Marx v. Akers

• Decision Date: 25 April 1996
• Citation: 88 N.Y.2d 189,666 N.E.2d 1034,644 N.Y.S.2d 121
• Court: New York Court of Appeals Court of Appeals
• Parties: , 666 N.E.2d 1034, 64 USLW 2679 Sylvia A. MARX, Appellant, v. John F. AKERS et al., Respondents.

Page 121

644 N.Y.S.2d 121

88 N.Y.2d 189, 666 N.E.2d 1034, 64 USLW 2679

Sylvia A. MARX, Appellant, v. John F. AKERS et al., Respondents.

Court of Appeals of New York.

April 25, 1996.

Silverman, Harnes & Harnes, New York City (John F. Harnes and Joan T. Harnes, of counsel), for appellant.

Cravath, Swaine & Moore, New York City (Evan R. Chesler, of counsel), Clark, Gagliardi & Miller, P.C., White Plains, Milberg Weiss Bershad Hynes & Lerach, New York City, Riker, Danzig, Scherer, Hyland & Perretti, of the New Jersey Bar, admitted pro hac vice, and Donato A. Evanelista, of the Connecticut Bar, admitted pro hac vice, for respondents.

OPINION OF THE COURT

SMITH, Judge.

Plaintiff commenced this shareholder derivative action against International Business Machines Corporation (IBM) and IBM's board of directors without first demanding that the board initiate a lawsuit. The amended complaint (complaint) alleges that the board wasted corporate assets by awarding excessive compensation to IBM's executives and outside directors. The issues raised on this appeal are whether the Appellate Division abused its discretion by dismissing plaintiff's complaint for failure to make a demand and whether plaintiff's complaint fails to state a cause of action. We affirm the order of the Appellate Division because we conclude that plaintiff was not excused from making a demand with respect to the executive compensation claim and that plaintiff has failed to state a cause of action for corporate waste in connection with the allegations concerning payments to IBM's outside directors.

Facts and Procedural History

The complaint alleges that during a period of declining profitability at IBM the director defendants engaged in self-dealing by awarding excessive compensation to the 15 outside directors on the 18-member board. Although the complaint identifies only one of the three inside directors as an IBM executive (defendant Akers is identified as a former chief executive officer of IBM), ¹ plaintiff also appears to allege that the director defendants violated their fiduciary duties to IBM by voting for unreasonably high compensation for IBM executives. ²

Defendants moved to dismiss the complaint for (1) failure to state a cause of action, and (2) failure to serve a demand on IBM's board to initiate a lawsuit based on the complaint's allegations. The Supreme Court dismissed, holding that plaintiff failed to establish the futility of a demand. Supreme Court concluded that excusing a demand here would render Business Corporation Law § 626(c) "virtually meaningless in any shareholders' derivative action in which all members of a corporate board are named as defendants." Having decided the demand issue in favor of defendants, the court did not reach the issue of whether plaintiff's complaint stated a cause of action.

The Appellate Division affirmed the dismissal, concluding that the complaint did not contain any details from which the futility of a demand could be inferred. The Appellate Division found that plaintiff's objections to the level of compensation were not stated with sufficient particularity in light of statutory authority permitting directors to set their own compensation.

Background

A shareholder's derivative action is an action "brought in the right of a domestic or foreign corporation to procure a judgment in its favor, by a holder of shares or of voting trust certificates of the corporation or of a beneficial interest in such shares or certificates" (Business Corporation Law § 626[a]. "Derivative claims against corporate directors belong to the corporation itself" (Auerbach v. Bennett, 47 N.Y.2d 619, 631, 419 N.Y.S.2d 920, 393 N.E.2d 994).

"The remedy sought is for wrong done to the corporation; the primary cause of action belongs to the corporation; recovery must enure to the benefit of the corporation. The stockholder brings the action, in behalf of others similarly situated, to vindicate the corporate rights and a judgment on the merits is a binding adjudication of these rights [citations omitted]" (Isaac v. Marcus, 258 N.Y. 257, 264, 179 N.E. 487).

