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Commercial Division Reaffirms Distinction Between Direct Versus Derivative Claims Under Delaware Law

When can a shareholder bring a direct claim in the Commercial Division against a corporate officer under Delaware law?  On September 29, 2016, in Southern Advanced Materials LLC v. Abrams, No. 650773/2015, 2016 BL 331371 (Sup. Ct. N.Y. Cnty.), Justice Saliann Scarpulla of the Commercial Division ruled on a corporate officer’s motion to dismiss breach of contract and fraudulent inducement claims brought by a plaintiff shareholder.  In her ruling, Justice Scarpulla articulated the distinction between direct and derivative claims under Delaware law, and applied that law to four contract and fraud claims brought by a shareholder against corporate officer.  Justice Scarpulla’s opinion provides guidance to litigants addressing shareholder claims against corporate officers in the Commercial Division.

  1. Factual Background

In Abrams, the plaintiff, Southern Advanced Materials Inc. (“SAM”) was a limited liability investment company that was formed in order to invest in a holding company, CV Holdings, LLC (“CVH”).  CVH owned several plastic manufacturing companies.  Defendant Robert Abrams was a member and the Manager of CVH, and co-defendant The Robert S. Abrams Living Trust (the “Trust”) was a trust established for Abrams’ sole benefit (collectively the “defendants”).[1] 

Between August 2001 and February 2004 the plaintiff invested $12.3 million to acquire preferred shares in CVH.  The plaintiff alleged that it purchased the shares in reliance on a promise by Abrams, as the promoter of the stock, that in the event that the plaintiff’s investment generated a return below 30% per year, the common shareholders would supplement his return by 10% annually (the “Promoter Agreement”). 

In 2014, Abrams reached an agreement to sell CVH’s assets to a purchaser.   Because the purchaser was interested in acquiring only some of CVH’s assets, Abrams agreed to a restructuring of CVH’s assets prior to the sale.  Abrams effectuated the restructuring through the sale of various CVH assets and the transfer of assets to the Trust.  Under the terms of the CVH Operating Agreement, the proceeds of the sale were to be distributed on a pro rata basis among the CVH members, including the plaintiff.  

Under the terms of the CVH’s Member Agreement, the plaintiff’s consent was required in order for Abrams to consummate the sale.  Following negotiations between the plaintiff and Abrams, the plaintiff agreed to execute the sale documents in exchange for a cash payment and the conditional reservation of some litigation rights (the “Retained Claims Agreement”).

On March 13, 2015, the plaintiff commenced this action, alleging Abrams concealed the true value of CVH’s assets during the restructuring and engaged in self-dealing.  The plaintiff brought breach of contract, breach of fiduciary duty, and fraud claims against the defendants.  The defendants moved to dismiss four of the claims on the ground that the plaintiff lacked standing because the claims were derivative on behalf of CVH. 

  1. The Court’s Analysis

The court began by providing an overview of derivative versus direct claims under Delaware law.  The court explained that whether a claim is derivative or direct “must turn solely on the following questions: (1) who suffered the alleged harm (the corporation or the suing stockholders individually); and (2) who would receive the benefit of any recovery or remedy. . . .”[1]

The court then applied this standard to four of the plaintiff’s claims.  First, the court denied the defendants’ motion to dismiss the plaintiff’s claim for breach of the Promoter Agreement.  The plaintiff had alleged that its investment did not generate a 30% annual return, and the defendants failed to provide plaintiff with its 10% supplemental return.  The court found that the claim was direct, and not derivative, reasoning that “commercial contract actions” are not subject to a derivative suit requirement under Delaware law.[2]

Second, the court dismissed as derivative the plaintiff’s claim that the defendants breached the CVH Membership Agreement by failing to obtain the plaintiff’s informed consent for the sale by failing to disclose the their self-dealing in connection with the restructuring of CVH’s assets.  The court dismissed this claim as derivative on the ground that “the claim that corporate formalities were not respected is a claim where the primary injury is suffered by the corporation.”[3]  

Third, the court denied the defendants’ motion to dismiss plaintiff’s claim for breach of fiduciary duty.  The plaintiff had alleged that the defendants structured the sale transaction to allow Abrams to embezzle the assets.  The plaintiff contended, therefore, that it had been deprived of its proper pro rata share of the transaction.   Here, the court held that the plaintiff had stated a direct, and not a derivative, claim.  The court found that the plaintiff was “deprive[d] . . . of the preferred return” and therefore stated a direct claim for breach of fiduciary duty.[4]  

Finally, the court dismissed as derivative the plaintiff’s claim for fraudulent inducement.  The plaintiff had alleged that the defendants had concealed their self-dealing from the plaintiff, and that the plaintiff would not have entered into the Retained Claims Agreement had it been aware of the self-dealing.  The court reasoned that the claim was one of “generalized self-dealing” which “entails harm first and foremost to CVH.”[5]  In particular, the court noted that the plaintiff had not pled any facts “that [the defendants] concealed [their] own self-dealing with the intent to induce [the plaintiff] to enter into the agreement.”[6]  The court therefore dismissed the claim on the ground that the plaintiff lacked standing to bring it.

In its treatment of direct versus derivative claims, Abrams provides key lessons for litigants addressing derivative claims in the Commercial Division regarding pleading of personal injuries and claims involving breaches of corporate formalities.

By Patrick D. Gibson and Muhammad U. Faridi

[1] Southern Advanced Materials LLC v. Abrams, No. 650773/2015, 2016 BL 331371, at *7 (Sup. Ct. N.Y. Cnty.)

[2] Id. at *10

[3] Id. at *12

[4] Id. at *14.

[5] Id. at *18. 

[6] Id.