Family Disputes and the Shareholder Derivative Action

• Posted on: Mar 23 2022

By: Jeffrey M. Haber

Family business disputes tend to be ugly, destructive, and protracted. For a case in point, we examine Max v. ALP, Inc., 2022 N.Y. Slip Op. 01969 (1st Dept. Mar 22, 2022) (here), a heated and contentious dispute among members of the Max family regarding control of ALP, Inc., a corporation formed by the iconic artist Peter Max to, among other things, market, license and commercialize his artwork.

ALP was formed in 2000. Adam and Libra, Peter’s children, each own a 40% interest in ALP with the remaining 20% belonging to Peter. In 2012, Peter ceded his positions with, and ownership interest in, ALP to Adam. 

Thereafter, according to plaintiffs, Adam and other individuals brought in by Adam began looting company assets by, among other things, generating artworks using “ghost artists” that would be signed by Peter as if they were original works, selling Peter’s artwork at fire sale prices, and collecting enormous and unwarranted fees and other payments from ALP. In 2018, Libra replaced Adam as the chair of ALP. 

Plaintiffs alleged that prior to Adam assuming control of the company, ALP was in significant debt. Adam claimed that by the end of 2012, ALP had recorded a net loss of over $4,000,000. Upon assuming management and control of ALP’s daily affairs, Adam claimed that by 2014 he remedied ALP’s financial issues and returned ALP to profitability.

According to Adam, Libra had never done any work for or shown any interest in ALP during those years, despite receiving a yearly salary of approximately $700,000. Notwithstanding, in 2017, purportedly due to personal conflicts between Libra, Adam and members of the Max family, Libra sought control of ALP. Adam maintained that Libra colluded with Lawrence Flynn, who had been appointed as the property guardian for Peter in December 2016, to gain a majority vote within the company and remove Adam as president of ALP.

In December 2018, a special meeting of ALP’s shareholders was held during which a new board of directors was elected. The new board consisted of Libra, Adam, and Michael Anderson, who Adam claimed was an acquaintance of Libra’s and unfamiliar with ALP or ALP’s business. 

On January 11, 2019, ALP’s board of directors held another meeting, wherein it resolved that Libra would be named as CEO and president, effective immediately. Adam alleged that after being elected, Libra and Anderson diminished Adam’s role in the company and terminated employees that Adam had hired. He also claimed they spent significant sums of money on legal fees to undo Adam’s prior sales of Peter’s artwork and to recover amounts Adam paid to previous ALP employees. Adam further alleged that Libra and Anderson abandoned the profitable business model Adam put in place. Adam averred that Libra and Anderson were so unskilled in conducting ALP’s business and the sale of art that they were leading ALP to financial ruin. Finally, Adam alleged that Libra improperly provided a reporter from the New York Times with false information relating to a purported scheme by Adam to use ghost artists to generate artwork that would then be signed by the ailing Peter and sold as if they were his own, damaging ALP’s business reputation.

Adam brought the action both derivatively, on behalf of ALP, and directly, on behalf of himself. The amended complaint asserted claims sounding in/seeking: (1) breach of fiduciary duty, (2) appointment of a receiver pursuant to CPLR § 6401(a) and BCL § 1202(3), (3) declaratory judgment voiding the December 2018 special meeting pursuant to BCL § 619, (4) attorneys’ fees pursuant to BCL § 626, (5) removal of Libra and Anderson as directors and officers pursuant to BCL § 706(d) and BCL § 716(c), (6) an accounting, and (7) breach of the duties of diligence, care, and skill.

Defendants moved to dismiss. The motion court granted the motion.

Defendants argued that ALP’s certificate of incorporation barred plaintiffs from bringing the action derivatively. The motion court agreed.

Under BCL § 720(a)(1), a shareholder’s right to bring a derivative action against directors for breach of duty is “[s]ubject to any provision of the certificate of incorporation authorized pursuant to paragraph (b) of section 402.” Section 402(b) of the BCL expressly permits shareholders to adopt provisions precluding director and shareholder liability under most circumstances. 

The motion court found that ALP’s certificate of incorporation tracked the language of BCL § 402(b). Therefore, plaintiffs were barred from bringing their claims against defendants derivatively.

The motion court rejected defendants’ argument that BCL § 402(b) did not apply because Libra and/or Anderson acted in bad faith or intentionally. The court explained that although plaintiffs averred that “Libra and Anderson have taken such action in bad faith and intentionally with full knowledge that their action constituted misconduct in knowing violation of the law and for the improper purpose of personally gaining financial profits and advantages to which they are not entitled,” plaintiffs pleaded no facts that would permit such inferences to be drawn. The court reasoned that Libra and Anderson’s decisions to distance ALP from Adam’s prior course of business, even if such decisions made ALP less profitable, did not constitute bad faith or intentional misconduct. 

The motion court also rejected Adam’s suggestion that taking control of ALP after Libra and Anderson received “warnings” that such a takeover “would lead to disaster” constituted bad faith or intentional misconduct. The motion court found that such an argument was without basis in law or logic.

The motion court also held that dismissal of Adam’s breach of fiduciary duty claims was appropriate. 

