Opinion
401919/03.
Decided October 17, 2003.
This is a shareholder derivative action brought by plaintiff, Meir Spear, a shareholder of nominal defendant Merrill Lynch Co., Inc. ("Merrill Lynch"), against Merrill Lynch and the members of its board of directors, defendants Jill K. Conway, George B. Harbey, Heinz-Joachim Neuberger, E. Stanley O'Neal, W.H. Clark, Aulana L. Peters, John J. Phelan, Jr., David H. Komansky, Robert P. Luciano, David K. Newbigging, and Joseph W. Prueher (the "director defendants"). Merrill Lynch and the director defendants now move, pursuant to CPLR 3211 (a)(1), (3) and (7) and CPLR 3016(b), for an order dismissing plaintiff's amended shareholder derivative complaint, dated February 3, 2003 (the "Complaint"), on the grounds that: (a) plaintiff failed to make a presuit demand upon Merrill Lynch's board of directors to prosecute the claims asserted, or to demonstrate that such a demand would be futile; (b) Merrill Lynch's Certificate of Incorporation contains a provision, pursuant to section 102(b)(7) of the Delaware General Corporation Law, barring claims against its directors; and (c) the allegations in the Complaint do not meet the pleading particularity requirements of CPLR 3016(b). For the reasons discussed infra, the motion to dismiss is granted on the first ground.
BACKGROUND
Plaintiff is a shareholder of Merrill Lynch, a Delaware corporation. The director defendants are members of Merrill Lynch's board of directors. Of the 11 director defendants, nine are non-employee, non-management directors. Plaintiff alleges that, since 1999, Merrill Lynch's internet research analysts routinely made false and fraudulent recommendations to the public pertaining to stocks in the internet sector that had no reasonable basis, and were merely made in order to generate investment banking business for Merrill Lynch in violation of New York and federal law. Plaintiff summarizes his claims in paragraphs 48 to 53 of the Complaint:
48. Since late 1999, the internet research analysts (the "Internet Group") at Merrill Lynch have published on a regular basis for internet stocks that were misleading because: (1) the ratings in many cases did not reflect the analysts' true opinion of the companies; (2) Merrill Lynch failed to disclose that as a matter of internal policy, no "reduce" or "sell" recommendations were issued, thereby converting a published five-point rating scale to a de facto three-point system; and (3) Merrill Lynch failed to disclose to the public that Merrill Lynch's ratings were tarnished by an undisclosed conflict of interest, i.e., that the research analysts' compensation was linked to the investment banking fees paid by the companies that the analysts covered and that as a result research analysts were acting as quasi-investment bankers for the companies at issue, often initiating, continuing, and/or manipulating research coverage for the purpose of attracting and keeping investment banking clients, thereby producing misleading ratings that were neither objective nor independent, as they purported to be.
49. Behind these ratings was a serious breakdown of the separation between Merrill Lynch's banking and research departments, a separation that was critical to the integrity of the recommendations issued to the public by Merrill Lynch. . . .
50. Research analysts knew that the investment banking business they generated or participated in would impact their compensation, and management encouraged them to produce investment banking business. . . .
51. The pressures put on the Merrill Lynch Internet Group to appease both investment bankers and clients led the Group to ignore the bottom two categories of the five-point rating system ("reduce" and "sell") and to use only the remaining ratings ("buy", accumulate, and "neutral").
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53 . . . [T]he [director] defendants who were directors of Merrill Lynch during the issuance of the fraudulent analyst ratings and recommendations breached their duties to Merrill Lynch and its shareholders by, inter alia, failing to ensure theat reasonable and adequate information and reporting systems were in place; failing to take steps to prevent the violations of federal and state securities laws which they knew were occurring; failing to adopt policies to prevent such fraudulent practices; and failing to detect fraudulent practices.
According to plaintiff, Merrill Lynch violated both New York and federal law, insofar as its analyst recommendations violated Article 23-A of the New York General Business Law (the "Martin Act") and Section 10(b) of the federal Securities Exchange Act of 1934, and Rule 10b-5. As a result of these actions, plaintiff alleges that, following an investigation by the New York State Attorney General, Merrill Lynch was ordered to pay a $100 million fine to the state, and is also required to defend itself in several class action lawsuits and private arbitration claims alleging securities law violations. Merrill Lynch stock suffered a precipitous decline, falling from $53.45 on April 8, 2002 to $38.76 by June 3, 2002, the cause of which plaintiff attributes to the above facts. Plaintiff adds that Merrill Lynch was required to pay an $80 million fine to the SEC in 2003 for its role in two transactions involving Enron Corporation.
