Commercial Division Blog

Posted: July 29, 2019 / Categories Commercial, Derivative Actions

Derivative Action Dismissed for Failure to Make Demand/Adequately Plead Demand Futility

On June 28, 2019, Justice Masley of the New York County Commercial Division issued a decision in Gammel v. Immelt, 2019 NY Slip Op. 32005(U), dismissing a derivative action for failure make a demand or adequately to allege demand futility, explaining:

Business Corporation Law § 626 sets forth specific procedures that must be followed in shareholder derivative actions. Importantly, Business Corporation Law § 626(c) provides that the complaint in any shareholder derivative action 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. The requirement of a pre-litigation demand relieves courts of unduly intruding into matters of corporate governance by first allowing the directors themselves to address the alleged abuses.

However, a plaintiff's failure to serve a pre-litigation demand upon the corporation may be excused if making such a demand would be futile. 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. If any one of these tests is met, the failure to file a pre-litigation demand is excused. Excusing a pre-litigation demand is an exception, and the Court of Appeals has indicated that the exception should not be permitted to swallow the rule that a pre-litigation demand is required. Therefore, conclusory allegations of wrongdoing are insufficient. If a plaintiff fails to plead with particularity that service of a pre-litigation demand should be excused, the complaint must be dismissed.

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. Here, the complaint fails to plead any particularized facts that the Director Defendants were interested parties for purposes of satisfying the first test in Marx, e.g. that they received a personal financial benefit from the transactions at issue, or that any one of them controlled or dominated the other directors. Plaintiff's allegation that the Director Defendants would have declined to initiate the litigation because they would have been subject to personal liability is insufficient. 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 Director Defendants received was excessive.

Moreover, as 17 of the Director Defendants were independent, outside directors elected by GE's shareholders to their positions, plaintiffs could not have reasonably concluded that the Board would have rejected a pre-litigation demand. Plaintiffs' contention that the Director Defendants had an interest ·in seeing a soft landing for G.E. as the business continues to deteriorate is wholly conclusory and inadequate to show that the Director Defendants were interested for purposes of demand futility, especially in the absence of a personal benefit to any of them.

Regarding the second test enunciated in Marx, a pre-litigation demand is excused where the board of directors did not fully inform themselves about the challenged transaction to the extent reasonably appropriate under the circumstances. A close reading of the complaint reveals that plaintiffs fail to plead with particularity facts showing that the Director Defendants failed to self-inform.

. . .

The third test described in Marx requires a plaintiff to plead particularized facts showing that the challenged transaction was so egregious on its face that it could not have been the product of sound business judgment of the directors. 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, but the rule will not protect directors who passively rubber-stamp the acts of active corporate managers. 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. Thus, so 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. Nevertheless, 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.

At oral argument, plaintiffs argued that GE's use of a chase plane constitutes egregious corporate waste, which falls under the third test in Marx. As noted above, plaintiffs fail to plead specific facts adequately showing that the Director Defendants engaged in self-dealing, or that they were so conflicted as to rebut the business judgment rule. Indeed, it has not been alleged that the Director Defendants personally benefited from the practice. Similarly, the complaint is silent as to the specific, fraudulent conduct on the part of the Director Defendants regarding their actions related to the chase plane, or their alleged failure to act. Moreover, plaintiffs admit that GE's March 12, 2018 DEF 14A filing indicated that GE's executives repaid the corporation for their personal use of corporate aircraft. Further, plaintiffs have failed to allege any specific instances where the Director Defendants acted in bad faith or include an allegation that could plausibly be read to infer bad faith. There are no allegations of conduct by the Director Defendants that they were acting for a purpose unaligned with the best interest of the corporation.

Accordingly, that part of the motion seeking dismissal based on demand futility is granted.

(Internal quotations and citations omitted).

This decision illustrates one of the special pleading requirements for derivative actions (where a shareholder brings an action on behalf of a corporation). Contact Schlam Stone & Dolan partner John Lundin at if you or a client have questions regarding bringing an action on behalf of a corporation or other business entity.