other Pokoik family members, who are also defendants in this action, we found that Pokoik’s relationship with defendants had not been shown to be “so acrimonious or emotional as to demonstrate that plaintiff cannot act as an adequate representative for the companies” (Pokoik v Pokoik, 146 AD3d 474, 475 [1st Dept 2017]). Nor is there in the present record any indication of an especially acrimonious relationship between the parties.

Takeaway

Breaking up a business relationship is hard to do. It can be acrimonious and/or emotional. The First Department’s decision in Pokoik shows that the degree of acrimony alleged is important, especially on a motion to dismiss. Although the facts in Pokoik – namely, Pokoik’s “litigious nature” and his improper use of the lawsuit as leverage in other cases against the defendants – showed some acrimony, it was not enough on the pleadings to demonstrate a conflict of interest sufficient to defeat derivative standing. The lesson of Pokoik, therefore, is that acrimony and/or personal animus alone is not be enough to defeat derivative standing, no matter how intensely expressed they may be. More facts are needed. Without such facts, defendants will be unable to demonstrate that a plaintiff cannot, and will not, “fairly and adequately represent the interests of the shareholders and the corporation.…”