In a pair of decisions last year, Lerner v. Prince and North Miami Beach v. McGraw-Hill, the First Department signaled a change in the way shareholders in New York corporations can, and likely will, challenge the conduct of their boards.¹ Both cases grew out of the sub-prime mortgage-related asset disaster, but they should apply with equal force to any New York corporation, whether it is a public company, a closely-held family company, or an apartment cooperative.

The Demand Requirement

The statutory demand requirement is the first obstacle for shareholders concerned about possible misfeasance, malfeasance or nonfeasance by their board of directors. Without satisfying the demand requirement, shareholders have no standing to maintain a derivative suit on behalf of the corporation against the members of the board. The first strategic considerations are whether, how and when to make a demand upon the board to investigate and root out the suspected conduct. The complaint must allege either demand and wrongful refusal or demand futility. In either instance, a heightened pleading standard applies, requiring the complaint to state with particularity how the demand was made and wrongfully refused or why demand would have been futile. New York Bus. Corp. Law §626(c) (2010) (requiring that the complaint “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”).

While the demand need not assume a particular form or recite any particular language, it must inform the board with particularity of the complained of acts, the potential defendants, and the potential cause of action. The purpose is to allow the board, in the first instance, the opportunity to discharge its duty to manage the affairs of the corporation and authorize actions that are in the best interests of the corporation. By serving a demand, shareholders concede that the demand would not be futile and that the Board can independently act on the demand. The board is then entitled to a “reasonable” amount of time to investigate the charges and respond. Until the board is afforded that opportunity, the shareholder making the demand has no standing to commence a derivative suit. As Lerner illustrates, this can put a petitioner shareholder in an uncomfortable limbo, waiting for the board to respond and unsure about when or whether the lack of a response could be deemed a refusal. The board may take days or even years to respond, which response will take one of two forms: (1) assent to the demand and commencement of an action; or (2) refusal to pursue the claim. At that point, standing to commence a derivative suit would only exist if the demand was wrongfully refused. Otherwise, the board or its delegate will be pursuing the claim without shareholder involvement.

In Lerner, the First Department held that derivative suit plaintiffs are not permitted to engage in discovery to support their allegations that the demand was wrongfully refused. Lerner represented an extension of a prior holding that discovery was not available to support allegations of demand futility.² So, with Lerner, the court effectively foreclosed any opportunity for plaintiffs to use Article 31 discovery devices to save a foundering derivative claim from pre-answer dismissal. And while this curtailment of shareholders' rights during litigation was heralded as a welcome trend in some circles, the decision did suggest in a footnote that the foreclosed plaintiff should have pursued pre-litigation demand for corporate records (instead of commencing suit with the expectation that discovery would be available). And later that year, in McGraw-Hill, the court dramatically expanded shareholders' rights of pre-litigation access to corporate records that could serve essentially the same purposes (e.g., discovery into not only the alleged mismanagement to support the substance of the claims, but also into those factors that would support an allegation of demand futility or wrongful refusal of a demand). These cases, read together, suggest that a New York court will give no quarter to derivative suit plaintiffs who fail to avail themselves of pre-litigation access to corporate records and cannot independently satisfy the pleading requirement.

The Limitation of Discovery

In Lerner, a demand-refused shareholder derivative suit, the First Department affirmed dismissal of the complaint for failing to allege with sufficient detail that the Board's investigation into the alleged misconduct was unreasonable, uninformed or conducted in bad faith. In December 2007, following Citigroup's multi-billion dollar write downs in connection with its mortgage-related securities holdings, shareholders made a pre-suit demand upon the board to investigate suspected breaches of fiduciary duty and mismanagement. The board responded by initially advising the shareholders that their demand would be considered, later advising that a demand committee was formed, and still later advising that the demand committee had retained counsel to assist in its investigation and evaluation of the demand. But more than 18 months passed without any substantive response so that, in July 2009, the shareholders commenced suit, alleging that the board's failure to respond amounted to a wrongful refusal of the demand. In June 2010, after the derivative suit had been pending for close to a year—and two and a half years after the demand was made—the board issued a refusal letter, indicating that it had adopted the recommendation of its demand committee. The seven page refusal letter recounted the actions of the demand committee, including the review of 17 million pages of internal documents, interviews with current and former officers, directors and employees and reliance upon expert advice regarding the products at issue.