Kaster v. Modification Systems, Inc.

• Decision Date: 27 March 1984
• Docket Number: D,No. 231,231
• Citation: 731 F.2d 1014
• Parties: Fed. Sec. L. Rep. P 91,410 Charles G. KASTER, Warren A. Frank, Francis W. Murray, Richard O. Hillery and John A. Makarczyk, Individually and as Shareholders of Modification Systems, Inc. Suing on behalf of themselves and all other shareholders of Modification Systems, Inc., similarly situated and in the right of Modification Systems, Inc., Plaintiffs-Appellants, v. MODIFICATION SYSTEMS, INC., Francis W. Meyers, Batiste DeLuca, E.L. Thomas and Frank L. Kelly, Defendants-Appellees. ocket 83-7426.
• Court: U.S. Court of Appeals — Second Circuit

Page 1014

731 F.2d 1014

Fed. Sec. L. Rep. P 91,410

Charles G. KASTER, Warren A. Frank, Francis W. Murray Richard O. Hillery and John A. Makarczyk, Individually and as Shareholders of Modification Systems, Inc. Suing on behalf of themselves and all other shareholders of Modification Systems, Inc., similarly situated and in the right of Modification Systems, Inc., Plaintiffs-Appellants, v. MODIFICATION SYSTEMS, INC., Francis W. Meyers, Batiste DeLuca, E.L. Thomas and Frank L. Kelly Defendants-Appellees.

No. 231, Docket 83-7426.

United States Court of Appeals, Second Circuit.

Argued Oct. 20, 1983.

Decided March 27, 1984.

Jeffrey L. Liddle, New York City (Richard B. Schaeffer, David D. Howe, Liddle & Henze, New York City, of counsel), for plaintiffs-appellants.

John Patrick Deveney, New York City (Charles Chehebar, Kellner, Chehebar, Deveney & Grizzle, New York City, of counsel), for defendants-appellees Meyers, DeLuca, Thomas and Kelly.

Charles D. Bock, New York City (Linda Meisler, Carro, Spanbock, Fass, Geller, Kaster & Cuiffo, New York City, of counsel), for defendant-appellee Modification Systems, Inc.

Before FRIENDLY, VAN GRAAFEILAND and MESKILL, Circuit Judges.

MESKILL, Circuit Judge:

This is an appeal from the dismissal of a shareholders' derivative suit by the United States District Court for the Southern District of New York, Lowe, J., pursuant to Fed.R.Civ.P. 12(b)(6). The suit was dismissed for failure to state a claim upon which relief could be granted because the complaint failed to allege with particularity that a demand had been made on the directors, or adequate facts to excuse a demand as required by Fed.R.Civ.P. 23.1.

We agree with the district court's holding that the complaint did not meet the Rule 23.1 requirement. The court erred, however, in not considering and acting on appellants' cross-motion for leave to amend their complaint. We therefore vacate the judgment and remand for further proceedings not inconsistent with this opinion.

BACKGROUND

Modification Systems, Inc. (MSI) is a closely held corporation which manufactures and modifies computer simulators for nuclear power plants. MSI was authorized to issue 11,490 Class A voting common shares and 8,510 Class B non-voting common shares, of which 8,450 voting shares and 7,840 non-voting shares had been issued and were outstanding in April 1980. Appellee Meyers was President, Chairman of the Board of Directors and controlling In their complaint, appellants alleged that appellees violated Rule 10b-5 by voting to accept defendant Meyers' subscription for over two thousand shares of MSI voting stock at a price substantially below book value and thus defrauded the corporation. The complaint also alleged that Meyers violated Rule 10b-5 by failing to disclose to the other directors that his primary objective in acquiring the shares was to dilute the interests of the appellants. Finally, appellants alleged that Meyers breached his fiduciary duty to the corporation by accepting unreasonable compensation, acquiring a luxury condominium with corporate funds, charging expenses that were not incurred and issuing corporate checks for non-corporate purposes, and that the other directors breached their fiduciary duties by approving the unreasonable compensation and the condominium purchase.

                shareholder owning 71 percent of the voting shares.  Appellee DeLuca was corporate counsel as well as a director.  All of the directors except Kenedy had been chosen by Meyers. 1   On February 3, 1982 appellants who owned 79 percent of the non-voting shares and 17.6 percent of the voting shares filed suit on behalf of and against the corporation and individual officers and directors of the corporation
                

On March 2, 1982, before any responsive pleadings were served, appellants filed a verified amended complaint pursuant to Fed.R.Civ.P. 15(a) which stated generally that:

[T]he plaintiffs have not made demands upon M.S.I., its officers or Directors with respect to commencing this action for the reason that the defendant Meyers possesses the voting control, and has utilized such control to name four of the five Directors, of the Corporation and further, has repeatedly used his control over the Board of Directors to dominate and oppress minority shareholders; thus, it would be futile and unavailing to demand that the Directors cause an action to be brought by M.S.I. against themselves.

