United States District Court, S.D. New York
OPINION AND ORDER GRANTING MOTION TO DISMISS
ALVIN K. HELLERSTEIN, District Judge.
Plaintiffs bring this shareholder derivative action under Maryland law on behalf of American Realty Capital Properties, Inc. ("ARCP"), a publicly-traded real estate investment trust ("REIT") incorporated in Maryland. Defendants are current and former ARCP officers and members of its board of directors. Jurisdiction is proper pursuant to 28 U.S.C. § 1331. The case arises from alleged incidents of accounting fraud by ARCP officers and corresponds to the securities class action In re Am. Realty Capital Props., Inc. Litig., No 15-mc-40 (S.D.N.Y). On April 3, 2015, Defendants filed a motion to dismiss pursuant to Fed.R.Civ.P. 23.1 on the ground that Plaintiffs failed to make a pre-suit demand on ARCP's board of directors. For the following reasons, Defendants' motion is granted.
ARCP is a REIT that generates income by purchasing real estate and renting it out to large commercial tenants. An important financial metric used by investors to value REITs is known as adjusted funds from operations ("AFFO"). AFFO is a non-GAAP value that measures a REIT's performance by excluding from net income all gains and losses unrelated to operations.
On October 29, 2014, following an investigation by the Audit Committee of the board of directors, ARCP filed a Form 8-K with the SEC in which it disclosed improper accounting in the company's 2013 Annual Report (Form 10-K) and its Quarterly Reports (Form 10-Q) for the periods ended March 31, 2014 and June 30, 2014. In its preliminary findings, the Committee revealed that ARCP "incorrectly included certain amounts related to its non-controlling interests in the calculation of adjusted funds from operations... and, as a result, overstated AFFO for [the quarter ended March 31, 2014.]" Compl. ¶ 90. The Audit Committee also revealed that "this error was identified but intentionally not corrected, and other AFFO and financial statement errors were intentionally made, resulting in an overstatement of AFFO and an understatement of the Company's net loss for the three and six months ended June 30, 2014." Id. The press release announced the resignations of the Chief Financial Officer, Brian Block, and the Chief Accounting Officer, Lisa McAlister, but expressed "full confidence in the management team and staff." Id. ¶¶ 93-94. ARCP's share price finished trading on October 29th approximately 20% below its previous day close, and in the days that followed, the SEC and FBI announced investigations into the company.
On December 15, 2014, ARCP filed another Form 8-K with the SEC announcing the resignations of Chairman Nicholas Schorsch,  Chief Executive Officer David Kay,  and President and Chief Operating Officer Lisa Beeson. On December 18, former Chief Accounting Officer Lisa McAlister brought a defamation claim in New York Supreme Court against ARCP, Schorsch, and Kay for the press release that accompanied her resignation. See Lisa Pavelka McAlister v. Am. Realty Capital Props., Inc., et al., No. 162499/2014 (Sup.Ct. N.Y. Cnty.). McAlister alleged that she had reported accounting irregularities to Mr. Schorsch and Mr. Kay as early as February 2014, but that they directed her "not to change or correct the fraudulent reports, in an apparent effort to avoid public disclosure of the Company's faltering financial performance." Compl. ¶ 111. She also alleged that her warning to ARCP's auditing firm Grant Thornton was ignored and that she was instructed to file the Q2 2014 report "as is." Ms. McAlister withdrew her complaint on February 19, 2015.
On March 2, 2015, ARCP released the final results of the Audit Committee's investigation. The investigation found a number of violations of U.S. GAAP accounting standards and other misrepresentations, such as mischaracterization of general and administrative expenses as expenses related to mergers and other non-routine transactions. The Committee also found possible instances of self-dealing by Mr. Schorsch, and concluded that internal controls for ensuring the accuracy of financial reports were deficient. See Compl. ¶ 120. The company revised AFFO downward by $0.08 per share for FY 2013, $0.07 per share for QI 2014, and $0.03 per share for Q2 2014.
On February 17, 2015, I consolidated under this caption three separate derivative actions brought on behalf of Nominal Defendant ARCP. On March 11, 2015, following the release of the Audit Committee's final report, Plaintiffs filed this amended complaint. It is undisputed that Plaintiffs did not make a demand for litigation on ARCP's board prior to commencing this action. Rather, Plaintiffs assert that demand would be futile and should therefore be excused.
In a derivative action, individual shareholders bring suit as nominal plaintiffs to enforce a corporation's causes of action against "faithless directors and managers." Kamen v. Kemper Fin. Servs., Inc., 500 U.S. 90, 95 (1991) (quoting Cohen v. Beneficial Loan Corp., 337 U.S. 541, 548 (1949)). As a threshold matter of standing, the shareholder generally must demonstrate "that the corporation itself had refused to proceed after suitable demand, unless excused by extraordinary conditions." Ross v. Bernhard, 396 U.S. 531, 534 (1970); In re IAC/InterActiveCorp Sec. Litig., 478 F.Supp.2d 574, 597 (S.D.N.Y. 2007). The purpose of the "demand requirement" is to "afford the directors an opportunity to exercise their reasonable business judgment" as to whether incurring the expense of enforcing a legal right is in the corporation's best interest. Daily Income Fund, Inc. v. Fox, 464 U.S. 523, 533 (1984) (internal quotations omitted). The Federal Rules specifically require a derivative complaint to
state with particularity  any effort by the plaintiff to obtain the desired action from the directors or comparable authority and... the reasons for not obtaining the action or not making the effort.
Fed. R. Civ. P. 23.1(b)(3). Unlike a 12(b)(6) motion, a motion to dismiss pursuant to Rule 23.1 "is not intended to test the legal sufficiency of the plaintiffs substantive claim. Rather, its purpose is to determine who is entitled, as between the corporation and its shareholders, to assert the plaintiffs underlying substantive claim on the corporation's behalf." Canty v. Day, 13 F.Supp. 3d 333, 343 (S.D.N.Y. 2014) (citation omitted).
But while the federal rules contemplate the existence of a demand requirement, the substance of the requirement and the circumstances that may excuse it "are determined by the law of the state of incorporation, " which in this case is Maryland. Kamen, 500 U.S. at 99. Under Maryland law, futility of a demand is
a very limited exception, to be applied only when the allegations or evidence clearly demonstrate, in a very particular manner, either that (1) a demand, or a delay in awaiting a response to a demand, would cause irreparable harm to the corporation, or (2) a majority of the directors are so personally and directly conflicted or committed to the decision in dispute that they cannot reasonably ...