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Kaster v. Modification Systems Inc.

decided: March 27, 1984.

CHARLES G. KASTER, WARREN A. FRANK, FRANCIS W. MURRAY, RICHARD O. HILLERY AND JOHN A. MAKARCZYK, INDIVIDUALLY AND AS SHAREHOLDERS OF MODIFICATION SYSTEMS, INC. SUING ON BEHALF OF THEMSELVES AND ALL OTHER SHAREHOLDERS OF MODIFICATION SYSTEMS, INC., SIMILARLY SITUATED AND IN THE RIGHT OF MODIFICATION SYSTEMS, INC., PLAINTIFFS-APPELLANTS,
v.
MODIFICATION SYSTEMS, INC., FRANCIS W. MEYERS, BATISTE DELUCA, E. L. THOMAS AND FRANK L. KELLY, DEFENDANTS-APPELLEES



Appeal from the dismissal of a derivative suit by the United States District Court for the Southern District of New York, Lowe, J., pursuant to Fed. R. Civ. P. 12(b)(6) for failure to state a cause upon which relief could be granted because the complaint failed to allege a demand on directors or an excuse for failure to make a demand as required by Fed. R. Civ. P. 23.1.

Friendly, Van Graafeiland and Meskill, Circuit Judges. Judge Friendly concurs and dissents in a separate opinion.

Author: Meskill

MESKILL, Circuit Judge:

This is an appeal from the dismissal of a shareholders' derivative suit by the United States District Court for the Southern District of New York, Lowe, J., pursuant to Fed. R. Civ. P. 12(b)(6). The suit was dismissed for failure to state a claim upon which relief could be granted because the complaint failed to allege with particularity that a demand had been made on the directors, or adequate facts to excuse a demand as required by Fed. R. Civ. P. 23.1.

We agree with the district court's holding that the complaint did not meet the Rule 23.1 requirement. The court erred, however, in not considering and acting on appellants' cross-motion for leave to amend their complaint. We therefore vacate the judgment and remand for further proceedings not inconsistent with this opinion.

BACKGROUND

Modification Systems, Inc. (MSI) is a closely-held corporation which manufactures and modifies computer simulators for nuclear power plants. MSI was authorized to issue 11,490 Class A voting common shares and 8,510 Class B non-voting common shares, of which 8,450 voting shares and 7,840 non-voting shares had been issued and were outstanding in April 1980. Appellee Meyers was President, Chairman of the Board of Directors and controlling shareholder owning 71 percent of the voting shares. Appellee DeLuca was corporate counsel as well as a director. All of the directors except Kenedy had been chosen by Meyers.*fn1 On February 3, 1982 appellants who owned 79 percent of the non-voting shares and 17.6 percent of the voting shares filed suit on behalf of and against the corporation and individual officers and directors of the corporation.

In their complaint, appellants alleged that appellees violated Rule 10b-5 by voting to accept defendant Meyers' subscription for over two thousand shares of MSI voting stock at a price substantially below book value and thus defrauded the corporation. The complaint also alleged that Meyers violated Rule 10b-5 by failing to disclose to the other directors that his primary objective in acquiring the shares was to dilute the interests of the appellants. Finally, appellants alleged that Meyers breached his fiduciary duty to the corporation by accepting unreasonable compensation, acquiring a luxury condominium with corporate funds, charging expenses that were not incurred and issuing corporate checks for non -corporate purposes, and that the other directors breached their fiduciary duties by approving the unreasonable compensation and the condominium purchase.

On March 2, 1982, before any responsive pleadings were served, appellants filed a verified amended complaint pursuant to Fed. R. Civ. P. 15(a) which stated generally that:

The plaintiffs have not made demands upon M.S.I., its officers or Directors with respect to commencing this action for the reason that the defendant Meyers possesses the voting control, and has utilized such control to name four of the five Directors, of the Corporation and further, has repeatedly used his control over the Board of Directors to dominate and oppress minority shareholders; thus, it would be futile and unavailing to demand that the Directors cause an action to be brought by M.S.I. against themselves.

Complaint para. 20, J. App. at 22. Appellants also claimed that Meyers had refused demands to act on appellants' complaints. Complaint para. 18, id. at 21-22. The complaint further alleged that the director representing minority shareholder interests had been systematically excluded from participating in the management of the corporation in that the other directors failed to provide him with notice of meetings and financial and other information. Complaint para. 19, id. at 22. Appellants, however, did not include any specific examples or details of the above alleged incidents.

Individual appellees moved to dismiss appellants' amended complaint on March 15, 1982, pursuant to Rule 12(b)(6) for failure to meet the demand requirement of Rule 23.1. In the alternative, they sought a change of venue to the District of Maryland. Appellee corporation joined in the individual appellees' motions.

Appellants responded with a cross-motion for leave to amend their complaint should the court grant appellees' motion to dismiss. Appellants contended in their papers supporting the motion that the complaint met the requirements of Rule 23.1 by stating that they had made numerous "oral demands" on the corporation and on Meyers. Alternatively, they argued that their complaint advanced grounds on which a demand should be excused as futile.

The district court granted appellees' motion to dismiss appellants' complaint finding that appellants had conceded that they had made no demand on the directors and then held that: "Plaintiffs' amended complaint fails to allege with particularity any adequate or sufficient reasons for failing to make due demand on the defendant directors to obtain the relief requested." Explaining its decision, the court said: "However, the mere recitation that the demand would be 'futile' is not enough. Plaintiff must allege specific facts which would lead the Court to determine that the demand would indeed be futile." Stein v. Aldrich, [1981-1982 Transfer Binder] Fed. Sec. L. Rep. (CCH) P98,473, at 92,780 (S.D.N.Y. July 18, 1980). Then, relying on Lewis v. Graves, 701 F.2d 245, 248 (2d Cir. 1983), the court held that mere allegations that directors had acquiesced in the wrongdoing was insufficient "involvement" to excuse demand. The court continued that allegations that Meyers, as majority shareholder, controlled the directors because he controlled their positions on the board was insufficient to demonstrate that the directors were adversely interested. The court also rejected as insufficient allegations that the directors were adversely interested because of their friendship with Meyers. In its dismissal of the action, the court discussed appellees' ...


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