The “Conflict of Interest” Defense to Shareholder Derivative Standing
August 29, 2022
In shareholder derivative litigation, defendants occasionally argue that the plaintiff – who ostensibly sues on behalf of the company and its owners in a fiduciary capacity – has some form of conflict of interest with the company or its remaining owners, so the court should disqualify the plaintiff from serving as plaintiff. The classic, most simple conflict of interest is where the plaintiff herself has engaged in some form of wrongdoing against the company, for which the entity or its owners have lodged (or may lodge) counterclaims.
The theory is that if the plaintiff is herself a bad actor, she cannot be expected to be an adequate steward and representative of the legal rights and interests of the entity she herself has harmed. In New York, one most often sees this argument asserted in the form of a pre-answer motion to dismiss for lack of capacity or standing to sue under CPLR 3211 (a) (3).
Origins of the Doctrine
The original and leading case in New York on shareholder derivative plaintiff conflicts of interest is Steinberg v Steinberg (106 Misc 2d 720 [Sup Ct, NY County 1980]), in which the Court ruled that a derivative plaintiff must “demonstrate that she will fairly and adequately represent the interests of the shareholders and the corporation, and that she is free of adverse personal interest or animus.”
In Steinberg, the Court found that the plaintiff’s prior “offer to discontinue outstanding litigation on the condition that she be paid a premium of approximately one million dollars above market value for her outstanding shares evinces a possibility, and indeed, a likelihood, that the instant action would be discontinued with prejudice before its conclusion, possibly foreclosing other shareholders from pursuing the wrongs plaintiff alleges.” The Court inferred a “strong financial inducement for her to settle on terms advantageous to her as an individual, rather than as a fiduciary — and indeed, at the very least, a willingness if not an intent, to personally profit from the litigation,” concluding that “by reason of conflict of interest, plaintiff lacks legal capacity to act as a fiduciary.”
The Current, Unsettled State of New York Law
Other disqualification cases in New York followed Steinberg. A fairly comprehensive discussion of the state of New York law (up to that time) of shareholder derivative plaintiff conflicts of interest was found in Pokoik v Norsel Realties, 55 Misc 3d 1208[A] [Sup Ct, NY County 2017]), in which former Manhattan Commercial Division (now Appellate Division – First Department) Justice Jeffrey K. Oing ruled that there was a “prototypical conflict of interest” requiring disqualification because the plaintiffs purported to sue on behalf of an entity’s partners while at the same time suing them as defendants. “Having brought their claims against all other Norsel partners,” the Court ruled, “plaintiffs cannot purport to simultaneously represent the interests of these adverse defendant partners.” Ironically, Justice Oing was reversed by his own court the following year in Pokoik v Norsel Realties (164 AD3d 1124 [1st Dept 2018]), the Appellate Division ruling that there was not “in the present record any indication of an especially acrimonious relationship between the parties” requiring disqualification.
Suffice it to say that the law of shareholder derivative plaintiff conflicts of interest in New York is murky and unpredictable, even for seasoned judges.
The Doctrine Under Delaware Law
Similarly, in Delaware, there is a line of case law emanating from Katz v Plant Indus., Inc. (an unpublished 1981 Delaware Chancery Court decision) and Youngman v Tahmoush, 457 A2d 376 [Del Ch 1983]), both holding that Delaware’s class action statute, Court of Chancery Rule 23.1, applies to shareholder derivative suits, and that Delaware courts should under Rule 23 examine the plaintiff’s adequacy as a derivative plaintiff (both at the pre-answer dismissal stage and at the final approval of any derivative settlement), including whether any conflicts or “economic antagonism” between the plaintiff, the entity, or the other owners. Youngman announced the Delaware standard that “purely hypothetical, potential or remote conflicts” are not enough, and that to prove the need to disqualify a derivative plaintiff, “a defendant must show that a serious conflict of interest exists, by virtue of one factor or a combination of factors, and that the plaintiff cannot be expected to act in the interests of others because doing so would harm his other interests.”
