Failure to Plead Demand Futility Results in Dismissal of a Shareholder Derivative Action Against the Officers and Directors of GEPrint Article
- Posted on: Jul 22 2019
Derivative actions are brought by current shareholders of a company to redress the harm (monetary or equitable) incurred by the company as the result of officer/director self-dealing, breaches of fiduciary duty, and/or other wrongdoing; to restore shareholder value caused by mismanagement and the waste of corporate assets; and to enhance and strengthen internal controls and the company’s governance policies and procedures.
Very often, shareholder derivative actions are filed in the wake of an investigation initiated by a regulatory agency, such as the Securities and Exchange Commission (“SEC”), or the filing of a securities class action alleging violations of the federal securities laws by a company and/or its officers and directors. Gammel v. Immelt, 2019 N.Y. Slip Op. 32005(U) (Sup. Ct., N. Y. County June 28, 2019) (here), recently decided by Justice Andrea Masley of the New York Supreme Court, Commercial Division, is an example of the foregoing. There, shareholders of the General Electric Company (“GE” or the “Company”) commenced a derivative action against the officers and directors of the Company following the filing of a securities class action lawsuit pending in the United States District Court for the Southern District of New York, Hachem v. Immelt, 17-cv-08457, and the initiation of an investigation by the SEC, concerning the Company’s insurance reserves and accounting for long-term service agreements.
This Blog takes a look at Gammel in today’s post. In particular, we take a look at the Court’s ruling concerning the “demand” requirement set forth in New York Business Corporation Law (“BCL”) § 626(c).
A Brief Primer on Derivative Litigation
It is well-settled that a plaintiff asserting a derivative claim seeks to recover for injury to the business entity. Marx v Akers, 88 N.Y.2d 189, 193 (1996). 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 A.2d at 1039.
Derivative actions are often brought by shareholders of a corporation (or limited liability company) to vindicate the entity’s rights. Bansbach v. Zinn, 1 N.Y.3d 1, 8 (2003), rearg denied, 1 N.Y.3d 593 (2004); Marx, 88 N.Y.2d at 193. 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.” Bansbach, 1 N.Y.3d at 8. 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.” Id.
The tension between the foregoing interests is tempered by the requirement that a shareholder demand with particularity that the board of directors takes action to address the alleged wrongdoing or explain why such demand would have been futile. 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”). 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.’” Bansbach, 1 N.Y.3d at 9, quoting Barr v. Wackman, 36 N.Y.2d 371, 378 (1975) (citation omitted). “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.” Id., citing Marx, 88 N.Y.2d at 194.
“Demand is futile, and excused, when the directors are incapable of making an impartial decision as to whether to bring suit.” Bansbach, 1 N.Y.3d at 9. In New York, the demand requirement is excused where a plaintiff pleads “with particularity that (1) a majority of the directors are interested in the transaction, or (2) the directors failed to inform themselves to a degree reasonably necessary about the transaction, or (3) the directors failed to exercise their business judgment in approving the transaction.” Marx, 88 N.Y.2d at 198. If any of these circumstances are met, the failure to file a pre-suit demand will be excused. Id. at 200-201.
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. 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. Thus, if a plaintiff fails to plead with particularity that service of a pre-litigation demand should be excused, the complaint must be dismissed. See Retirement Plan for Gen. Empls. of the City of N. Miami Beach v. McGraw, 158 A.D.3d 494, 495 (1st Dept. 2018).
“[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.” Matter of Comverse Tech., Inc. Deriv. Litig., 56 A.D.3d 49, 54 (1st Dept. 2008). “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. Wandel v. Eisenberg, 60 A.D.3d 77, 80 (1st Dept. 2009). 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.” 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).
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. Walsh v. Wwebnet, Inc., 116 A.D.3d 845, 848 (2d Dept. 2014).
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.’” Stein v. Immelt, 472 Fed. Appx. 64, 66 (2d Cir. 2012), quoting Wandel, 60 A.D.3d at 82).
“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.” 40 W. 67th St. Corp. v. Pullman, 100 N.Y.2d 147, 153 (2003) (citation omitted). The rule does not, however, protect directors who “passively rubber-stamp the acts of active corporate managers.” Matter of Comverse Tech, Inc. Deriv. Litig., 56 A.D.3d 49, 56 (1st Dept. 2008), citing Barr, 36 N.Y.2d at 381. 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.” Goldstein v. Bass, 138 A.D.3d 556, 557 (1st Dept. 2016). 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.” Matter of Levandusky v. One Fifth Ave. Apt. Corp., 75 N.Y.2d 530, 538 (1990) (internal quotation marks and citation omitted).