Business Corporation Law § 626(c) provides that in any shareholders' derivative action, "the complaint 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." Enacted in 1961 (L.1961, ch. 855) section 626(c) codified a rule of equity developed in early shareholder derivative actions requiring plaintiffs to demand that the corporation initiate an action, unless such demand was futile, before commencing an action on the corporation's behalf (Barr v. Wackman, 36 N.Y.2d 371, 377, 368 N.Y.S.2d 497, 329 N.E.2d 180). ³ The purposes of the demand requirement are to (1) relieve courts from deciding matters of internal corporate governance by providing corporate directors with opportunities to correct alleged abuses, (2) provide corporate boards with reasonable protection from harassment by litigation on matters clearly within the discretion of directors, and (3) discourage "strike suits" commenced by shareholders for personal gain rather than for the benefit of the corporation (Barr, 36 N.Y.2d, at 378, 368 N.Y.S.2d 497, 329 N.E.2d 180). "[T]he demand is generally designed to weed out unnecessary or illegitimate shareholder derivative suits" (id.).

By their very nature, shareholder derivative actions infringe upon the managerial discretion of corporate boards. "As with other questions of corporate policy and management, the decision whether and to what extent to explore and prosecute such [derivative] claims lies within the judgment and control of the corporation's board of directors" (Auerbach, 47 N.Y.2d, at 631, 419 N.Y.S.2d 920, 393 N.E.2d 994, supra ). Consequently, we have historically been reluctant to permit shareholder derivative suits, noting that the power of courts to direct the management of a corporation's affairs should be "exercised with restraint" (Gordon v. Elliman, 306 N.Y. 456, 462, 119 N.E.2d 331).

In permitting a shareholder derivative action to proceed because a demand on the corporation's directors would be futile,

"the object is for the court to chart the course for the corporation which the directors should have selected, and which it is presumed that they would have chosen if they had not been actuated by fraud or bad faith. Due to their misconduct, the court substitutes its judgment ad hoc for that of the directors in the conduct of its business" (id., at 462, 119 N.E.2d 331).

Achieving a balance between preserving the discretion of directors to manage a corporation without undue interference, through the demand requirement, and permitting shareholders to bring claims on behalf of the corporation when it is evident that directors will wrongfully refuse to bring such claims, through the demand futility exception, has been accomplished by various jurisdictions in different ways. One widely cited approach to demand futility which attempts to balance these competing concerns has been developed by Delaware courts and applies a two-pronged test to each case to determine whether a failure to serve a demand is justified. At the other end of the spectrum is a universal demand requirement which would abandon particularized determinations in favor of requiring a demand in every case before a shareholder derivative suit may be filed.

The Delaware Approach

Delaware's demand requirement, codified in Delaware Chancery Court Rule 23.1, provides, in relevant part,

"In a derivative action brought by 1 or more shareholders or members to enforce a right of a corporation * * * [the complaint shall allege] with particularity the efforts, if any, made by the plaintiff to obtain the action the plaintiff desires from the directors or comparable authority and the reasons for the plaintiff's failure to obtain the action or for not making the effort."

Interpreting Rule 23.1, the Delaware Supreme Court in Aronson v. Lewis, 473 A.2d 805 developed a two-prong test for determining the futility of a demand. Plaintiffs must allege particularized facts which create a reasonable doubt that,

"(1) the directors are disinterested and independent and (2) the challenged transaction was otherwise the product of a valid exercise of business judgment. Hence, the Court of Chancery must make two inquiries one into the independence and disinterestedness of the directors and the other into the substantive nature of the challenged transaction and the board's approval thereof" (473 A.2d, at 814).

The two branches of the Aronson test are disjunctive (see, Levine v. Smith, 591 A.2d 194, 205). Once director interest has been established, the business judgment rule becomes inapplicable and the demand excused without further inquiry (Aronson, 473 A.2d, at 814). Similarly, a director whose independence is compromised by undue influence exerted by an interested party cannot properly exercise business judgment and the loss of independence also justifies the excusal of a demand without further inquiry (see, Levine, 591 A.2d, at 205-206, supra ). Whether a board has validly exercised its business judgment must be evaluated by determining whether the directors exercised procedural (informed decision) and substantive (terms of the transaction) due care (Grobow v. Perot, 539 A.2d 180, 189).

The reasonable doubt threshold of Delaware's two-fold approach to demand futility has been criticized. The use of a standard of proof which is the heart of a jury's determination in a criminal case has raised questions concerning its applicability in the corporate context (see, Starrels v. First Natl. Bank, 870 F.2d 1168, 1175 [7th Cir] [Easterbrook, J., concurring]. The reasonable doubt standard has also been criticized as overly subjective, thereby permitting a wide variance in the application of Delaware law to similar facts (2 American Law Institute, Principles of Corporate Governance: Analysis...