In Casey Capital, LLC v. Levy, the Commercial Division provides a cautionary tale for derivative shareholder plaintiffs alleging demand futility
Activist investors are an increasing presence on the stock ledgers and in the boardrooms of public companies. Since 2010, one in seven companies on the S&P 500 has faced an activist shareholder challenge. But activists can encounter pitfalls when they seek to challenge incumbents through derivative litigation, as illustrated by the recent Commercial Division decision in Casey Capital, LLC v. Levy, C.A. No. 652805/15, 2016 N.Y. Misc. LEXIS 3107 (N.Y. Sup. Ct. Aug. 19, 2016) (Scarpulla, J.).
Getting a foot in the courtroom door
Some activist investors, like the plaintiffs in Casey Capital, LLC v. Levy, manage to get seats in the corporate boardroom through hard-fought proxy campaigns. But they still often find themselves in the minority and thus unable to effect desired changes in corporate policies. One way to make an outsized impact is through a successful derivative shareholder lawsuit.
To get a foot in the courtroom and challenge perceived corporate waste or breaches of fiduciary duty, however, activist investors need standing to sue. Under the law of most jurisdictions, including New York and Delaware, a shareholder may sue derivatively on behalf of the company only upon particularized allegations that either: (i) a pre-suit demand was made on the board to pursue the corporate claim and the demand was wrongfully refused; or (ii) the directors are incapable of making an impartial decision regarding such a litigation demand, referred to as demand futility. The demand requirement stems from the policy principle that the board of directors is entrusted with managing the corporation, including decisions on whether to bring or refrain from litigation on behalf of the corporation; thus, the managerial freedom of the board should not be impinged absent wrongful refusal or inability to exercise impartial business judgment.
New York law’s demand requirement is based in Business Corporation Law § 626(c), under which the shareholder plaintiff is required to “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.” Delaware’s equivalent rule is found in Delaware Chancery Court Rule 23.1(a).
Casey Capital and demand futility
In Casey Capital, Justice Saliann Scarpulla held that the plaintiff-investor failed to adequately plead demand futility and thus lacked standing to bring a derivative suit. The court dismissed the investor’s claims in their entirety and granted costs to the defendants without considering the substance of the plaintiff’s cause of action. The Casey Capital decision therefore provides a cautionary tale for the activist investor who seeks to challenge the actions of incumbent directors and officers through derivative shareholder litigation.
According to the complaint, Casey Capital owns stock in Essex Rental Corp., a provider of cranes used in construction projects. The complaint alleged that Essex Rental was mismanaged by its chairman and a former director-defendant, causing the company’s shares to lose nearly all of their value. Plaintiff cited excessive compensation awarded to the company’s chairman and the former board member, a lease of unnecessary and expensive New York City office space from a company affiliated with the chairman, and financial statements errors in 2013 and 2014 that damaged the company’s reputation.
After Casey Capital began a proxy battle in connection with the June 2015 election of three of the company’s six total directors, the company announced that only two of the three open spots on the board would be filled. The Casey Capital slate of two nominees was ultimately elected, but remained in the minority on the board. Plaintiff alleged that the board reduction decision was made to ensure that the chairman would continue to control the board despite the insurgents’ challenge.
Rather than first make a demand on the current five-member board to take action against the chairman and former director in the name of the company to pursue the alleged wrongdoing, Casey Capital brought suit against these individuals, alleging that such a demand would be futile. The Commercial Division, applying Delaware law under the internal affairs doctrine, found the demand futility allegations deficient.
The court found that the primary problem with the plaintiffs’ futility allegations was their conclusory nature. Although the chairman of the board was named as a defendant, the complaint did not make particularized allegations of wrongdoing against the two other allegedly interested directors. Although the complaint asserted that “three of the five current members of the board ‘at all relevant times were interested, lacked independence or faced a threat of liability and therefore would not be able to impartially consider a demand by Plaintiffs,” the pleading failed to provide “any factual allegations showing how [directors] Fox and Matthews were interested in the alleged breaches of fiduciary duty by the Director Defendants, faced a threat of liability, lacked independence, or were controlled by” the chairman. As the court’s decision points out, “[director] Matthews is not even mentioned by name in the complaint, and [director] Fox is mentioned only as having been elected to chair two unspecified committees.”
The court also found that an allegation that the allegedly interested directors approved the challenged transactions would not have sufficed. “As stated by the Delaware Supreme Court, if ‘any board approval of a challenged transaction automatically connotes ‘hostile interest’ and ‘guilty participation’ by directors,’ then the Delaware demand requirement would be rendered meaningless.’” Thus “the fact that Fox and Matthews may have approved decisions by the board which resulted in the challenged corporate actions is insufficient under Delaware law to demonstrate lack of impartiality.” The court similarly rejected the conclusory allegation that the contested director compensation and lease agreement could not possibly have been valid exercises of business judgment by the board as “circular reasoning,” which was insufficient to establish demand futility under Delaware law.
Case Capital underscores the need to make a formal demand on the board unless an exception applies. A demand can sometimes provide tactical advantages. It puts the ball in the board’s court. The board cannot simply ignore the demand, as it has a duty to act with care. If the board investigates and rejects the claim, the board’s rejection will sometimes set forth a road map for the board’s defense, the merits of which the activist investor could evaluate before filing suit. On the other hand, the demand process could take considerable time, which is an issue if time is of the essence. An investor filing suit without a demand should be mindful to plead particularized allegations of demand futility against the board and not to advance the type of “circular reasoning” criticized by the court.
 Shareholder activism: Capitalism’s unlikely heroes, The Economist, Feb. 7, 2015.
 Casey Capital, 2016 N.Y. Misc. LEXIS 3107, at *5 (quoting Rales v. Blasband, 634 A.2d 927, 932 (Del. 1993) (Delaware law).
 See Kamen v. Kemper Fin. Servs., Inc., 500 U.S. 90, 101 (1991); Bansbach v. Zinn, 1 N.Y.3d 1, 8-9 (N.Y. 2003) (New York law); Barr v. Wackman, 36 N.Y. 2d 371, 378 (1975) (New York law); Casey Capital, 2016 N.Y. Misc. LEXIS 3107, at *6 (quoting Aronson v. Lewis, 473 A.2d 805, 811-812 (Del. 1984), partially overruled on other grounds by Brehm v. Eisner, 746 A.2d 244 (Del. 2000)) (Delaware law).
 N.Y. Bus. Corp. Law § 626(c).
 Id. at *11.
 Id. at *5 (citing Lerner v. Prince, 119 A.D. 3d 122, 987 N.Y.S.2d 19 (1st Dep’t 2014)).
 Id. at *6.
 Id. at *9-10; see also id. at 9 (“As Defendants point out, Matthews is not even mentioned by name in the complaint, and Fox is mentioned only as having been elected to chair two unspecified committees.”).
 Id. at *9.
 Id. at *10 (quoting Aronson, 473 A.2d at 814).
 Id. at *8 (citing In re infoUSA, 953 A.2d at 972).