New York Law Review

Tag: Demand Futility

  • Bansbach v. Zinn, 1 N.Y.3d 1 (2003): Excusing Demand Futility in Derivative Suits Based on Director Interest

    Bansbach v. Zinn, 1 N.Y.3d 1 (2003)

    Demand on a board of directors is excused as futile in a shareholder derivative suit when the board is incapable of making an impartial decision about whether to pursue the litigation, particularly when a majority of the board is interested in the challenged transaction due to self-interest or a loss of independence caused by a controlling, self-interested director.

    Summary

    This shareholder derivative action sought damages for Besicorp Group Inc. due to alleged illegal conduct by its founder, Michael Zinn. The plaintiff did not make a pre-litigation demand on the board, arguing it would be futile. The key issues were whether a prior litigation collaterally estopped the plaintiff from claiming futility, whether demand was indeed futile, and whether the plaintiff deserved summary judgment. The Court of Appeals found that collateral estoppel did not apply, demand was futile due to Zinn’s control over the board, and the plaintiff was entitled to summary judgment against Zinn regarding liability. The board’s decision to indemnify Zinn despite his guilty plea and the corporation’s implication demonstrated their inability to act impartially.

    Facts

    Michael Zinn, Besicorp’s founder, was investigated for illegal campaign contributions. Zinn allegedly reimbursed employees for contributions to Maurice Hinchey’s campaign using company funds. The board, including Habib, Harris, and Rosen, decided to indemnify Zinn for legal fees. Zinn and Besicorp were indicted; Zinn pleaded guilty to aiding the submission of false statements to the Federal Election Commission, admitting he knowingly violated the law. Despite this, the board continued to authorize payments for Zinn’s legal fees. After Zinn resigned, the Legal Defense Management Committee sought partial reimbursement but later voted to indemnify Zinn for all costs, including his fine, after he was reinstated.

    Procedural History

    The plaintiff filed a derivative action alleging breach of fiduciary duty and waste of corporate assets. The Supreme Court initially dismissed the action for failure to make a demand. The Appellate Division reversed, finding sufficient allegations of a lack of board independence to excuse demand. After another derivative suit was dismissed, the defendants moved for summary judgment, arguing collateral estoppel based on Lichtenberg v. Zinn. Supreme Court denied the motion and granted the plaintiff summary judgment regarding Zinn’s liability. The Appellate Division reversed, but the Court of Appeals then reinstated the Supreme Court’s order with modifications.

    Issue(s)

    1. Whether the prior litigation, Lichtenberg v. Zinn, collaterally estops the plaintiff from arguing demand futility.

    2. Whether demand on the Besicorp board was futile, excusing the plaintiff from the pre-litigation demand requirement.

    3. Whether the plaintiff is entitled to summary judgment against the defendants.

    Holding

    1. No, because there is no identity of issue between the present case and Lichtenberg v. Zinn.

    2. Yes, because the board was dominated and controlled by Zinn, who had a clear self-interest in the matter, making it futile to expect them to initiate action against him.

    3. Yes, as to the liability of Zinn, because his own sworn admissions establish that he acted in bad faith and had reasonable cause to believe that his conduct was unlawful; no as to the other defendants, because factual issues remain regarding their motivations.

    Court’s Reasoning

    The Court of Appeals held that collateral estoppel was inapplicable because the issues in Lichtenberg v. Zinn were different. In Lichtenberg, the directors’ independence was challenged concerning stock options, whereas this case involves indemnification related to Zinn’s criminal conduct. Furthermore, in this case, the directors were personally implicated in the alleged wrongdoing.

    The court found that demand was futile because the board was controlled by Zinn, demonstrated by their initial indemnification of his legal fees, delaying reimbursement, and ultimately indemnifying him even after his guilty plea. The Court highlighted the board’s decision to indemnify Zinn for his actions, despite his admission of knowingly violating the law, indicated they could not objectively determine whether to pursue litigation against him.

