Shareholder Derivative Lawsuits and Homeowners Associations

Shareholder Derivative Lawsuits And Homeowners Associations

I. Introduction

Former Speaker of the House Tip O’Neill once remarked that all politics is local. In the context of homeowners’ associations, however, even the most local disputes can end up in federal district court. Disputes over elections, assessments, and collection practices can each end up in federal district court.[1] And as often as note, homeowners will attempt to sue on behalf of the homeowners association under Federal Rule of Civil Procedure 23.1 (“Rule 23.1”). This paper outlines a simple approach to quickly end shareholder derivative lawsuits.

Rule 23.1 unequivocally provides that the plaintiffs’ complaint must state with particularly “any effort by the plaintiff[s] to obtain the desired action from the directors or comparable authority and, if necessary, from the shareholders or members” and “the reasons for not obtaining the action or not making the effort.” Fed. R. Civ. P. 23.1(b)(3)(A)-(B). As often as not, Plaintiffs will simply rush to the courthouse and challenge a myriad of actions that their homeowners association has undertaken. And when they do, they fail to satisfy Rule 23.1’s procedural requirements and the district court can dismiss the lawsuit without prejudice. E.g., Renfro v. FDIC, 773 F.2d 657, 660 (5th Cir. 1985) (per curiam) (“[W]e find it hard to avoid the conclusion that from the outset plaintiffs were resolved upon making a trip to the briar patch and sought only an excuse to be thrown in.”). Rule 23.1 therefore constitutes a surprisingly underutilized weapon in the arsenal of homeowners’ associations. Given the invariably emotional nature of lawsuits against homeowners’ associations and the costs associated with these lawsuits, homeowners’ associations that face derivative lawsuits in federal district court should cite Rule 23.1’s futility requirement and quickly end lawsuits before they begin in earnest.

II. Background

a. Rule 23.1

The Supreme Court has noted that “[a] derivative action by shareholders to enforce corporate rights is a remedy of last resort.” Id. at 658. Rule 23.1 applies when one or more shareholders or members of a corporation or unincorporated association “bring a derivative action to enforce a right that the corporation or association may properly assert but has failed to enforce.” Fed. R. Civ. P. 23.1(a). Plaintiffs to seek to sue on behalf of a corporation or association, however, must satisfy several requirements. Fed. R. Civ. P. 23.1(a)-(c). First, the putative plaintiffs must “fairly and adequately represent the interests of shareholders or members who are similarly situated in enforcing the right of the corporation or association.” Fed. R. Civ. P. 23.1(a). Second, the potential plaintiffs must satisfy three pleading requirements. Fed. R. Civ. P. 23.1(b)(1)-(3).

Plaintiffs must file a verified complaint in any shareholder derivative lawsuit. Fed. R. Civ. P. 23.1(b). The complaint must:

(1) allege that the plaintiff was a shareholder or member at the time of the transaction complained of, or that the plaintiff’s share or membership later devolved on it by operation of law;

(2) allege that the action is not a collusive one to confer jurisdiction that the court would otherwise lack; and

(3) state with particularity:

(A) any effort by the plaintiff to obtain the desired action from the directors or comparable authority and, if necessary, from the shareholders or members; and

(B) the reasons for not obtaining the action or not making the effort.

Fed. R. Civ. P. 23.1(b)(1)-(3) (emphasis added).[2]

b. Rule 23.1’s Demand Requirement

Rule 23.1 expressly contemplates that plaintiffs must demand that the association in whose name they bring the lawsuit provide them with the desired relief. Fed. R. Civ. P. 23.1(b)(3)(A)-(B); Kamen v. Kemper Fin. Servs., Inc., 500 U.S. 90, 96 (1991). And although Rule 23.1 “does not create a demand requirement of any particular dimension, Kamen, 500 U.S. at 96 (emphasis added),[3] Rule 23.1 nonetheless imposes a demand requirement. Fed. R. Civ. P. 23.1(b)(3)(A)-(B). More often than not, plaintiffs either fail to meet or choose to ignore this requirement. Renfro, 773 F.2d at 660. And if they do, defendants may move to dismiss their complaint under Rule 12(b)(6).

