New York Law Review

Tag: Derivative Suit

  • Tzolis v. Wolff, 10 N.Y.3d 100 (2008): Derivative Suits Permitted for LLC Members Despite Statutory Silence

    10 N.Y.3d 100 (2008)

    Members of a limited liability company (LLC) may bring derivative suits on the LLC’s behalf, even though the Limited Liability Company Law doesn’t explicitly authorize such suits.

    Summary

    This case addresses whether members of an LLC can bring derivative suits on behalf of the LLC when the LLC’s management fails to act. The Court of Appeals held that members can bring such suits, emphasizing the historical importance of derivative suits and the absence of a clear legislative intent to abolish this remedy when the Limited Liability Company Law was enacted. The Court reasoned that barring derivative suits would leave LLC members without recourse against faithless fiduciaries, an unacceptable outcome with potentially far-reaching and negative consequences for the business environment.

    Facts

    Plaintiffs, owning 25% of Pennington Property Co. LLC, sued derivatively on behalf of the LLC. They alleged that the individuals controlling the LLC arranged to lease and sell the company’s primary asset (a Manhattan apartment building) below market value, and that fiduciaries personally profited from these transactions. The plaintiffs sought to declare the sale void and terminate the lease.

    Procedural History

    The Supreme Court dismissed the derivative causes of action, holding that New York law doesn’t allow members to bring derivative actions on behalf of an LLC. The Appellate Division reversed, concluding that derivative suits on behalf of LLCs are permissible. The Court of Appeals granted permission to appeal, leading to this decision.

    Issue(s)

    Whether members of a limited liability company (LLC) are permitted to bring derivative suits on behalf of the LLC in the absence of explicit statutory authorization.

    Holding

    Yes, because the omission of a provision authorizing derivative suits in the Limited Liability Company Law does not indicate a legislative intent to prohibit them. The Court relied on the established importance of derivative suits in corporate law and the lack of clear evidence that the legislature intended to eliminate this remedy when passing the LLC law.

    Court’s Reasoning

    The Court reasoned that derivative suits are a long-standing, essential remedy in corporate law, originating in case law to protect shareholders from breaches of fiduciary duty. Analogizing to trust law, the Court noted that beneficiaries can sue on behalf of a trust when trustees fail to act. While the legislature omitted an explicit provision for derivative suits when enacting the Limited Liability Company Law, this omission does not equal prohibition. The Court found no legislative intent to abolish derivative suits for LLCs, a move that would require devising substitute remedies and potentially lead to double liability. The court cited past instances where derivative suits were recognized without express statutory authorization. The dissent argued that the legislative history demonstrated a conscious decision to exclude derivative suits for LLCs as a compromise. However, the majority found the legislative history too ambiguous to support such a conclusion. The Court stated, “Finding no clear legislative mandate to the contrary, we follow Robinson, Klebanow and Riviera in concluding that derivative suits should be recognized even though no statute provides for them.”

  • Auerbach v. Bennett, 47 N.Y.2d 619 (1979): The Business Judgment Rule and Special Litigation Committees

    Auerbach v. Bennett, 47 N.Y.2d 619 (1979)

    The business judgment rule protects decisions by a special litigation committee (SLC) to terminate a derivative suit, provided the committee members are disinterested, independent, and their investigative procedures are adequate and appropriate.

    Summary

    A shareholder derivative action was brought against directors of General Telephone & Electronics Corporation (GTE) for alleged illegal payments. The board formed a special litigation committee (SLC) of disinterested directors to determine if pursuing the lawsuit was in the company’s best interest. The SLC concluded it was not and moved to dismiss the suit. The court addressed the extent to which the SLC’s decision was protected by the business judgment rule. The Court of Appeals held that while the substance of the SLC’s decision is protected, courts can review the SLC’s disinterestedness, independence, and the adequacy of its investigation. Finding no issues with these factors in this case, the Court reinstated the dismissal of the derivative action.

    Facts

    GTE’s management initiated an internal investigation into potentially questionable payments to foreign officials. The audit committee, with the assistance of outside counsel and auditors, investigated worldwide operations from 1971 to 1975. Their report revealed possible bribes and kickbacks totaling over $11 million, involving some directors. A shareholder, Auerbach, filed a derivative action against GTE’s directors and its auditor, Arthur Andersen & Co. The board then created a special litigation committee (SLC) comprised of three disinterested directors who joined the board after the transactions in question.

    Procedural History

    The SLC determined that pursuing the derivative action was not in the corporation’s best interest and directed dismissal. The corporation and the defendant directors moved to dismiss the complaint. The Supreme Court, Special Term, granted the motions and dismissed the complaint. When Auerbach didn’t appeal, another shareholder, Wallenstein, appealed. The Appellate Division reversed the Special Term’s order and denied the defendants’ motions for summary judgment. The Court of Appeals granted defendants’ motion for leave to appeal.

    Issue(s)

    1. Whether the business judgment rule bars judicial inquiry into the decision of a special litigation committee of disinterested directors to terminate a shareholder derivative action.

    2. Whether the court can inquire into the disinterestedness and independence of the committee members and the appropriateness of their investigative procedures.

    Holding

    1. Yes, the business judgment rule generally protects the substantive decision of a special litigation committee to terminate a derivative suit because courts are ill-equipped to evaluate business judgments.

    2. Yes, because the court can inquire into the disinterested independence of the committee members and the appropriateness and sufficiency of the investigative procedures chosen and pursued by the committee, but absent evidence of bad faith or fraud, the court should respect the SLC’s determinations.