    Regarding summary judgment, the Court determined that Zinn’s own admissions under oath that he knowingly and willfully violated campaign finance laws and tax laws precluded a finding that he acted in good faith or reasonably believed his actions were in the best interest of the corporation. The Court quoted Zinn’s allocution: “I made funds available to certain employees of my company through bonuses and advances so that their contributions to the 1992 congressional campaign of Maurice Hinch[e]y were in fact contributions of Besicorp…” This constituted active and deliberate dishonesty, barring indemnification under New York’s Business Corporation Law. Summary judgment was not granted against the other defendants due to remaining factual issues about their motivations.

  • Marx v. Akers, 93 N.Y.2d 323 (1999): Excusing Demand in Shareholder Derivative Suits

    93 N.Y.2d 323 (1999)

    In New York, demand on a board of directors before filing a shareholder derivative suit is excused if the complaint alleges with particularity that a majority of the directors are interested in the challenged transaction, failed to adequately inform themselves, or failed to exercise business judgment.

    Summary

    Plaintiff, a shareholder of IBM, brought a derivative action against IBM’s board, alleging excessive compensation for executives and outside directors. The defendants moved to dismiss for failure to make a demand on the board to initiate a lawsuit and for failure to state a cause of action. The New York Court of Appeals considered whether the lower court abused its discretion in dismissing the complaint for failure to make a demand and whether the complaint stated a cause of action. The Court of Appeals affirmed the dismissal, holding that demand was not excused regarding executive compensation and that the complaint failed to state a cause of action for corporate waste concerning payments to outside directors.

    Facts

    The plaintiff alleged that during a period of declining profitability at IBM, the director defendants engaged in self-dealing by awarding excessive compensation to the 15 outside directors on the 18-member board. The plaintiff also alleged that the director defendants violated their fiduciary duties by voting for unreasonably high compensation for IBM executives. The plaintiff did not make a demand on IBM’s board to initiate a lawsuit before commencing the action.

    Procedural History

    The Supreme Court dismissed the complaint, holding that the plaintiff failed to establish the futility of a demand. The Appellate Division affirmed the dismissal, concluding that the complaint lacked sufficient details to infer the futility of a demand, especially considering statutory authority allowing directors to set their own compensation. The case then came before the New York Court of Appeals.

    Issue(s)

    1. Whether the Appellate Division abused its discretion by dismissing the plaintiff’s complaint for failure to make a demand on IBM’s board of directors to initiate a lawsuit.

    2. Whether the plaintiff’s complaint fails to state a cause of action for corporate waste.

    Holding

    1. No, because the plaintiff failed to allege with particularity that demand would have been futile with respect to the executive compensation claim.

    2. Yes, because the plaintiff failed to state a cause of action for corporate waste in connection with the allegations concerning payments to IBM’s outside directors.

    Court’s Reasoning

    The Court of Appeals addressed the demand requirement under Business Corporation Law § 626(c), which requires a shareholder to demand that the corporation initiate an action before commencing a derivative suit, unless demand is futile. The court analyzed different approaches to demand futility, including the Delaware approach and universal demand requirements adopted by some states, but ultimately relied on New York precedent, particularly Barr v. Wackman. The court clarified that conclusory allegations of wrongdoing are insufficient to excuse demand. A demand is excused if the complaint alleges with particularity that: (1) a majority of directors are interested in the transaction; (2) the directors failed to inform themselves adequately; or (3) the transaction was so egregious that it could not have been the product of sound business judgment.

    Regarding executive compensation, the court found that the plaintiff failed to allege that a majority of the board was interested in setting the compensation, nor did the allegations of faulty accounting procedures move beyond conclusory allegations. However, the court found that demand was excused concerning the compensation of outside directors because they constituted a majority of the board and would directly benefit from increased compensation. Nevertheless, the court held that the complaint failed to state a cause of action for corporate waste because it lacked factually based allegations of wrongdoing or excessive compensation rates. The court emphasized that merely alleging a lack of relationship between compensation and duties performed or the cost of living is insufficient to state a cause of action. The court noted, “The courts will not undertake to review the fairness of official salaries, at the suit of a shareholder attacking them as excessive, unless wrongdoing and oppression or possible abuse of a fiduciary position are shown.”