The shareholder derivative lawsuit was devised as a suit in equity. Kamen, 500 U.S. at 95. The purpose of a shareholder derivative lawsuit is to “place in the hands of the individual shareholders a means to protect the interests of the corporation” from its officers’ misdeeds. Id. This remedy, however, is open to potential abuse. Id. at 96. In order to prevent abuse of this remedy, courts have consistently established as a “precondition to the suit” that the shareholders demonstrate that “the corporation itself had refused to proceed after suitable demand, unless excused by extraordinary conditions.” Rossv. Bernhard, 396 U.S. 531, 534 (1970).

i. Pre-Suit Demand

Any shareholder who seeks to sue on behalf of a corporation must “show, to the satisfaction of the court, that he has exhausted all the means within his reach to obtain” the action he desires. Hawes v. Oakland, 104 U.S. 450, 460-61 (1882); see also Galef v. Alexander, 615 F.2d 51, 59 (2d Cir. 1980). Rule 23.1’s demand requirement is no mere formality. See Smachlo v. Birkelo, 576 F. Supp. 1439, 1443 (D. Del. 1983). Rather, the shareholder must make “an earnest, not a simulated effort . . . to induce remedial action.” Hawes, 104 U.S. at 461. The shareholder cannot simply make one demand on the corporation’s officers or directors before heading to the courthouse. Equitec-Cole Roesler LLC v. McClanahan, 251 F. Supp. 2d 1347, 1352 (S.D. Tex. 2003).

Directors or officers must receive “full knowledge of the basis for the claim.” Halprin v. Babbitt, 303 F.2d 138, 141 (1st Cir. 1962). Receiving fair notice enables the officers or directors to redress the plaintiffs’ grievance. Kamen, 500 U.S. at 96. If the shareholder derivative complaint does not state that the plaintiffs have made an earnest effort to obtain the relief they seek, dismissal of their complaint is the proper remedy. Renfro, 773 F.2d at 660.

ii. Futility

One narrow exception exists to the demand requirement that Rule 23.1 codifies. E.g., Abramowitz v. Posner, 672 F.2d 1025, 1033 (2d Cir. 1982). Shareholder plaintiffs need not make a demand if doing so would be “futile.” The reasons for a claim of futility must appear on the face of the complaint. Elfenbein v. Gulf & W. Indus., Inc., 590 F.2d 445, 450 (2d Cir. 1978). Among other situations, a demand is futile if the directors are “antagonistic, adversely interested, or involved in the transactions attacked.” Abramowitz, 672 F.2d at 1033. Notably, however, a demand is not futile simply because the corporation or association chooses not to respond to it. Cf. Renfro, 773 F.2d at 660-61.

Rule 23.1 specifically requires the plaintiffs to state in their complaint either that they made a legitimate pre-suit complaint or that doing so would have been futile. Fed. R. Civ. P. 23.1(b)(1)-(3). No exception exists for belatedly making a demand after the plaintiffs have filed suit—and after the defendant has filed a Rule 12(b)(6) motion to dismiss. Id.; see also Grossman v. Johnson, 674 F.2d 115, 125 (1st Cir. 1982). In that situation, the district court will dismiss the lawsuit. Grossman, 674 F.2d at 125. The district court’s dismissal is without prejudice to the plaintiffs’ right to re-file the lawsuit. McClanahan, 251 F. Supp. 2d at 1354.

III. Renfro

Renfro v. FDIC, 773 F.2d 657 (5th Cir. 1985) (per curiam) provides an excellent example of the obstacles that shareholder plaintiffs face. In Renfro, more than several shareholders of a failed national bank notified the FDIC that they intended to sue the bank’s former officials. Id. at 658. The bank’s shareholders notified the FDIC “in the event that the FDIC owne[d] the causes of action.” Id. They did not, however, receive any response to their letter. Id.

The shareholder plaintiffs sued numerous former officers and directors of the bank. Id. The FIDC removed the lawsuit, then sought to dismiss it for failure to comply with Rule 23.1. Id. The district court dismissed the shareholders’ lawsuit. Id. On appeal, the Fifth Circuit affirmed the judgment of the district court. Id. at 660.

The Fifth Circuit began its analysis by noting that a shareholder derivative lawsuit is a “remedy of last resort.” Id. The Fifth Circuit further observed that shareholder plaintiffs cannot simply demand that the corporation file suit. Id. at 659. Rather, the shareholder plaintiffs must “make reasonable efforts to assist the corporation in initiating action.” Id. Comparing the shareholders’ actions against this standard, the Fifth Circuit determined that the shareholders’ efforts “were inadequate as a matter of law.” Id.

The bank’s shareholders did not inform the FDIC of the claims that they wanted the FDIC to assert. Id. Moreover, the bank’s shareholders included precisely no information regarding the allegedly wrongful actions that the bank’s officers and directors committed. Id. Instead, the shareholders’ complaint simply included “conclusory charges without factual allegations.” Id. at 659. The Fifth Circuit characterized the plaintiffs’ efforts to induce action as “pro forma.” Id. at 660. Consequently, the Fifth Circuit affirmed the judgment of the trial court. Id.