    Court’s Reasoning

    The Court reasoned that derivative claims belong to the corporation, and the decision to pursue them lies within the board’s judgment. The business judgment rule protects directors’ decisions made in good faith and with honest judgment. The Court acknowledged that courts are not equipped to evaluate business decisions. The Court emphasized that the business judgment rule shields the decisions of the SLC only if its members are disinterested and independent. The court can examine the committee’s investigative procedures to ensure adequacy and appropriateness, but it cannot delve into the committee’s substantive evaluation or the weight given to various factors. The court stated, “Questions of policy of management, expediency of contracts or action, adequacy of consideration, lawful appropriation of corporate funds to advance corporate interests, are left solely to their honest and unselfish decision…and the exercise of them 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.” The Court found no evidence to challenge the disinterestedness of the SLC members or the adequacy of their investigation, which included engaging special counsel, reviewing prior reports, interviewing directors and employees, and obtaining legal advice. The court also addressed the intervener’s argument for further discovery, finding it speculative and not a basis to postpone summary judgment. The disclosure proposed by Wallenstein would only go to particulars as to the results of the committee’s investigation and work. Therefore, the Court modified the Appellate Division’s order and reinstated the Special Term’s dismissal of the complaint.

  • Riviera Congress Associates v. Yassky, 18 N.Y.2d 540 (1966): Limited Partners’ Right to Bring Derivative Suits

    Riviera Congress Associates v. Yassky, 18 N.Y.2d 540 (1966)

    Limited partners may bring a derivative suit on behalf of the partnership when those in control of the business (the general partners) wrongfully decline to enforce a claim belonging to the partnership, particularly when the general partners’ self-dealing creates a conflict of interest.

    Summary

    Five limited partners in a real estate syndicate (Riviera Congress Associates) sued the general partners, alleging breach of fiduciary duty and seeking to recover unpaid rent from another entity controlled by the general partners (Mid-Manhattan Associates). The New York Court of Appeals held that the limited partners had the right to bring a derivative suit on behalf of the partnership because the general partners, due to their conflict of interest, wrongfully declined to pursue the claim for unpaid rent. However, the court also found that there were triable issues of fact regarding whether the general partners’ self-dealing was authorized by the partnership agreement, precluding summary judgment for the limited partners.

    Facts

    A real estate syndicate (Riviera Congress Associates) was formed to own a motel, with the individual defendants as general partners. The prospectus indicated the motel would be leased to Yassky Corporation, whose principals were also the general partners of the Syndicate. Yassky Corporation was thinly capitalized. The lease was assigned to Riviera Corporation of Manhattan, then to Mid-Manhattan Associates (another limited partnership controlled by the same general partners), and ultimately back to a subsidiary of the Syndicate, Riviera Congress Associates, Inc. The general partners later advised the limited partners that they accepted surrender of the operating lease due to financial losses, ceasing rental income. The limited partners alleged the general partners breached their fiduciary duty.

    Procedural History

    The limited partners sued in the name of the partnership, alleging three causes of action, including a claim for unpaid rent. The defendants asserted a release as a defense. The Supreme Court, Special Term granted summary judgment to the plaintiffs. The Appellate Division modified, finding issues of fact regarding the defendants’ good faith because the agreement permitted self-dealing, and stated the plaintiffs could sue individually for an accounting, but not derivatively. The case was appealed to the New York Court of Appeals.

    Issue(s)

    1. Whether limited partners can bring a derivative suit on behalf of the partnership to enforce a partnership claim when the general partners, who control the business, wrongfully decline to do so?

    2. Whether the plaintiffs are entitled to summary judgment on their claim for unpaid rent, given the defendants’ defense of release and the potential for authorized self-dealing?

    Holding

    1. Yes, because the general partners were in a conflict of interest and therefore the limited partners, as beneficiaries of a trust, have the right to sue on behalf of the partnership.

    2. No, because there are disputed issues of fact regarding whether the general partners’ self-dealing was authorized by the partnership agreement and whether they acted in good faith.

    Court’s Reasoning

    The court reasoned that while Section 115 of the Partnership Law generally prevents limited partners from interfering with the general partners’ management, this does not apply when the general partners wrongfully refuse to enforce a partnership claim. The court emphasized the fiduciary duty owed by general partners to limited partners, making the latter cestuis que trustent. As such, they have the right to sue for the benefit of the trust (the partnership) if the trustees (the general partners) refuse to perform their duty. The court characterized the suit as a derivative action, a combination of a claim against the trustees for refusing to sue and a claim against the party liable to the trust.

    Regarding the summary judgment issue, the court acknowledged the apparent self-dealing but noted that partnership agreements can authorize such conduct. The prospectus disclosed the general partners’ intention to lease the premises to their own corporation, which, according to the court, “has the effect of ‘exonerating’ the defendants, at least in part, ‘from adverse inferences which might otherwise be drawn against them’ simply from the fact that they dealt with themselves.” The court concluded that the lower court incorrectly granted summary judgement because a trial was required to determine whether the defendants acted honestly and in good faith.

    The Court quoted Everett v. Phillips, 288 N.Y. 227, 237 stating the disclosure of the general partners’ intent to lease the premises to their own corporation “has the effect of ‘exonerating’ the defendants, at least in part, ‘from adverse inferences which might otherwise be drawn against them’ simply from the fact that they dealt with themselves.”