Complaint p 20, J.App. at 22. Appellants also claimed that Meyers had refused demands to act on appellants' complaints. Complaint p 18, id. at 21-22. The complaint further alleged that the director representing minority shareholder interests had been systematically excluded from participating in the management of the corporation in that the other directors failed to provide him with notice of meetings and financial and other information. Complaint p 19, id. at 22. Appellants, however, did not include any specific examples or details of the above alleged incidents.

Individual appellees moved to dismiss appellants' amended complaint on March 15, 1982, pursuant to Rule 12(b)(6) for failure to meet the demand requirement of Rule 23.1. In the alternative, they sought a change of venue to the District of Maryland. Appellee corporation joined in the individual appellees' motions.

Appellants responded with a cross-motion for leave to amend their complaint should the court grant appellees' motion to dismiss. Appellants contended in their papers supporting the motion that the complaint met the requirements of Rule 23.1 by stating that they had made numerous "oral demands" on the corporation and on Meyers. Alternatively, they argued that their complaint advanced grounds on which a demand should be excused as futile.

The district court granted appellees' motion to dismiss appellants' complaint finding that appellants had conceded that they had made no demand on the directors and then held that: "Plaintiffs' amended complaint fails to allege with particularity any adequate or sufficient reasons for failing to make due demand on the defendant directors to obtain the relief requested." Explaining its decision, the court said: "However, the mere recitation that the demand would be 'futile' is not enough. Plaintiff

                must allege specific facts which would lead the Court to determine that the demand would indeed be futile."    Stein v. Aldrich, [1981-1982 Transfer Binder] Fed.Sec.L.Rep.  (CCH) p 98,473, at 92,780 (S.D.N.Y. July 18, 1980).  Then, relying on Lewis v. Graves, 701 F.2d 245, 248 (2d Cir.1983), the court held that mere allegations that directors had acquiesced in the wrongdoing was insufficient "involvement" to excuse demand.  The court continued that allegations that Meyers, as majority shareholder, controlled the directors because he controlled their positions on the board was insufficient to demonstrate that the directors were adversely interested.  The court also rejected as insufficient allegations that the directors were adversely interested because of their friendship with Meyers.  In its dismissal of the action, the court discussed appellees' alternative motion for a change of venue and commented that a transfer would be proper pursuant to 28 U.S.C. Sec. 1404(a) (1976) for the convenience of the parties and the witnesses if the action was not dismissed.  The district court, however, did not mention appellants' cross-motion for leave to amend the complaint in the event of dismissal
                

DISCUSSION

Fed.R.Civ.P. 23.1 requires that in a derivative action the complaint must "allege with particularity the efforts, if any, made by the plaintiff to obtain the action he desires from the directors or comparable authority and, if necessary, from the shareholders or members, and the reasons for his failure to obtain the action or for not making the effort." Demand on the directors is intended "to give the derivative corporation itself the opportunity to take over a suit which was brought on its behalf in the first place, and thus to allow the directors the chance to occupy their normal status as conductors of the corporation's affairs." Brody v. Chemical Bank, 517 F.2d 932, 934 (2d Cir.1975) (per curiam). Such a demand is excused if the demand would be "futile," "useless" or "unavailing;" if the directors are "antagonistic, adversely interested, or involved in the transaction attacked, a demand on them is presumptively futile and need not be made." Cathedral Estates v. Taft Realty Corp., 228 F.2d 85, 88 (2d Cir.1955) (citations omitted).

Appellants deny conceding that no demand had been made on the directors and they maintain that their complaint did allege facts sufficient to demonstrate the futility of making a demand on the directors. They point to the complaint's allegation that "numerous oral demands" had been made on Meyers and the corporation. J.App. at 21. This, however, is the only allegation regarding demands to rectify the wrongs alleged in the complaint. For our purposes it is unimportant whether appellants conceded that they had not satisfied the demand requirements of Rule 23.1. Appellants have not pleaded "with particularity" their efforts to obtain action from the directors; the amended complaint does not supply any information on the timing, circumstances, or manner of the alleged demands or on the response of the directors. A demand on Meyers does not constitute a demand on a "comparable authority" under Fed.R.Civ.P. 23.1 because Meyers is not invested with the full powers of the board of directors. See Greenspun v. Del E. Webb Corp., 634 F.2d 1204, 1209 (9th Cir.1980).

Appellants argue in the alternative that they have satisfied the requirements of Rule 23.1 by pleading sufficient facts to excuse a demand and that the district court abused its discretion by not finding that a demand on the directors would have been futile. Appellants do not challenge the district court's determination that allegations that the directors acquiesced in and benefited from the...