Renfro offers a useful precedent for homeowners’ associations that must defend against challenges arising from elections of or actions taken by directors and officers. Plaintiffs to seek to avail themselves of Rule 23.1 cannot simply send a cursory demand letter before filing a lawsuit. Id. at 659. Rather, the shareholder plaintiffs must attempt to assist and work with the homeowners’ association in resolving the dispute. Id. If and when the shareholder plaintiffs fail to do so, they cannot continue to seek relief in federal district court. See id.

IV. How To Defeat A Shareholder Derivative Lawsuit

Homeowners’ associations who face dissatisfied or disappointed members do not lack options. If potential plaintiffs intend to seek relief under federal law,[4]they must affirmatively state in their complaint that they made sufficient efforts to obtain the result sought before filing suit or that doing so was futile. Fed. R. Civ. P. 23.1(b)(3)(A)-(B). Homeowners’ associations who receive demands should offer to work with potential plaintiffs to resolve the dispute in question. Further, any pre-suit correspondence must emphasize that litigation is the last resort—not the first one. There is no downside to attempting to resolve these matters before litigation in federal district court begins. If the plaintiffs are serious about resolving their disputes, further communication will ensue; if the plaintiffs are adamant that litigation will ensue, they will likely proceed to file a lawsuit that doesn’t comply with Rule 23.1.

Due to the occasionally emotional nature of disputes between homeowners and homeowners’ associations and the clash of personalities that can invariably result, it is quite likely that putative shareholder plaintiffs will file suit before attempting to negotiate in good faith. In that situation, the best means to avoid protracted litigation is the filing of a Rule 12(b)(6) motion to dismiss. Even a legitimate effort to achieve the result sought after the filing of the complaint cannot avoid dismissal for failure to satisfy Rule 23.1’s requirement of a pre-suit demand. Grossman, 674 F.2d at 125.

Although a shareholder derivative lawsuit is a remedy of last resort, the first option chosen by plaintiffs in real estate disputes is often litigation. Any dismissal for failure to meet Rule 23.1’s requirement of a pre-suit demand is without prejudice. Renfro, 773 F.2d at 660; McClanahan, 251 F. Supp. 2d at 1354. Thus, the plaintiffs can attempt to re-file their complaint to more particularly state that they have met Rule 23.1’s requirements.[5] Yet an initial, procedural victory can often lead to an eventual triumph.

The dismissal of a complaint without prejudice all but officially forces any homeowners to attempt to resolve their dispute with the homeowners’ association in whose name they previously attempted to sue. Moreover, it is quite possible that the plaintiffs might not wish to pursue their lawsuit any further once the district court has dismissed their complaint without prejudice. Alternatively, by having to file an amended complaint, the plaintiffs will lose the opportunity to conduct discovery and develop their claims. In any event, failure to comply with Rule 23.1 will halt, and possibly end, a lawsuit.

V. Conclusion

The pre-suit demand requirement codified by Rule 23.1 constitutes a significant yet underutilized weapon for homeowners’ associations who are hauled into federal district court. Defendants who force their homeowners to comply with this rule will, at a minimum, reduce litigation costs and quite possibly avoid litigation altogether.

Michael M. Gallagher[6]

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02240.146 / 1167803.1

[1]For example, an aggrieved homeowner could contend that an election regarding the incorporation of an association as a municipality violated his Fourteenth Amendment rights or his civil rights.

[2]Plaintiffs that wish to settle, compromise, or voluntarily dismiss a shareholder derivative lawsuit must do so “only with the court’s approval.” Fed. R. Civ. P. 23.1(c). Further, the court must give notice of a proposed settlement voluntary dismissal or compromise to all shareholders or members “in the manner that the court orders. Id.

[3] Rule 23.1 is “only a procedural requirement empowering federal courts to determine from the pleadings whether the demand requirement has been met.” RCM Sec. Fund, Inc. v. Stanton, 928 F.2d 1318, 1329 (2d Cir. 1991). Courts examine the adequacy of a shareholder’s demand by consulting the law of the forum state. E.g., Stoner v. Walsh, 772 F. Supp. 790, 795 (S.D.N.Y. 1991).

[4]In the absence of a federal question, plaintiffs will file and prosecute most lawsuits against a homeowners’ association in state court because the parties are not completely diverse.

[5]Of course, Rule 11 governs all statements in an amended complaint. SeeFed. R. Civ. P. 11.

[6] Associate, Hays, McConn, Rice & Pickering, Houston, Texas; B.A., cum laude, Georgetown University; J.D., 2003, University of Houston Law Center. Law Clerk to the Honorable Richard A. Schell, United States District Court, Eastern District of Texas, 2003-2004.