Gammel v. Immelt
Gammel arose out of the alleged acts and omissions of the current and former members of the GE Board of Directors (the “Board,” or “Director Defendants”) in connection with GE’s alleged lack of internal controls and the Director Defendants’ alleged failure to oversee the administration and management of the Company, including being uninformed about material aspects of several segments of the Company, including its Long Term Care (“LTC”) insurance business and the GE Power segment’s Long Term Services (“LTS”) Agreements (“LTSAs”). Plaintiffs brought the action derivatively on behalf of GE, the nominal defendant, against 19 GE officers and directors, alleging breaches of their fiduciary duty to the Company and its shareholders.
GE is a global company engaged in a variety of different industries, such as insurance, through GE Capital, and energy, through GE Power. In 2004, GE spun off its LTC business into Genworth, Inc. (“Genworth”), although GE retained significant exposure as a reinsurer for Genworth’s LTC policies.
According to plaintiffs, GE was required to maintain adequate cash reserves in order to pay claims on LTC insurance policies, but GE failed to increase their insurance reserves until late 2017. As alleged, Genworth was taking significant charges to reserves due to exposure to liabilities for LTCs. Given Genworth’s disclosures, as well as information that was publicly available, plaintiffs maintained that the Board should have addressed the reasons for such charges. Indeed, plaintiffs alleged that the entire LTC industry recorded massive charges to earnings and sought premium increases as high as 90%, all in connection with long-term care policies. Despite obvious red flags, plaintiffs contended that the Director Defendants failed to reassess GE’s LTC actuarial assumptions and make meaningful adjustments to the Company’s insurance reserves.
A portion of GE Power’s business involved the service and maintenance of energy equipment for third parties pursuant to contracts known as Long Term Services Agreements. Plaintiffs alleged that flawed revenue projections from GE Power’s LTSAs negatively impacted the Company’s earnings. Despite negative trends in the power industry, plaintiffs maintained that GE Power improperly increased revenue estimates from the LTSAs until 2017, when GE Power announced an $850 million charge to earnings to account for project cost overruns. GE allegedly engaged in complex, aggressive accounting practices to conceal the extent of the problems with GE Power while simultaneously releasing false or misleading statements praising GE Power’s financial health. Plaintiffs alleged that the SEC had charged GE with accounting fraud previously in relation to these improper accounting practices, which GE had also used to increase its reported earnings.
In addition to the foregoing, plaintiffs alleged that the Director Defendants wasted the Company’s assets by allowing Jeffrey Immelt to routinely use a “chase plane” when flying to foreign destinations – that is, a second aircraft that was completely empty to fly behind Immelt’s aircraft. Plaintiffs maintained that the use of such an aircraft was roundly criticized as wasteful and an improper use of corporate funds.
Plaintiffs alleged that the truth was disclosed when GE announced: (1) in October 2017, a reduction in earnings guidance from $1.60-$1.70 per share to $1.05-$1.10 per share for 2017 due to “recently observed elevated claims experience” in the Company’s long-term care insurance business and “underperformance in its GE Power segment”; (2) in November 2017, a 50% reduction in GE’s dividend; and (3) in January 2018, a $6.2 billion after-tax charge and the setting aside of $15 billion over seven years to increase long-term care reserves and an investigation by the SEC concerning “the process that led to the insurance reserve increase and the fourth-quarter charge.”
As noted, GE is the subject of a shareholders’ class action pending in Southern District of New York for violations of the federal securities laws, and the subject of an SEC investigation into GE’s LTC business and its revenue accounting practices related to GE Power.
Plaintiffs commenced the action seeking damages for breach of fiduciary duty, unjust enrichment, waste of corporate assets, abuse of control, and gross mismanagement.
Defendants moved to dismiss, contending that plaintiffs failed to plead demand futility with particularity.
Plaintiffs opposed the motion, arguing that such a demand would have been futile. Plaintiffs argued that a majority of the Board was interested in the wrongs complained of and, therefore, incapable of arriving at an independent decision. They claimed that the Board ignored the “red flags” described in numerous published reports and articles, excerpts of which were contained in the complaint, warning of the downward trends in the LTC and energy industries, yet chose to rubber-stamp the decisions of GE’s executives whose actions they were charged with overseeing and monitoring.
