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Posted on Wednesday, July 25, 2018

Taking Exception to the Futility Exception

Dorothy C. Davis, derivatively on behalf of Woodside Properties, LLC v. MKR Development, LLC, et al., Virginia Supreme Court No. 171020 (31 May 2018)

“Happy families are all alike; every unhappy family is unhappy in its own way.” (Anna Karenina, by Leo Tolstoy).  This case is about an unhappy family that is unhappy in its own way.

The amended complaint alleges that Melvin L. Davis, Sr., founded and owned Melvin L. Lewis Oil Company.  He sold the company’s stock to his children, Kaye, Melvin, Jr. and Rex.  Melvin and his wife, Dorothy, also owned real estate that the oil company leased.  Melvin and Dorothy formed Woodside Properties, LLC, (“Woodside”) to take ownership of the real estate.  Melvin and Dorothy intended to establish an arrangement through which they would receive income from Davis Oil’s rental of the real estate owned by Woodside.  The operating agreement for Woodside appointed MKR Development, LLC, (“MKR”) as the manager of Woodside.  Under MKR’s operating agreement, Kaye, Melvin, Jr., and Rex were the managers of MKR.

Dorothy owns 72 percent of Woodside, and she alleges that as of December 2011 Woodside should have received $1.3 million in rent under the lease.  Instead, she alleges that the bank account established for Woodside had a balance of only $35,000.  She asserts that the funds that should have gone to Woodside were used for improper purposes.  When she asked Melvin, Jr. and Rex for payment of funds due, they refused and also refused to provide an accounting.[1]

In May 2014, Dorothy filed a complaint, later amended, against MKR and her two sons, Melvin Jr. and Rex, and against Woodside.  Her amended complaint alleges that MKR and her sons, as managers, had breached their fiduciary duties toward Woodside, wasted corporate assets, and unjustly enriched themselves.  She asks that MKR be removed as manager of Woodside and for a constructive trust and an accounting.  Dorothy’s amended complaint acknowledges that she did not make a demand on MKR, Melvin, Jr. or Rex to bring this action on behalf of Woodside, because such demand would have been a futile, wasteful and useless act as they were the parties who authorized, ratified, and benefitted from the wrongful conduct.

The Circuit Court dismissed the derivative action on the ground that Dorothy failed to first make demand for Woodside to take the requested action.

The derivative form of action permits an individual shareholder to bring suit to enforce a corporate cause of action against officers, directors and third parties. Ross v. Bernhard, 396 U.S. 521, 534 (1970).  A derivative action is an equitable proceeding. Simmons v. Miller, 261 Va. 561, 573, 544 S.E.2d 666, 674 (2001).  To prevent abuse of the remedy, equity courts required shareholders to allege and prove that a request or demand was made upon the persons managing the company and those persons had refused to act. Mount v. Radford Trust Co., 93 Va. 427, 431, 25 S.E. 244-245 (1896).  In the alternative, the stockholder could allege facts sufficient to show that the persons controlling the company would refuse to act. Id.  See also Virginia Passenger & Power Co. v. Fisher, 104 Va. 121, 126-27, 51 S.E. 198, 200 (1905).  This became known as the “futility exception.”

Virginia Code §13.1-1042 codifies this case law.  Before 2011, that section provided that a plaintiff could bring a derivative action “if members or managers with authority to do so have refused to bring the action or if an effort to cause those members or managers to bring the action is not likely to succeed.”  In 2011, the General Assembly amended §13.1-1042 in pertinent part to provide that:

B.     No member may commence a derivative proceeding until:

  1. A written demand has been made on the limited liability company to take suitable action; and
  2. Ninety days have expired from the date delivery of the demand was made unless (i) the member has been notified before the expiration of 90 days that the demand has been rejected by the limited liability company or (ii) irreparable injury to the limited liability company would result by waiting until the end of the 90-day period.

This clear language seems to lead to the conclusion that Dorothy’s suit should be dismissed for failure to make a written demand before suing.  But wait!  There is another provision of the statute setting forth the pleading requirements for derivative suits, §13.1-1044.  That section says that “[i]n a derivative action, the complaint shall set forth with particularity the effort of the plaintiff to secure commencement of the action by a member or manager with the authority to do so or the reasons for not making the effort.”  (Italics supplied.)

Dorothy argued that if §13.1-1042 categorically requires a demand without exception, then the language of §13.1-1044 is superfluous.  The Supreme Court said that ordinarily it resists a construction of a statute that would render part of a statute superfluous.  “Every part of a statute is presumed to have some effect and no part will be considered meaningless unless absolutely necessary.”  City of Richmond v. Virginia Elec. & Power Co., 292 VA. 70, 75, 787 S.E,2d 161, 164 (2016).  In addition, Code §13.1-1001.1(A) provides that “the principles of law and equity supplement this chapter” except where they are “displaced by particular provisions of this chapter.

This clear language seems to lead to the conclusion that Dorothy’s suit should be dismissed for failure to make a written demand before suing.  But wait!  There is another provision of the statute setting forth the pleading requirements for derivative suits, §13.1-1044.  That section says that “[i]n a derivative action, the complaint shall set forth with particularity the effort of the plaintiff to secure commencement of the action by a member or manager with the authority to do so or the reasons for not making the effort.”  (Italics supplied.)

Dorothy argued that if §13.1-1042 categorically requires a demand without exception, then the language of §13.1-1044 is superfluous.  The Supreme Court said that ordinarily it resists a construction of a statute that would render part of a statute superfluous.  “Every part of a statute is presumed to have some effect and no part will be considered meaningless unless absolutely necessary.”  City of Richmond v. Virginia Elec. & Power Co., 292 VA. 70, 75, 787 S.E,2d 161, 164 (2016).  In addition, Code §13.1-1001.1(A) provides that “the principles of law and equity supplement this chapter” except where they are “displaced by particular provisions of this chapter.

By referring to the principles of equity, §13.1-1001.1(A) embraces within its scope the futility exception, which has long been part of the law.  Moreover, the language of §13.1-1044 presupposes the continued existence of the futility exception.  The combined force of the textual provisions of §13.1-1001.1(A) and §13,1-1044 leads to the conclusion that the General Assembly did not abrogate the futility exception when it amended §13.1-1042 in 2011.  In derivative suits, the futility exception is alive and well, and the circuit court erred in dismissing the complaint.

[1] In a separate proceeding, Kaye was dissociated from MKR.

John Polk is a Special Counsel at Berenzweig Leonard, LLP. John can be reached at JPolk@BerenzweigLaw.com.