Barenbaum v. FTE Networks, Inc

Background

Efraim Barenbaum, IRA, brought a shareholder derivative action on behalf of nominal defendant FTE Networks, Inc. A derivative action is a lawsuit brought by a shareholder for alleged harm to the corporation. Barenbaum alleged that, from December 2016 through January 2019, individuals acting for FTE issued 71 short-term convertible notes totaling approximately $22.7 million without proper board authorization, using forged signatures, and without notifying shareholders. He also alleged that former executives used FTE funds for personal expenses and that Michael Palleschi increased his salary by more than $1 million without consulting the board.

FTE’s audit committee allegedly found that some equity issuances lacked board authorization or relied on falsified authorizations. The company also disclosed that its financial statements for 2016, 2017, and 2018 should not be relied upon, faced an investigation by the Securities and Exchange Commission, and was eventually delisted from the New York Stock Exchange. The board did not bring litigation against Palleschi, David Lethem, or other current or former executives or directors, although FTE filed a counterclaim in an arbitration brought by Palleschi.

Barenbaum’s amended complaint asserted three causes of action: breach of fiduciary duty under Nevada law, unjust enrichment under Nevada law, and a claim under Section 14(a) of the Securities Exchange Act based on allegedly misleading proxy materials. The defendants filed several motions to dismiss. Their principal arguments were that Barenbaum had not pleaded demand futility and that the amended complaint failed to state legally sufficient claims. Lethem appeared without a lawyer and filed an answer rather than moving to dismiss.

Judicial Notice

Barenbaum asked the court to take judicial notice of FTE’s revised 2018 annual report filed with the Securities and Exchange Commission and FTE’s answer and counterclaims in another lawsuit. The court granted the motion only to the extent that it would acknowledge that the documents had been filed and contained the statements described. The court did not treat those statements as proof that the alleged misconduct occurred or that the defendants violated their duties.

Demand Futility and Derivative Standing

Because Barenbaum did not make a pre-suit demand on FTE’s board, he had to plead with particularity why making a demand would have been futile. The court treated demand futility as a requirement for standing to bring the derivative action. Federal Rule of Civil Procedure 23.1 supplied the pleading standard, while Nevada law supplied the substantive demand-futility rules because FTE was incorporated in Nevada.

The court explained that Nevada follows Delaware’s demand-futility framework. The plaintiff generally must plead specific facts showing that at least half of the relevant board could not impartially consider a demand. The relevant board ordinarily is the board in place when the operative amended complaint was filed. A plaintiff may instead rely on the board in place when the original complaint was filed if the claims were already “validly in litigation”—meaning the original complaint was properly pleaded, satisfied the demand requirement or its excuse, and challenged essentially the same conduct.

The court held that Barenbaum’s original complaint was not validly in litigation because it did not adequately plead demand futility. The original complaint alleged possible interestedness by Sacramone and Shiah, but the court found that it did not allege specific facts showing that Shiah was interested. Allegations that Shiah participated in challenged board actions, or was negligent, were insufficient. The original complaint also alleged no interestedness by Kingsley, Berini, or Omanoff. Therefore, it did not show that the required portion of the board could not impartially consider a demand.

Because the original complaint was defective, the court evaluated demand futility based on the board in place when Barenbaum filed the amended complaint. The amended complaint did not identify that board or plead particularized facts showing that its members could not consider a demand. The court therefore held that Barenbaum failed to plead demand futility and lacked standing to sue derivatively. The motions to dismiss on that ground were granted.

Failure to State a Claim

The court also granted the motions to dismiss on the alternative ground that the amended complaint failed to state claims against all defendants other than Palleschi and Lethem.

For breach of fiduciary duty, Nevada law required allegations of a fiduciary relationship, a breach, and damages caused by the breach. In the corporate setting, the complaint also had to allege intentional misconduct, fraud, or a knowing violation of law. The court found that the amended complaint improperly grouped defendants together and did not allege facts showing that the relevant directors or executives knowingly or intentionally breached their duties. Allegations that directors negligently failed to monitor internal controls were not enough.

The unjust-enrichment claim failed because it depended on the inadequate fiduciary-duty allegations. The court also noted that Nevada law does not generally permit an unjust-enrichment claim when the compensation at issue comes from an express contract. In addition, Barenbaum alleged no facts beyond conclusory assertions showing that the compensation was unfair or resulted from intentional misconduct, fraud, or a knowing violation of law.

The Section 14(a) claim alleged that FTE’s 2018 proxy statement contained misleading information about related-party transactions and the company’s accounting. The court assumed that the alleged accounting misstatements could be material but held that Barenbaum did not adequately plead causation. He did not explain how the proxy solicitation itself, rather than the underlying fraud or accounting problems, caused FTE’s injury. He also did not allege that electing a different board would have prevented the alleged harm. The Section 14(a) claim was therefore dismissed for failure to state a claim.

Disposition

Judge Vyskocil held that dismissal with prejudice was appropriate because Barenbaum had already amended his complaint after receiving notice of the same deficiencies, and the earlier judge had warned that another opportunity to amend ordinarily would not be granted. The court dismissed the amended complaint with prejudice as to all defendants. Although Lethem had not moved to dismiss, the court held that the standing defect applied to the entire derivative action and dismissed the claims against him as well.

The court granted the motions to dismiss at docket entries 59, 63, and 66 with prejudice, granted the motion for judicial notice at docket entry 99 to the limited extent described above, and directed the clerk to close the case.