In Yudell v. Gilbert, 2012 WL 3166788 (N.Y. App. Div. 1st Dep’t Aug. 7, 2012), the Appellate Division of the New York Supreme Court, First Department, abandoned its prior ad hoc approach to determining whether a stockholder’s claim is “direct” (i.e., on behalf of the stockholder personally) or “derivative” (i.e., on behalf of the corporation as a whole), and held that the test applied by the Delaware Supreme Court in Tooley v. Donaldson, Lufkin & Jenrette, Inc., 845 A.2d 1031 (Del. 2004), provides the appropriate analysis for resolving this inquiry. Under the Tooley test, the court must consider (i) who suffered the alleged harm (the corporation or the stockholder) and (ii) who would receive the benefit of any recovery or other remedy (the corporation or the stockholders individually). If the court determines that the corporation suffered the alleged harm and would receive the benefit of any remedy sought in the stockholder’s claim, then the claim must be brought derivatively, on behalf of the corporation, and is subject to the pre-suit demand requirement. Although the court’s decision appears to provide greater clarity to this often vexing issue under New York law, Delaware cases applying the test show that Tooley is far from the last word on the subject.

In Yudell, plaintiffs owned an interest in a joint venture partnership intended to construct and manage a shopping center. Dissatisfied with the perceived mismanagement of the shopping center, plaintiffs initiated a lawsuit against the manager of the shopping center and their partners in the joint venture purporting to allege both direct and derivative claims.

Defendants moved to dismiss the complaint for a failure to plead demand futility with the requisite specificity. In response, plaintiffs argued that although most of their claims were derivative, their third cause of action for breach of fiduciary duty was direct and thus not subject to the demand requirement. In this claim, plaintiffs alleged that the manager “failed to preserve [the entity’s] rights to collect unpaid tax obligations … and rent.”

The trial court disagreed, holding that all of plaintiffs’ causes of action were derivative in nature. For this reason, it dismissed the complaint after concluding that plaintiffs failed to plead either (i) that they made a pre-suit demand upon the board to pursue the claim on behalf of the entity or (ii) particularized facts indicating that pre-suit demand upon the board would have been futile. Plaintiffs appealed.

The Appellate Division affirmed. It began by recognizing that New York courts had not previously articulated a clear test for determining whether a claim is direct or derivative. Instead, New York jurisprudence approached the issue on a case-by-case basis depending upon the nature of the allegations. After discussing various circumstances where New York courts found that a stockholder’s claims are derivative (e.g., where the stockholder suffers solely through depreciation in the value of his or her stock, sues for mismanagement or alleges diversion of corporate assets or corporate opportunity), the Appellate Division adopted the Tooley test as consistent with New York law and applied it expressly to the facts of Yudell.

The Appellate Division observed that the manager’s alleged failure to collect the tax obligations and rent affected each of the joint venture members in proportion to their ownership interest in the entity. Moreover, in the event plaintiffs were successful with their lawsuit, the court recognized that any recovery would properly inure to the benefit of the corporation, not plaintiffs. Accordingly, the court held that plaintiffs’ claims were properly classified as derivative because the harms alleged in the complaint were suffered by the corporation.

By adopting the Delaware Supreme Court’s Tooley test, the court in Youdell appears to articulate a clearer test in New York for determining whether a claim is direct or derivative. Delaware cases applying Tooley, however, have recognized that applying this test can be difficult in practice. For example, in Feldman v. Cutaia, 951 A.2d 727 (Del. 2008), the Delaware Supreme Court rejected the stockholder plaintiffs’ argument that their claims against the company’s directors in connection with a cash-out merger were direct because the shareholders would have ultimately recovered the damages alleged. Instead, the Delaware Supreme Court concluded:

The mere fact that the alleged harm is ultimately suffered by, or the recovery would ultimately inure to the benefit of, the stockholders does not make a claim direct under Tooley. In order to state a direct claim, the plaintiff must have suffered some individualized harm not suffered by all of the stockholders at large.

Likewise, in In re NYMEX Shareholder Litigation, 2009 Del. Ch. LEXIS 176 (Del. Ch. Sept. 30, 2009), stockholders brought a class action alleging, inter alia, that the chairman of the New York Mercantile Exchange (“NYMEX”) breached his fiduciary duties by rejecting a proposed acquisition of NYMEX by the NYSE and favoring a merger with the Chicago Mercantile Exchange in order to secure a continued position with the exchange. Applying Tooley, the Delaware Court of Chancery explained, “the critical question is: ‘Looking at the body of the complaint and considering the nature of the wrong alleged and the relief requested, has the plaintiff demonstrated that he or she can prevail without showing an injury to the corporation.’”

In short, while Youdell certainly clarifies the law in New York, the question of whether a claim is direct or derivative is highly fact-intensive and can still be difficult to resolve.

For further information, please contact John Stigi* at (310) 228-3717 or Alejandro E. Moreno at (619) 338-6664.

* Admitted in New York and California.