New York has recognized the right of limited liability company members and managers to bring derivative claims – that is, claims belonging to the LLC – against other members or managers. But, the derivative plaintiff needs to beware of the demand requirement or face having their case dismissed.
Derivative Suit Seeks Recovery for LLC of Management Fees
In a derivative case, the plaintiff is actually asserting a claim that belongs to the company. If there is a recovery, it goes to the company and the derivative plaintiff only gets individually what may, or may not, be passed through to the equity members. The law even provides for an award of attorney’s fees in some derivative cases to encourage shareholders or members to police the business.
But there are procedural requirements, one of which is the requirement that the derivative plaintiff make a formal demand on the majority to address and act on wrongdoing, or prove that making such a demand would be futile.
Demand Not Excused and Case Dismissed
A decision from the New York Supreme Court in Danial v. Monasebian (N.Y. Supreme Oct. 11, 2016) demonstrates that the “demand requirement” requires either a clear demand, or clear reasons why the demand was futile. In that case, a member seeking to recover some $550,000 in payments that she alleged were wrongfully made to a company controlled by one of the managers was dismissed for failure to meet the demand requirements.
Danial was a member in of 260 West Managing Member LLC, which owned real estate. Under the company’s operating agreements, the mangers had the right to appoint a company controlled by one of the managers as the real estate manager of the property. In December 2013, the plaintiff demanded access to various financial records and ultimately brought suit alleging that the defendant had diverted $555,000 to a company that he controlled.
The Demand Requirement in LLC Derivative LItigation
The defendants moved to dismiss, arguing that plaintiff had not made a demand on the defendants, nor pleaded that making a demand would be futile. (The majority receiving a demand to sue the manager would be entitled to exercise its judgment about whether to bring the lawsuit. The majority is within its rights in responding to a demand if it investigates the claim in good faith and decides to do nothing further.)
The demand requirement, the court noted, “relieves courts of unduly intruding into matters of corporate governance by first allowing the directors themselves to address the alleged abuses.”
When Demand is Excused
The plaintiff alleged both that demand was futile and that its prior correspondence with the majority constituted a demand. The court began by reviewing the standards for demand futility:
Demand is deemed futile and thus excused in the following three situations when alleged with particularity by a plaintiff: 1) a majority of the board of directors either has a self-interest in the challenged transaction or is controlled by a self-interested director; 2) the board of directors did not fully inform themselves about the challenged transaction to a “reasonably appropriate” extent; and 3) the challenged transaction was so egregious that “it could not have been the product of sound business judgment.”
In order to meet the requirement for demand futility, the plaintiff must plead particularized facts that establish the circumstances excusing a demand. The plaintiff had failed to meet these requirements. The assertion that the board was under the control of one manager who was a target of the lawsuit was not supported by particularized facts. They court noted that no New York decision has inferred such control from the sole fact that they were family members.
The allegations of futility were also contrary to the authority granted by the operating agreement, since the management fees were authorized. Similarly, letters to the majority that did not demand a lawsuit did not meet the requirements for a demand.