Failure To Plead Demand Futility Warrants Dismissal Of Derivative Complaint

• Posted on: May 23 2018

This Blog has previously examined the different aspects of a shareholder’s derivative action, such as the standing requirements and the distinction between direct and derivative claims. (Here, here and here.) Today’s article revisits these issues.

The Demand Futility Requirement

Under Delaware law, to have standing to bring a derivative claim on behalf of a corporation, a plaintiff “must make a pre-suit demand that the board pursue the contemplated action.” Asbestos Workers Phila. Pension Fund Asbestos Workers v. Bell, 137 A.D.3d 680, 682 (1st Dept. 2016). “A pre-suit demand upon a board may be excused, however, if such a demand would have been ‘futile.’” Id.  Either allegation must be pled with particularity in order for a derivative claim to survive a motion to dismiss. See, e.g., Brehm v. Eisner, 746 A.2d 244, 254 (Del. 2000).

Where the “subject of the derivative suit is not a business decision of the board” but, instead, is a wrong committed against the company by a third party, or the board’s inaction, demand is only excused when the plaintiff alleges facts “rais[ing] a reasonable doubt that … the board of directors could have properly exercised its independent and disinterested business judgment in responding to a demand.” Rales v. Blasband, 634 A.2d 927, 934 (Del. 1993).

“[T]o rebut the presumption of disinterestedness under the Rales test, the plaintiff must plead particularized facts that, if proved, would establish that a majority of the directors face a ‘substantial likelihood’ of personal liability for the wrongdoing alleged in the complaint.” Wandel v. Dimon, 135 A.D.3d 515, 517 (1st Dept. 2016). Demand futility is examined with respect to the board’s membership at the time the complaint is filed. Braddock v. Zimmerman, 906 A.2d 776, 785 (Del. 2006).

The Distinction Between Direct and Derivative Claims

Where the wrong is against a corporation, the shareholder does not have an individual claim, even if the shareholder loses the value of his/her shares or incurs personal liability in an attempt to keep the corporation solvent. Abrams v. Donati, 66 N.Y.2d 951, 953 (1985); Serino v.  Lipper, 123 A.D.3d 34, 40 (1st Dept. 2014). “The distinction between derivative and direct claims is grounded upon the principle that a stockholder does not have an individual cause of action that derives from harm done to the corporation but may bring a direct claim when the wrongdoer has breached a duty owed directly to the shareholder which is independent of any duty owing to the corporation.” Accredited Aides Plus, Inc. v. Program Risk Mgmt., Inc., 147 A.D.3d 122, 132 (3d Dept. (2017) (citation and internal quotation marks omitted).

In determining whether a claim is direct or derivative, “a court must look to the nature or the wrong and to whom the relief should go.” Tooley v. Donaldson Lufkin & Jenrette, Inc., 845 A.D.2d 1031, 1038 (Del. 2004). Specifically, the court should consider “(1) who suffered the alleged harm (the corporation or the suing stockholders, individually); and (2) who would receive the benefit of any recovery or other remedy (the corporation or the stockholders, individually).” Yudell v. Gilbert, 99 A.D.3d 108, 114 (1st Dept. 2012) (internal quotation marks and citations omitted); Maldonado v. DiBre, 140 A.D.3d 1501, 1503-1504 (3d Dept. 2016).

“The pertinent inquiry is whether the thrust of the plaintiff’s action is to vindicate his [or her] personal rights as an individual and not as a stockholder on behalf of the corporation.” Maldonado, 140 A.D.3d at 1504 (internal quotation marks and citation omitted). The plaintiff must show that the duty allegedly breached was owed to the shareholder, and that he/she can prevail without showing an injury to the corporation. Yudell, 99 A.D.3d at 114. If the individual claim of harm is “confused with or embedded” within the harm to the corporation, then it must be dismissed. Serino, 123 A.D.3d at 40; Patterson v. Calogero, 150 A.D.3d 1131, 1133 (2d Dept. 2017) (even where individual harm is claimed, if it is confused with or embedded in the harm to corporation, it cannot stand separately).

