When filing a shareholder derivative suit, it‘s important to get the job done right the first time, as other shareholders may not get a second bite of the proverbial apple.
In Noor v. Mahmood, the Second Department upheld Justice Lawrence Knipel’s Order which granted defendants’ motion for summary judgment, dismissing a shareholder derivative action pursuant to the doctrine of res judicata where a previous derivative action commenced by a different shareholder against the same defendants and based on the same alleged wrongdoings had already been dismissed.
In the earlier action, commenced in 2015, a shareholder brought a derivative suit on behalf of the corporation based on defendants’ alleged breaches of fiduciary duty and diversion of corporate assets. That action was dismissed pursuant to CPLR 3211 as a result of the shareholder’s failure to adequately allege demand futility. There, the majority of the board consisting of disinterested directors had exercised their business judgment and refused to authorize the derivative suit (click here to read my blog on avoiding dismissal based on demand futility).
In 2017, plaintiff, a different shareholder, brought a separate derivative suit against the same defendants with identical allegations as those raised in the 2015 suit. Interestingly, plaintiff in this action was one of the disinterested directors who had refused to authorize the derivative suit in the earlier action.
In an effort to save the second derivative suit from the same fate of the earlier action, plaintiff argued that because he had changed his mind and decided to file suit, there was no longer a disinterested majority that considered the action meritless. Furthermore, plaintiff argued that the prior dismissal was not on the merits and cannot be the basis for res judicata.
The Second Department, however, reasoned that claims asserted in a shareholder’s derivative action belong to and are brought on behalf of the corporation, not the shareholders themselves. Thus, a judgment in an action brought on behalf of the corporation by one shareholder precludes other actions brought by other shareholders where they are predicated on the same wrongdoing (Grika v. McGraw, 161 A.D.3d 450 [1st Dept. 2018]).
This case is in line with the public policy behind the doctrine of res judicata: to ensure finality, prevent vexatious litigation, and promote judicial economy (Xiao Yang Chen v. Fischer, 6 N.Y.3d 94, 100 ).
The holding in Noor is also consistent with the precedent established in New York federal courts: that a determination on the merits in a shareholders’ derivative action is res judicata in subsequent actions as to the corporation and all of its shareholders, including those who were not parties to the prior derivative action, as long as the parties’ interest were adequately represented in the original action (Lee v. Marvel Enterprises, Inc., 765 F.Supp.2d 440 [S.D.N.Y. 2011]; see, e.g., Henrik v. LaBranche, 433 F.Supp.2d 372 [S.D.N.Y. 2006]).
The court in Henrik v. LaBranche noted that the general rule precluding other actions brought by subsequent shareholders where they are predicated on the same wrongdoing is not without exception. There, the U.S. District Court for the Southern District of New York discussed the possibility for a different result where the plaintiff shareholder in the first action is alleged to have inadequately represented the interests of all of the shareholders and there is a showing that the “representative failed to prosecute or defend the action with due diligence and reasonable prudence, and the opposing party was on notice of facts making that failure apparent” (Henrik, citing Restatement (Second) of Judgments,§ 42).
Takeaway: Recognizing that shareholders may not get a second bite of the apple when filing a shareholder derivative action, it is important to analyze the merits of a derivative suit and determine if any claims may be brought by the shareholder individually. Additionally, shareholders contemplating a subsequent derivative action should also consider whether their interests were adequately represented in the earlier action.