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The Difficulty Distinguishing Between Direct and Derivative Claims Revisited

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  • Posted on: Sep 14 2022

By: Jeffrey M. Haber

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. “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.”1
Sometimes, the distinction between the two types of actions is not readily apparent.2

Direct vs. Derivative Examined

As noted, where the wrong complained of is directed against a corporation, the claim belongs to
the entity. 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.3

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.”4 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).”5

“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.”6 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.7 If the individual claim of harm is
“confused with or embedded” within the harm to the corporation, then it must be dismissed.8

“The lost value of an investment in a corporation is quintessentially a derivative claim by a
shareholder.”9

[Ed. Note: This Blog has previously written about the difficulties plaintiffs often have
distinguishing between direct and derivative claims. (E.g., here, here and here.)]

In today’s article, this Blog looks at Johnson v. Cestone, 2022 N.Y. Slip Op. 33011(U) (Sup. Ct.,
N.Y. County Sept. 8, 20220 (here). In Johnson, the court dismissed breach of contract claims
because the plaintiff failed to demonstrate that the claims belonged to her as opposed to the
entities she sued.

Johnson arose from payments plaintiff made to the defendant entities between 2011 and 2014.
Plaintiff alleged that the defendant entities, as well as several of their officers or principals,
provided her with inflated projections and made other misrepresentations, promises, and
omissions to induce her to invest in the businesses. Plaintiff claimed that after investing her
money, defendants grossly mismanaged the entities, such that she recouped only a fraction of the
$25 million she contributed. Plaintiff also alleged that defendants breached their agreement to
handle her investments with ordinary care and reasonable diligence, and that her investments in
certain entities would be deployed only for financing, production or management fees after she
recouped her investment, plus a 20% return.

Following motion practice and discovery, defendants moved for summary judgment on, among
others, plaintiff’s breach of contract claims. Defendants argued that plaintiff alleged only
derivative harms that could be redressed only through a derivative litigation.
The motion court agreed with defendants.

The court found that plaintiff did not allege any direct harm to herself. Instead, the gravamen of
her complaint, said the motion court, was that defendants did not handle her investments with
ordinary care and reasonable diligence as promised – i.e., that defendants mismanaged her
investment.10 “The nature of this alleged injury,” held the court, “is derivative.”11

The motion court rejected plaintiff’s argument that defendants failed to use the funds as
promised – i.e., that defendants breached their promise not to use the funds she contributed to
one of the entities for financing, production or management fees until she recouped her
investment plus a 20% return.12 In doing so, the motion court noted that even if the claim was to
some extent a direct one, it was “confused with or embedded in the harm to the corporation”.13
The court explained that “[e]ven assuming that defendants deployed financing, production or
management fees from [plaintiff’s] investment before she recouped her investment plus a 20%
return (as opposed to using her investment for other, allowable purposes), any resulting injury
[was] embedded in the harm the defendants’ alleged mismanagement caused to the business
entity.”14 “In this regard,” said the court, plaintiff “allege[d] that Worldview Inc. and Holdings
LLC were paid ‘exorbitant financing, management and/or production fees in connection with
nearly all of the film investments that it made – oftentimes directly from investor money,’ and
that these fees were ‘contrary to industry standards’”.15 “The harm this mismanagement caused”, concluded the court, “is inextricably intertwined with the harm [plaintiff] claims occurred as a
result of defendants misusing her funds for financing, production or management fees.”16

Plaintiff also alleged that she entered into an agreement with defendants WEC II, Holdings LLC
and Worldview Inc. pursuant to which the funds she loaned to WEC II would not be deployed
until the required minimum capital raise of $30 million was reached for the fund and, that
[plaintiff’s] investment would be handled with, at a minimum, ordinary care and reasonable
diligence. She also alleged that pursuant to the agreement, “no financing, production and and/or
management fees would be paid out of funds contributed by [plaintiff] to WEC I. Plaintiff
maintained that these defendants materially breached the agreement by “causing financing,
production and/or management fees to be paid to Worldview Inc. and/or Holdings” and by
“deploying more than $7 million of [plaintiff’s] funds loaned to WEC II despite the fact that the
minimum capital raise of $30 million had never been reached.”17 Plaintiff further alleged that
these defendants failed to engage in any reasonable care in managing the funds, including
transferring at least $6 million to [The Weinstein Company] without any agreement in place.

Like the other breach of contract allegations, the motion court found the foregoing allegations to
be derivative in nature.

Takeaway

The difference between a direct and derivative claim is not always easy to discern. For many
practitioners, even those who devote most of their practice litigating derivative claims, the
distinction between the two types of claims can be elusive. Nuance and subtlety often rule the
day, leading to confusion and uncertainty. The consequences of such confusion can (and often
will) result in dismissal of one’s claims.


Footnotes

  1. Accredited Aides Plus, Inc. v. Program Risk Mgmt., Inc., 147 A.D.3d 122, 132 (3d Dept. (2017) (citation and internal quotation marks omitted).
  2. Yudell v. Gilbert, 99 A.D.3d 108, 113 (1st Dept. 2012).
  3. Abrams v. Donati, 66 N.Y.2d 951, 953 (1985); Serino v. Lipper, 123 A.D.3d 34, 40 (1st Dept. 2014).
  4. Tooley v. Donaldson Lufkin & Jenrette, Inc., 845 A.D.2d 1031, 1038 (Del. 2004).
  5. Yudell, 99 A.D.3d at 114 (internal quotation marks and citations omitted); Maldonado v. DiBre, 140 A.D.3d 1501, 1503-1504 (3d Dept. 2016).
  6. Maldonado, 140 A.D.3d at 1504 (internal quotation marks and citation omitted).
  7. Yudell, 99 A.D.3d at 114.
  8. 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 the corporation, it cannot stand separately).
  9. Serino, 123 A.D.3d at 41.
  10. Slip Op. at *5.
  11. Id. (citing, Sajust, LLC v. Mendelow, 198 A.D.3d 582, 582-583 (1st Dept. 2021); and Yudell, 99 A.D.3d at 115).
  12. Id. at *6.
  13. Id. (quoting, Serino, 123 A.D.3d at 40).
  14. Id.
  15. Id. (quoting, the second amended complaint).
  16. Id. at 6-7.
  17. Id. at *10 (quoting, the second amended complaint).

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.

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