Plaintiff contends that this alleged scheme was orchestrated by the internet analysts, with the director defendants' knowledge, and that the director defendants intentionally ignored, and in bad faith refused, to prevent these illegal acts from occurring in order to avoid interfering with Merrill Lynch's investment banking business. Even if the director defendants did not know of the scheme, plaintiff maintains that they are accountable because they failed to assure that a reasonable information and reporting system was implemented that would prevent such acts from occurring and thereby ensure the integrity of analyst recommendations.
The Complaint charges defendants with breach of fiduciary duties, as follows: 243. The [director defendants] intentionally, in bad faith and/or with gross negligence breached their fiduciary duties by, inter alia, knowingly violating state and federal securities laws; failing to adopt policies and procedures to prevent the fraudulent positive recommendations for investment banking business; failing to ensure reasonable and adequate information and reporting systems were in place to ensure compliance with state and federal securities laws; and failing to take steps to prevent the violations of state and federal securities laws which they knew were occurring. 244. The [director defendants] failed to ensure that reasonable and adequate reporting and information systems were in place to prevent analysts from making false recommendations about banking clients and from failing to disclose their conflicts of interest. 245. The [director defendants] knew that Merrill Lynch compensated their analysts based on their ability to generate investment banking business. 246. The [director defendants] knew that conflicts of interest caused analysts to make false and misleading positive statements about potential and actual investment banking clients. 247. The [director defendants] knew that the analysts were violating state laws and federal laws and took no action to prevent these violations.
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250. The [director defendants], by their conduct, have caused [Merrill Lynch] to waste its valuable assets and otherwise unnecessarily expend its corporate funds to have its reputation and credibility impaired, as a result of which [Merrill Lynch] has been and continues to be substantially damaged in its reputation, in its finances. . . .
Plaintiff maintains that there were many "red flags" that should have put the director defendants on notice of the illegal conduct, including the facts that: (a) Merrill Lynch failed to provide a sufficient divider between its research and investment banking divisions; (b) Merrill Lynch gave incentive compensation to analysts based on their ability to generate or participate in investment banking activities; (c) Merrill Lynch allowed investment bankers and company executives to rewrite negative coverage; and (d) in April 1999, SEC Chairperson Levitt publically criticized Wall Street brokerage firms because their analysts were conflicted and refused to issue "sell" recommendations, and warned that Wall Street analysts were coming under increasing pressure to give positive ratings to companies when the firm's investment banking arm has a relationship with the companies.
DISCUSSION
On a motion to dismiss under CPLR 3211(a)(7), the pleading is to be afforded a liberal construction, allegations are accepted as true and plaintiff is accorded the benefit of all favorable inferences which may be drawn from the pleading (Campaign for Fiscal Equity, Inc. v. State of New York, 86 NY2d 307, 318; P.T. Bank Central Asia v. ABN AMRO Bank, N.V., 301 AD2d 373, 375-76 [1st Dept 2003]). However, conclusory allegations and those flatly contradicted by documentary evidence, are not entitled to such inferences (Franklin v. Winard, 199 AD2d 220 [1st Dept 1993]; see also, Marx v. Akers, 88 NY2d 189, 204). As stated by the First Department:
While the court will accept well-pleaded facts as true, it will not take as true conclusory allegations of fact or law not supported by allegations of specific fact (Grobow v. Perot, 539 A2d 180, 187). "A trial court need not blindly accept as true all allegations, nor must it draw all inferences from them in plaintiffs' favor unless they are reasonable inferences" (supra, at 187).
(Wilson v. Tully, 243 AD2d 229, 234 [1st Dept 1998]).
Defendants contend that dismissal is warranted because plaintiff failed to plead demand futility with sufficient particularity. In determining whether a prelitigation demand was required, Delaware law controls (see, Wilson v. Tully, supra, 243 A2d, at 232). Shareholders seeking to bring a derivative action on behalf of the corporation must make a demand on the board of directors, unless such demand would be futile (Id., quoting Rales v. Blasband, 634 A2d 927, 933 [Del Supr 1991]). Delaware Chancery Court Rule 23.1, provides that every shareholder derivative complaint must allege "with particularity the efforts, if any, made by the plaintiff to obtain the action he or she desires from the directors or comparable authority and the reasons for [his or her] failure to obtain the action or for not making the effort." Plaintiff bears the burden of pleading "futility" (Rales v. Blasband, supra, 634 A2d, at 932-933).