The Court’s Decision
The Court granted the motion.
The Court held that the complaint failed to plead any particularized facts that the Director Defendants were interested parties who received a personal financial benefit from the transactions alleged in the complaint. Slip Op. at *2, citing Marx, 88 N.Y.2d at 202; Walsh, 116 A.D.3d at 848. Likewise, the Court found that plaintiffs failed to allege any particularized facts demonstrating that any one of the Director Defendants controlled or dominated the other directors. Id., citing Voluto Ventures, LLC v. Jenkins & Gilchrist Parker Chapin LLP, 46 A.D.3d 354, 356 (1st Dept. 2007).
Moreover, the Court found that plaintiffs failed to allege any particularized facts showing that the Director Defendants were conflicted because, inter alia, they would have been held liable for their actions. Id. In this regard, the Court noted, citing Wandel, 60 A.D.3d at 80, that merely alleging that “the Director Defendants would have declined to initiate the litigation because they would have been subject to personal liability is insufficient.” Slip Op. at *7. Simply naming each current or former director as a defendant without more, said the Court, was “insufficient to establish that they are conflicted and demand is futile.” Id. at *9 (citations and internal quotation marks omitted). This was especially so since 17 of the Director Defendants were outside directors elected by the Company’s shareholders. Id.
Finally, the Court rejected the allegation that because certain directors controlled the amount of compensation other directors would have received sufficed to show that those directors were beholden to the other directors. Id. at *8. Such allegations, held the Court, “especially in the absence of an allegation that the compensation the Director Defendants received was excessive,” were insufficient. Id., citing Walsh, 116 A.D.3d at 848).
Addressing the second prong of the Marx test, whether the Director Defendants were fully informed with regard to the transactions at issue, the Court held that plaintiffs failed to plead any particularized facts showing that they were not so informed. The Court noted that plaintiffs failed to refute the fact that “the Board, and its committees, met regularly” during the relevant time period. Id. There were no allegations, said the Court, beyond merely “describe[ing] the duties of each committee” that “causally relat[ed] those duties to the purported acts, or omissions, at issue to each of the Director Defendants.” Id.
The Court also took issue with plaintiffs’ allegation that the Director Defendants knew, or were aware, of the purported red flags found in the publicly available documents cited in the complaint. Id.
[T]he complaint does not allege that the Board had been presented with red flags warning of the general health of the LTC and energy industries, or the specific health of GE Capital and GE Power, and that the Director Defendants consciously chose to overlook or ignore them.
Plaintiffs do not allege that Genworth’s filings with the SEC had been presented to the Board, nor does it allege that it was GE’s policy to raise and discuss Genworth’s public disclosures at Board or committee meetings Notably, the complaint refers to three Genworth filings with the SEC on November 5, 2014, March 2, 2015 and November 8, 2016. These three filings hardly constitute a sustained pattern of red flags or warnings that should have caught the attention of the Director Defendants.
In addition, there is no allegation that “any member of the Board actually read or learned the contents of” the published news articles, from 2017 and 2018, identified in the complaint. The complaint does not identify what actions the Director Defendants should have taken had they been aware of the red flags. Hence, merely identifying news articles discussing general, downward trends in the LTC and energy industries is “insufficient to alert [the] corporate directors to internal wrongdoing.”
Id. at **9-11 (citations and internal quotation marks omitted).
The Court further held that plaintiffs failed to plead particularized facts showing that that use of the “chase plane” – the second corporate jet that trailed Immelt when he traveled for business, and which GE executive allegedly used for personal reasons – was so egregious on its face that it could not have been the product of sound business judgment of the directors. The Court found that the complaint was devoid of any facts showing “that the Director Defendants personally benefited from the practice” or identifying the specific, fraudulent conduct by the Director Defendants regarding their actions related to the chase plane, or their alleged failure to act. Id. at *14. This was especially notable since plaintiffs “admit[ted] that GE’s March 12, 2018 DEF 14A filing indicated that GE’s executives repaid the corporation for their personal use of corporate aircraft.” Id. In short, plaintiffs failed to allege any facts from which the Court could infer that the Director Defendants acted in bad faith or that “that they were acting for a purpose unaligned with the best interest of the corporation.” Id. at *15, citing Foley v. D’Agostino, 21 A.D.2d 60, 66 (1st Dept. 1964).
Having failed to satisfy the tests set forth in Marx, the Court dismissed the complaint for failure to plead demand futility with the requisite particularity.