To plead a cause of action for breach of fiduciary duty, a plaintiff must allege (1) the existence of a fiduciary relationship, (2) misconduct by the defendant, and (3) damages directly caused by the defendant’s misconduct.¹ “A cause of action sounding in breach of fiduciary duty must be pleaded with particularity under CPLR 3016(b).”² 

The motion court found that plaintiffs failed to allege any action by defendants that would constitute misconduct such that a cause of action for breach of fiduciary duty would lie against them. Instead, said the motion court, the amended complaint alleged that defendants engaged in a series of decisions that deviated from ALP’s previous business model (e.g., the board reduced Adam’s control of the company, removed employees hired by Adam, and abandoned Adam’s previous business model of creating and selling artworks on cruise ships). Under the business judgment rule, said the motion court, judicial inquiry into the actions of corporate directors, which are taken in good faith, in the exercise of honest judgment, and the legitimate furtherance of corporate purposes, is prohibited.³ 

Moreover, the motion court held that plaintiffs merely alleged that Adam and his associates were displeased with the direction in which Libra and Anderson had taken ALP. Such allegations – that a course of action other than that pursued by a board of directors would have been more advantageous – said the motion court are insufficient to support a cause of action for breach of fiduciary duty.⁴ To be actionable, noted the motion court, the complaint must allege that the corporate decisions of the board of directors lacked a legitimate business purpose or were tainted by a conflict of interest, bad faith, or fraud.⁵ 

The motion dismissed plaintiffs’ remaining causes of action seeking attorneys’ fees pursuant to BCL § 626(e), removal of ALP’s directors and officers pursuant to BCL § 706(d) and BCL § 716(c), and an accounting because plaintiffs failed to allege an underlying cause of action for breach of fiduciary duty.

[Ed. Note: Attorneys’ fees pursuant to BCL § 626(e) are premised on the successful prosecution of a derivative suit. A cause of action seeking the removal of directors pursuant to BCL § 706(d) and BCL § 716(c) requires a showing of wrongdoing on the part of the directors with regard to their fiduciary obligations to the corporation.⁶ Finally, a cause of action for an accounting requires a plaintiff to sufficiently allege a breach of fiduciary duty.⁷] 

On appeal, the Appellate Division, First Department affirmed.

The Court held that the motion court “properly dismissed plaintiffs’ causes of action alleging breach of fiduciary duty and negligence.”⁸ First, the Court found that the business judgment rule barred the claims.⁹ Second, the Court found that plaintiffs merely disagreed with the decisions of ALP’s Board of Directors.¹⁰ 

The Court also held that plaintiffs’ claims against defendants in their capacity as directors of ALP were barred by the exculpation clause in ALP’s certificate of incorporation.¹¹ Like the motion court, the Court rejected plaintiffs’ attempts to plead around the exculpatory language.¹²

Further, the Court held that plaintiffs’ collateral claims for an accounting, attorneys’ fees, and for the removal of defendants as directors and officers failed because the underlying claims (i.e., breach of fiduciary duty) were not viable.¹³

Takeaway

The exculpatory clause in a company’s certificate of incorporation can be a powerful tool for directors and shareholders to insulate themselves from liability for actions that do not rise to the level of bad faith, a knowing violation of the law, or intentional misconduct. In Max, defendants were found to be exempt from liability under the exculpatory clause set forth in ALP’s certificate of incorporation. As discussed, plaintiffs did not sufficiently allege that defendants engaged in such improper actions or omissions.

The business judgment rule is also a powerful tool that can insulate directors from liability for the decisions they make. “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.”¹⁴ The rule does not, however, protect directors who “passively rubber-stamp[] the acts of active corporate managers.”¹⁵ To avoid application of the rule, 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.”¹⁶ In Max, plaintiffs were unable to overcome application of the rule – that is, plaintiffs failed to allege that defendants’ actions lacked a legitimate business purpose and/or were tainted by a conflict of interest, bad faith or fraud. 

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. See Burry v. Madison Park Owner LLC, 84 A.D.3d 699 (1st Dept. 2011); Rut v. Young Adult Inst., Inc., 74 A.D.3d 776 (2d Dept. 2010).
2. Swartz v. Swartz, 145 A.D.3d 818, 823 (2d Dept. 2016).
3. See Auerbach v. Bennett, 47 N.Y.2d 619 (1979); Barr v. Wackman, 36 N.Y.2d 371 (1975).
4. See Amfesco Indus., Inc. v. Greenblatt, 172 A.D.2d 261 (1st Dept. 1991); Kamin v. Am. Exp. Co., 86 Misc. 2d 809 (Sup. Ct., N.Y. County 1976), aff’d sub nom., 54 A.D.2d 654 (1st Dept. 1976).
5. Amfesco Indus., supra.
6. See Benedict v. Whitman Breed Abbott & Morgan, 110 A.D.3d 935 (2d Dept. 2013).
7. See Palazzo v. Palazzo, 121 A.D.2d 261 (1st Dept. 1986).
8. Slip Op. at *1.
9. Id.
10. Id. (quoting, Amfesco Indus., 172 A.D.2d at 264). 
11. Id.
12. Id. at *1-*2 (citations omitted).
13. Id. at *2.
14. 40 W. 67th St. Corp. v. Pullman, 100 N.Y.2d 147, 153 (2003) (citation omitted).
15. Matter of Comverse Tech, Inc. Deriv. Litig., 56 A.D.3d 49, 56 (1st Dept. 2008) (citation omitted).
16. Goldstein v. Bass, 138 A.D.3d 556, 557 (1st Dept. 2016).