Thus, the court must first determine whether plaintiff has sufficiently pleaded that a prelitigation demand by him on Merrill Lynch's board would have been futile. The test, under Delaware law, for determining whether a derivative complaint adequately pleads demand futility is whether the particular facts alleged create a reasonable doubt that: (1) the directors were independent and disinterested; and (2) the challenged transaction was otherwise the product of a valid exercise of business judgment (see, Aronson v. Lewis, 473 A2d 805, 814 [Del Supr 1984]; see also, Brehm v. Eisner, 746 A2d 244, 256). Where, as here, inaction rather than action by a board is charged, the inquiry is limited to the first prong of the Aronson test (see, Rales v. Blasband, supra, 634 A2d, at 933; see also, Wilson v. Tully, supra, 243 AD2d, at 233-234). As explained in Wilson v. Tully, supra:
Similarly, consistent with the context and rationale of Aronson, a court should not apply the Aronson test for demand futility where the board that would be considering the demand did not make the business decision that is being challenged. Thus, where inaction, rather than action, by a board is charged and "directors are sued derivatively because they have failed to do something (such as a failure to oversee subordinates), demand should not be excused automatically in the absence of allegations demonstrating why the board is incapable of considering a demand. Indeed, requiring demand in such circumstances is consistent with the board's managerial prerogatives because it permits the board to have the opportunity to take action where it has not previously considered doing so" (Rales v. Blasband, 634 A2d 927, 933-934, n. 9, supra).
In such a case, "it is appropriate . . . to examine whether the board that would be addressing the demand can impartially consider its merits without being influenced by improper considerations. Thus, a court must determine whether or not the particularized factual allegations of a derivative stockholder complaint create a reasonable doubt that, as of the time the complaint is filed, the board of directors could have properly exercised its independent and disinterested business judgment in responding to a demand" (supra, at 934).
Plaintiffs, in seeking to excuse their failure to make a presuit demand, allege that the defendant directors either wittingly or unwittingly permitted the allegedly illegal course of conduct to develop and continue to the point where Merrill Lynch was exposed to enormous legal liability and that, in so doing, they violated their fiduciary duty to monitor Merrill Lynch's corporate affairs. It has been said that such a claim is possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment (In re Caremark Intl. Inc. Derivative Litig., 698 A2d 959, 967 [Del].)
(Id.).
Here, since this lawsuit does not challenge a business judgment made by the director defendants, the court "must determine whether or not the particularized factual allegations of a derivative stockholder complaint create a reasonable doubt that . . . the board of directors could have properly exercised its independent and disinterested business judgment in responding to a demand" (Id). To determine whether a demand would have been futile under these circumstances, the court must decide whether or not the factual allegations contained in the complaint create a reasonable doubt that, at the time the complaint was filed, the board was capable of exercising independent and disinterested judgment in response thereto (Rales v. Blasband, supra, 634 A2d 927, 932-933). Demand will not be excused absent particular factual allegations demonstrating why the board is not capable of considering a demand (see, Wilson v. Tully, supra, citing Rales v. Blasband, supra, 634 A2d 927, 932-933).
The Complaint here contains various boilerplate allegations to the effect that a presuit demand would have been futile due to the directors' interest and/or lack of independence. For example, the Complaint alleges that demand is excused because the director defendants would not sue themselves, that certain individual wrongdoers dominate and control the board, and that the director defendants receive director fees (Complaint, ¶ 47). In their moving papers, defendants cited both New York and Delaware law for the proposition that conclusory boilerplate allegations of director interest, such as these, do not provide a basis to excuse demand (see, e.g., Aronson v. Lewis, supra, 473 A2d, at 817; Brehm v. Eisner, supra, 746 A2d, at 257; Marx v. Akers, supra, 88 NY2d, at 199-200). In response, plaintiff has failed to even attempt to counter defendants' arguments on this point in any respect.
Instead, plaintiff, in his opposing papers, focuses upon the director defendants' alleged failure to monitor the internet group's activities, and their failure to adopt procedures and policies that would have prevented the occurrence of fraudulent practices by the internet research analysts. This type of claim, based on a board's alleged failure to oversee corporate activities, is referred to as a Caremark claim (see, In re Caremark International Inc. Deriv. Litig., 698 A2d 959, 971 [Del Ch 1996]; see also, Guttman v. Huang, 823 A2d 492, 506-507 [Del Ch 2003]; In re Citigroup Inc. Shareholders Litigation, 2003 WL 21384599 [Del Ch 2003] [unpublished opinion]). In Caremark, the Delaware Chancery Court stated:
Generally where a claim of directorial liability for corporate loss is predicated upon ignorance of liability creating activities within the corporation. . . . only a sustained or systematic failure of the board to exercise oversight — such as an utter failure to attempt to assure a reasonable information and reporting system exists — will establish the lack of good faith that is a necessary condition to liability. Such a test of liability — lack of good faith as evidenced by sustained or systematic failure of a director to exercise reasonable oversight — is quite high.