The Youngman standard has worked its way into New York jurisprudence, including a decision last fall from Manhattan Commercial Division Justice Joel M. Cohen, TNJ Holdings, Inc v Rubenstein (Decision and Order [Sup Ct, NY County Sept. 13, 2021]), in which the Court, applying Delaware law, dismissed a shareholder derivative suit for lack of standing under CPLR 3211 (a) (3) because the plaintiff brought a mix of direct and derivative claims, the value of the direct claims eclipsing the derivative claims. “Under the circumstances,” the Court ruled, “TNJ is incentivized to settle its direct claim even at the expense of the derivative claim,” requiring dismissal under Youngman and its progeny.
In the past month and a half, a pair of decisions in both New York and Delaware have thrown cold water on the “conflict of interest” defense to shareholder derivative standing.
The Larsen Decision
The first was Larsen v Larsen (2022 NY Slip Op 32415(U) [Sup Ct, Kings County July 18, 2022]), in which Brooklyn Commercial Division Justice Leon Ruchelsman considered and rejected a pre-answer dismissal challenge to a shareholder derivative suit based upon the suing minority shareholder’s alleged conflict of interest.
In a lengthy complaint, the trustees of a family trust owning a minority stake in a decades-old family HVAC business formerly, Power Cooling, sued their sister, the controlling shareholder, Lauren, alleging she was looting the entity’s assets for her own personal benefit and that of her family members, including “no-show jobs,” “luxury cars,” “first class airfare tickets,” “life insurance policies for her mother and daughters that have no benefit to the Companies,” a “home in Montana for one of her daughters,” and other personal expenses. Lauren moved to dismiss, arguing in her affidavits (read here and here) that her adversaries “gladly pocketed” corporate assets for themselves, including “large monetary and nonmonetary gifts worth well in excess of $2 million from Power Cooling,” including “unearned salary for 30 years.” You can read the parties’ briefs here and here.
In Larsen, Justice Ruchelsman interpreted the conflict of interest defense to standing narrowly, ruling that a standing-based dismissal under CPLR 3211 (a) (3) “only concerns a legal disability such as infancy or lunacy and not the reasons for such derivative suit.” The Court relied upon a seldom-cited decision, Corcoran v Corcoran (192 AD2d 503 [2d Dept 1993]), in which the Court ruled that the shareholder in that case may “bring and maintain this derivative action regardless of his personal motive for so doing.”
The Court also ruled that “the mere fact there are allegations that the plaintiffs likewise received funds for work they did not perform and hence do not deserve does not mean the allegations are made in bad faith. Rather, the defendant can surely file counterclaims against the plaintiffs for such alleged improprieties.”
The Court concluded, “To be sure, this familial dispute is very contentious and allegations of wrongdoing have been asserted by all parties. However, there are no legal grounds to dismiss the action at this time where the facts are so vigorously contested. Further discovery will sharpen the issues and prepare the parties for trial.”
Larsen stands for the general proposition that where there are hotly disputed accusations of wrongdoing on both sides of the caption, it is premature to dismiss a shareholder derivative suit on the pleadings alone based upon the plaintiff’s alleged conflict of interest.
The Griffith Decision
Less than a month after Larsen, the Delaware Supreme Court, in Griffith v Stein (___A3d ___ [Del Aug. 16, 2022]), abrogated the Katz and Youngman decisions discussed above. The Court did not necessarily disagree with the legal concept that a shareholder derivative plaintiff might under the right facts have a disqualifying conflict of interest. But the Court held that Court of Chancery Rule 23.1, upon which both Katz and Youngman were based, did not empower courts to consider a derivative plaintiff’s adequacy. The Court ruled:
Court of Chancery Rule 23.1 contains express requirements to settle derivative claims. The plaintiff’s adequacy as a representative of the corporation’s interest is not one of them. Absent an express requirement in Court of Chancery Rule 23.1 that the Court determine the adequacy of a derivative plaintiff before approving a settlement of litigation, we are reluctant to imply such a requirement. . . . We recommend, however, that the Court of Chancery Rules Committee consider amendments to Rule 23.1, to include whether to make the plaintiff’s adequacy an express requirement to maintain a derivative action . . . .
The Need for Guidance
Hopefully the Court of Chancery Rules Committee will take up the Delaware Supreme Court’s suggestion to amend or clarify Rule 23.1.
For New York practitioners, though, no clear prospects are in sight for settling the shaky, unclear doctrine of shareholder derivative plaintiff conflicts of interest. Hopefully one of our appeals courts will eventually take up the issue and provide some clear, practical legal standards for practitioners and lower courts to follow.