Glaubach v. PricewaterhouseCoopers, LLP

In Glaubach v. PricewaterhouseCoopers, LLP, 2018 N.Y. Slip Op. 30875(U) (Sup. Ct., N.Y. County, May 9, 2018) (here), Justice O. Peter Sherwood of the Supreme Court, New York County, considered the foregoing principles in dismissing an action brought against, among others, PricewaterhouseCoopers, LLP (“PwC”) for accounting malpractice.

Background

In 2010, Plaintiff, Felix Glaubach (“Glaubach”), the founder, former president, and a minority shareholder of Personal Touch Holding Corp. (“Personal Touch”), a home health services company, took a medical leave of absence from Personal Touch. From 2010 through 2011, several Personal Touch executives, particularly chief executive officer David Slifkin (“Slifkin”), executive vice-president and general counsel Robert Marx (“Marx”), and vice-president Gertrude Balk (“Balk”), caused Personal Touch to pay themselves undeclared and undisclosed income that was improperly classified as reimbursement of education expenses that they never incurred.

When Glaubach recovered from his illness and returned to Personal Touch, he blew the whistle on the fraud and improprieties. In 2013, the Internal Revenue Service (“IRS”) audited the company. Personal Touch hired counsel to represent it in the audit. The firm discovered the fraud and advised Glaubach of it. Glaubach personally paid $827,759 to the IRS and the New York State Treasury to address the wrongdoing perpretrated by the company’s executives.

On July 2, 2013, Slifkin resigned from the board of directors. Notwithstanding Slifkin’s resignation, Glaubach claimed that the board, which added four new directors, was beholden to him.

In July 2014, Glaubach demanded that the board take action with regard to the financial improprieties previously identified. That demand was followed up with a demand letter in October 2014 letter, and again in January 2015.

In February 2015, the board appointed a committee consisting of newly appointed board members to investigate the allegations. During this time, PwC performed independent audits of Personal Touch’s consolidated financial statements and issued opinion letters with respect thereto.

In March 2015, Glaubach commenced a derivative action in Supreme Court, Queens County, in which he asserted claims against all of the members of the board and company officers. Glaubach claimed that he incurred $5 million in legal expenses in that action.

In 2016, Glaubach commenced the action in New York Supreme Court against PwC, asserting one derivative claim for accounting malpractice (first cause of action), and the remaining claims as direct claims arising from the fraudulent misconduct by the executives at the company (second through seventh causes of action).

Glaubach asserted that for years he had a “direct relationship of trust” with PwC, and that each year PwC discussed the financial health of the company with Glaubach at Personal Touch’s offices. He also asserted that he discussed with PwC his role as a 27% shareholder, as a lender of $10 million, and the importance of the audits to his own financial decisions. PwC was told of the fraud and improper activities and reexamined and reevaluated the previous years’ financial statements to address those issues.

Glaubach claimed that due to the fraudulent activities at the company and the alleged accounting malpractice, the value of the company had severely declined, and the value of his shares had plummeted. Glaubach stated that he loaned millions of dollars to the company, and that he had spent millions of dollars in legal fees to try to repair the damage to the company and to his reputation.

PwC moved to dismiss, contending that Glaubach’s direct claims against it were derivative, and that it did not owe any duty to Glaubach independent of any duty it owed to Personal Touch. It also contended that the nature of the damages Glaubach sought demonstrated that the claims were derivative.

As to the derivative claim, PwC contended that Glaubach failed to plead demand futility. The Court agreed and dismissed the complaint in its entirety.

The Court’s Ruling

The Court found that Glaubach failed to make a pre-suit demand on the board to pursue a  malpractice claim against PwC, or allege that such a demand would have been futile. The Court rejected Glaubach’s reliance on his letter demands because they were not directed at the claimed auditor malpractice:

First, while Glaubach alleges “demands” that he made on the board of directors, his demands were for the Board to investigate alleged wrong doing of certain company executives, not to investigate and commence an action against PwC for auditing malpractice. Specifically, he demanded that the Board take “‘action against all parties who received monies fraudulently characterized as ‘educational expenses.’” This fails to satisfy Delaware’s presuit demand requirement for the derivative accounting malpractice claim.