(emphasis added; Id., at 971).
The court in Caremark noted that a claim for failure to exercise proper oversight is a very difficult theory upon which to prevail (Id.). In the typical Caremark case, "[i]n order to hold the directors liable, [a] plaintiff will have to demonstrate that they were grossly negligent in failing to supervise these subordinates" (see, Rattner v. Bidzos, 2003 WL 22284323, at 12 [Del Ch 2003], quoting Seminaris v. Landa, 662 A2d 1350, 1355 [Del Ch 1995]). Guttman v. Huang, supra, is to the same effect:
[P]laintiffs have not come close to pleading a Caremark claim. Their conclusory complaint is empty of the kind of fact pleading that is critical to a Caremark claim, such as contentions that the company lacked an audit committee, that the company had an audit committee that met only sporadically and devoted patently inadequate time to its work, or that the audit committee had clear notice of serious accounting irregularities and simply chose to ignore them or, even worse, to encourage their continuation.
(Id., at 506-507; see also, In re Citigroup Inc. Shareholders Litigation, supra).
Plaintiff's reliance upon In re Abbott Laboratories Derivative Shareholders Litigation ( 325 F 3d 795 [7th Cir 2003]) is misplaced. In Abbott, the Seventh Circuit determined that the members of the board were explicitly aware of the alleged practices complained of over a lengthy period of time and had consciously chosen not to act in response thereto — that the board's "inaction" was intentional and conscious, and that the directors knew of the violations of law, took no steps in an effort to prevent or remedy the situation, and that failure to take any action for such an inordinate amount of time resulted in substantial corporate losses (Id., at 809).
Here, plaintiff's allegations, even if true, suggest only that a wrongdoing was committed somewhere within Merrill Lynch. Other than conclusory statements, the Complaint contains no allegations linking the alleged wrongful conduct by the internet group to Merrill Lynch's board of directors, or leading to an inference that the director defendants knew of said misconduct and made a conscious decision not to act in response thereto (see, Wilson v. Tully, supra, 243 AD2d, at 234; "Nowhere in their 68-page complaint do plaintiffs point to any specific conduct of the individual directors or board resolution relating to [the alleged wrongdoing], but rely upon conclusory allegations that the defendant directors 'knew or recklessly disregarded' or 'knew or were reckless in not knowing' of Merrill Lynch's perilous course of conduct, thereby exposing the Company to numerous lawsuits and substantial damages"). Nor are the supposed "red flags" identified by plaintiff sufficient to impute or suggest the director defendants' knowledge of the internet group's wrongdoing. Thus "despite all of plaintiffs' conclusory allegations, there is no well-grounded evidentiary showing that a reasonable doubt exists as to whether any of the defendant directors' alleged actions or inaction with regard to the so-called "red flags" cited by plaintiffs were other than valid exercises of the directors' business judgment and fiduciary responsibility to Merrill Lynch" (Wilson v. Tully, supra, 243 AD2d, at 237]). "Red flags' are only useful when they are either waived in one's face or displayed so that they are visible to the careful observer" (In re Citigroup Inc. Shareholders Litigation, supra, at 2).
Upon analysis, it is evident that plaintiff has failed to allege, with the necessary particularity, facts that would support a conclusion that a presuit demand by him would have been futile (Wilson v. Tully, supra, 243 AD2d, at 239), and the motion to dismiss is thus granted on that ground.
The court therefore does not reach defendants' additional grounds for dismissal, i.e., that Merrill Lynch's Certificate of Incorporation contains an enforceable provision barring claims against its directors, and that the allegations in the Complaint do not meet the pleading particularity requirements of CPLR 3016(b).
CONCLUSION
It is ORDERED that defendants' motion to dismiss the Complaint is granted, and the Complaint is dismissed with costs and disbursements to defendants, as taxed by the Clerk of the Court upon the submission of an appropriate bill of costs; and it is further
ORDERED that the Clerk is directed to enter judgment accordingly.