  • Barr v. Wackman, 36 N.Y.2d 371 (1975): Excusing Demand in Derivative Suits Based on Board’s Breach of Duty

    Barr v. Wackman, 36 N.Y.2d 371 (1975)

    A shareholder derivative suit demand on the board of directors is excused when the complaint alleges particularized facts demonstrating that a majority of the directors may be liable for breach of their duties of due care and diligence to the corporation, even without allegations of fraud or self-dealing.

    Summary

    A shareholder derivative action was brought against Talcott National Corporation directors, alleging they breached their fiduciary duties. The plaintiff didn’t demand the board initiate action, claiming it would be futile because the board participated in the alleged wrongdoing. The court addressed whether allegations of board participation and approval of acts involving bias by affiliated directors, coupled with the remaining directors’ alleged failure to exercise due care, were sufficient to excuse demand. The court held that the demand was excused because the complaint sufficiently alleged that a majority of the directors might be liable, making it unlikely they would pursue the action.

    Facts

    Plaintiff, a shareholder of Talcott National Corporation, brought a derivative action against several directors, including affiliated directors (those with official capacities beyond their directorships) and unaffiliated directors (those whose only connection was as directors). The complaint alleged that the affiliated directors, seeking personal benefits, conspired with Gulf & Western Industries to facilitate its acquisition of Talcott on terms less favorable to Talcott’s shareholders. As part of this scheme, the board allegedly abandoned a merger agreement, approved a tender offer, authorized favorable employment contracts for officers, and sold a subsidiary at a loss, all to benefit Gulf & Western and the affiliated directors. The unaffiliated directors allegedly failed to exercise independent judgment and due care.

    Procedural History

    The defendants moved to dismiss the complaint for failure to make a demand on the board as required by Business Corporation Law § 626(c). The Supreme Court denied the motion, and the Appellate Division affirmed. The case was appealed to the New York Court of Appeals by permission of the Appellate Division on a certified question regarding the propriety of the denial of the motion to dismiss.

    Issue(s)

    Whether allegations of board participation in and approval of acts involving bias and self-dealing by minority affiliated directors and breach of fiduciary duties of due care and diligence by the remaining majority unaffiliated directors are sufficient to withstand a motion to dismiss for failure to make a demand.

    Holding

    Yes, because the complaint alleges acts for which a majority of the directors may be liable, and therefore, the plaintiff reasonably concluded that a demand would be futile. The court emphasized that the board’s actions, as part of a series of events benefiting the affiliated directors rather than Talcott, were not immune from question in a derivative action.

    Court’s Reasoning

    The court reasoned that the demand requirement, codified in Business Corporation Law § 626(c), is rooted in the principle that corporate management is entrusted to the board of directors. The demand rule aims to allow directors to correct alleged abuses without court intervention and to protect them from harassment by litigious shareholders. However, a demand is excused when it would be futile, such as when the alleged wrongdoers control or comprise a majority of the directors. The court emphasized that it is insufficient to merely name a majority of directors as defendants with conclusory allegations. Here, the complaint presented particularized transactions benefiting Gulf & Western and the affiliated directors, while the unaffiliated directors allegedly disregarded Talcott’s interests. The court stated, “Plaintiff may prove that the exercise of reasonable diligence and independent judgment under all the circumstances by the unaffiliated directors, at least to meaningfully check the decisions of the active corporate managers, would have put them on notice of the claimed self-dealing of the affiliated directors and avoided the alleged damage to Talcott. If the unaffiliated directors abdicated their responsibility, they may be liable for their omissions.” The court explicitly rejected the notion that directorial fraud or self-interest is always required to excuse demand, noting that directors have affirmative duties of due care and diligence beyond avoiding self-dealing. The court emphasized, “Particular allegations of formal board participation in and approval of active wrongdoing may, as here, suffice to defeat a motion to dismiss.” The court concluded that the determination of whether a demand is necessary rests in the sound discretion of the court, based on a liberal construction of the complaint. The court cited Kavanaugh v Commonwealth Trust Co., 223 NY 103, 106 stating, “No custom or practice can make a directorship a mere position of honor void of responsibility, or cause a name to become a substitute for care and attention. The personnel of a directorate may give confidence and attract custom; it must also afford protection.”