Moreover, the Court held that “the complaint fail[ed] to sufficiently allege demand futility.” The Court found that Glaubach failed to allege “particular facts establishing that a majority of the board at the time plaintiffs commenced this action was interested or lacked independence,” as required under Delaware law. The Court went on to note that “Plaintiffs fail[ed] to allege that any, much less a majority, of the directors faced a substantial likelihood of liability for PwC’s alleged malpractice.” The complaint failed to allege that “there were direct ties between PwC and Personal Touch’s board members, or any allegations that the board was dominated by a director or officer who condoned PwC’s alleged improper conduct.” (Citations omitted.) The Court further noted that the complaint did “not even detail the size of the board or its current composition, or that a majority of them were involved in, or even stood to gain by any alleged fraudulent conduct, or other improper conduct by PwC.” As such, Glaubach failed “to meet the heightened pleading standard set forth in Delaware Chancery Court Rule 23.1, as it failed to plead in a ‘director-by-director’ fashion, instead, asserting conclusory and speculative statements about the board.” (Citations omitted.)

The Personal Touch executives Glaubach asserts were looting the company for their personal benefit, Slitkin, Balk, and Marx, were not a majority. In fact, Slifkin resigned from the Board in July 2013, and these executives were not alleged to have control over the board. Glaubach’s conclusory allegations that the board is populated by persons with “ties to” one of the alleged wrongdoers, falls far short of the requirement of particularized allegations that a majority of the board would face a substantial likelihood of personal liability.

Accordingly, the Court dismissed the accounting malpractice claim against PwC.

The Court also dismissed the remaining claims against PwC, holding that they were derivative, rather than direct, claims. As such, they “should have been pleaded as derivative claims, and were required to meet the demand requirements” discussed above.

Here, Glaubach’s claim for damages based on the lost value of his shares is derivative. “The lost value of an investment in a corporation is quintessentially a derivative claim by a shareholder.” Because Glaubach’s alleged damage for lost share value is not any different from the losses suffered by any other shareholder, and his claim is supported by the identical proof, it is not viable as a direct claim, as a matter of law. All of the shareholders of Personal Touch are harmed by PwC’s alleged auditing failures and would recover pro rata in proportion with their ownership of the company’s stock because they are stockholders. [Citations and internal quotation marks omitted.]

In addition, his claim for damages in the amount of $2.2 million for the allegedly false continuing education reimbursements clearly alleges injuries suffered by the company, which would receive the benefit of any recovery, not the individual shareholders.

The Court rejected Glaubach’s attempt to convert the action into a direct one by alleging that PwC made misrepresentations to him personally, or that PwC knew that he had a financial interest in the company. Such allegations, held the Court, were “unsubstantiated.”

Similarly, the Court rejected Glaubach’s attempt to convert the action into a direct one because of the damage to his reputation “as a pioneer in the health services industry” and for lost earnings, “because they are inextricably intertwined within the derivative claim.” The Court noted that while Personal Touch did “not have any right to recover for damage to Glaubach’s reputation in the health services community, it is the financial difficulties that the company suffered as a result of the financial mismanagement and purported looting that could have negatively impacted his reputation.” The Court held that this claim was “indistinguishable from the embedded claims.”

Finally, the Court rejected the argument that Glaubach had a relationship with PwC that converted the claim to a direct one.

Contrary to Glaubach’s contentions, the amended complaint fails to allege and seek recovery for any personal damages for an individual, personal contractual relationship with PwC. Glaubach does not allege that he ever hired or paid PwC to perform any services for him individually. The annual engagement letters demonstrate that PwC was retained by Personal Touch, not Glaubach, and that it was for services for the company, not for him personally. Glaubach was not a party to a commercial contract with PwC that he was seeking to enforce in his own right. His allegations that he made personal financial decisions in reliance upon PwC’s audits of Personal Touch do not convert these derivative claims into direct claims. [Citations omitted.]

Takeaway

Glaubach demonstrates that a board’s failure to act is “possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment.” Asbestos Workers, 137 A.D.3d at 684. One reason for such difficulty is the demand requirement. The cases show that the demand requirement is rigorous. Factual particularity is necessary. As Justice Sherwood found, Glaubach could not meet those requirements.

Tagged with: Commercial Litigation, Demand, Demand Futility, Securities, Shareholder Derivative Litigation