A few weeks ago, my colleague Sonia Russo blogged about how shareholders seeking to bring successive derivative actions should be wary, since dismissal of a derivative action for failure to allege pre-suit demand or  demand futility may have a preclusive effect on a subsequent derivative action based on the same issues.  But what if a shareholder plaintiff, whose first derivative suit was dismissed for failure to serve a pre-suit demand or allege demand futility, brings a subsequent derivative action based upon a different issue, such as a boards’ refusal to take action after a valid pre-suit demand has been made?

The Queens County Commercial Division in Feliciano v Seabrook, 2020 NY Slip Op 50753(U) (Sup Ct, Queens County Jun. 11, 2020) (Livote, J.) recently decided this issue, holding a subsequent derivative action will not be barred by the doctrine of res judicata if the board’s wrongful refusal of a litigation demand was not an issue that could have been litigated in the prior derivative action.

The plaintiffs in Feliciano, active and retired members of the Corrections Officers Benevolent Association, Inc. (“COBA”) and beneficiaries of the COBA Annuity Fund and COBA General Fund (“Plaintiffs”), commenced a derivative action in state court against Norman Seabrook (“Seabrook”), the former President of COBA, several members of COBA’s Executive Board (collectively “Executive Board Defendants”), and Koehler & Isaacs, LLP (“K&I”), a law firm that represented COBA, stemming from Seabrook’s participation in a Ponzi scheme (the “State Court Action”).

The complaint alleges Seabrook was indicted (and ultimately convicted) for investing money from COBA’s Annuity Fund and General Fund (the “COBA Funds”) with a “high-stakes” investment firm, which later turned out to be a Ponzi scheme, in exchange for bribes and personal kickbacks.  Plaintiffs allege the Executive Board Defendants, who were charged with overseeing the COBA Funds pursuant to COBA’s Constitution and Bylaws, had no safeguards in place to protect against Seabrook’s activities, and essentially authorized Seabrook’s investments. With respect to K&I, Plaintiffs allege K&I breached its fiduciary duties to COBA by failing to inform the Executive Board of Seabrook’s high-risk investments, or that the investments were being made without their approval.

The State Court Action was not the first lawsuit between Plaintiffs and Defendants.  Plaintiffs had previously filed a derivative action in the United States District Court for the Southern District of New York seeking to hold Seabrook, the COBA Executive Board and K&I responsible for the harm suffered by COBA (the “Federal Action”).  The Federal Action was ultimately dismissed for Plaintiffs’ failure to serve a pre-suit demand or allege demand futility with sufficient particularly

After the Federal Action was dismissed, Plaintiffs made a litigation demand on the Executive Board, requesting that it undertake an investigation, and take action to remedy the financial harm suffered by COBA.   Plaintiffs alleged in the State Court Action that the COBA Executive Board wrongfully refused Plaintiffs’ litigation demand, and declined to make any investigation or pursue any legal remedies against those responsible for causing harm to COBA.

K&I moved to dismiss the State Court Action on the ground that Plaintiffs’ claims were barred by the doctrine of res judicata, since the Federal Action “involved the same parties and alleged facts, and reached final resolution on the merits.”  According to K&I “dismissal of a derivative action for failure to plead demand futility is a final judgment on the merits for purposes of res judicata.”

The Court rejected K&I’s arguments, holding that dismissal based on demand futility does not have res judicata effect on a subsequent action based on the Executive Board’s failure or refusal to take appropriate action after the litigation demand was madeAs the Court explained, “[t]he Executive Board’s business judgment was not an issue litigated or one that could have been litigated in the Federal Action,” since, at the time of the Federal Action, the Executive Board had not yet decided whether or not to investigate and ultimately litigate Plaintiffs’ claims.

In the context of a corporate derivative action, dismissal for failure to plead demand futility is a final judgment on the merits for purposes of res judicata under New York law (see City of Providence v Dimon, 2015 WL 4594150, at * 6 [“[U]nder New York law, the dismissal of a derivative action for failure to plead demand futility is a final judgment on the merits for purposes of res judicata”]; Henik ex rel. LaBranche & Co., Inc. v LaBranche, 433 F Supp 2d 372, 379 [SD NY 2006] [precluding plaintiffs, on both res judicata and collateral estoppel grounds, from relitigating the issue of demand futility]; Wietschner v Dimon, 2015 WL 4915597, at *6 [Sup Ct, NY County, Aug. 14, 2015], aff’d 139 AD3d 461 [1st Dept 2016]).

But, this does not mean that dismissal of a demand futility action has a res judicata effect on a subsequent action based on a board of directors’ alleged refusal to initiate suit.  In Weitschner, for example, the later-filed case raised the same demand futility arguments as the action to which res judicata applied, effectively barring the subsequent action.  By contrast, in Seabrook, the State Court Action and Federal Action raised two different issues: demand futility (the Federal Action) and the Executive Board’s wrongful refusal to take action after a litigation demand had been made (the State Court Action).  While the Plaintiffs in Seabrook would not have been able to relitigate the issue of demand futility in the State Court Action, they were certainly permitted to litigate the issue of the Executive Board’s wrongful refusal – an issue that could not have possibly been litigated in the Federal Action, since that action was dismissed prior to the Executive Board’s alleged wrongful refusal.

Takeaway:

Under New York law, once the issue of demand futility is litigated and decided against a shareholder, the doctrine of res judicata bars all subsequent plaintiffs from relitigating the issue of demand futility.  However, where a subsequent derivative action involves different issues which could not have been raised in the prior action, res judicata will not apply.