Shareholder Derivative Suits

When an investor buys the stock of a corporation, he or she becomes an owner of the company. Although the board of directors and appointed executive officers run the day-to-day operations of the company, they ultimately serve at the pleasure of the shareholders. Although management is the job of the directors, shareholders are permitted under certain circumstances to file a lawsuit on behalf of the corporation. These are called shareholder derivative suits or shareholder derivative actions.

What Is a Shareholder Derivative Action?

One of the duties of a company’s directors is to pursue litigation against those who have harmed the company. However, if the directors choose not to pursue valid claims against the appropriate parties, it is possible for a shareholder to do so. The suit is filed by the shareholder on behalf of the corporation against the party alleged to have harmed the company.

Why Are Derivative Suits Filed?

Since shareholders are generally allowed to file a lawsuit in the event that a corporation has refused to file one on its own behalf, many derivative suits are brought against a particular officer or director of the corporation for breach of contract or breach of fiduciary duty. Other derivative actions are filed against accountants and other advisers who have somehow harmed the corporation, although there is generally no limitation on the type of claim made by a derivative suit.

What Are the Requirements of a Derivative Lawsuit?

A shareholder derivative action is filed pursuant to state law. If the suit is filed in state court, the substantive law and procedural rules of that state usually apply. Filing in federal court means that state substantive law and the Federal Rules of Civil Procedure—including Fed. R. Civ. P. 23.1, which specifically addresses derivative actions—are likely in force.

California, Delaware, and New York are a few states in which these suits are commonly filed, due to the fact that they serve as the home states for many corporations. Although the specific requirements for a shareholder derivative action vary, there are a few commonalities among many state laws.

Only shareholders of a corporation can bring a derivative suit. Some states allow a person to bring a derivative suit as long as he or she held the company’s stock at the time of the incident that gave rise to the suit. Others require that the shareholder owns stock in the company at the time of the inciting action and continuously throughout the resolution of the lawsuit. This is referred to as the “continuous ownership requirement.” If the shareholder’s interest in the company was lost, or devolved, because of the inciting action, many states allow the suit to be filed.

State laws and federal procedures almost universally require that the shareholder show that he or she attempted to bring the problem to the attention of company’s directors, but they chose not to pursue the action. Often, procedural rules require that the initial pleading state with particularity the efforts made in this regard. In some cases when the action alleges misconduct on the part of board members, this requirement may be relaxed, since it is not expected that people would voluntarily sue themselves.

In federal court, once a derivative action has been filed, it may only be voluntarily dismissed or settled with approval of the court, which must inform the shareholders of such a proposed action ahead of time.

In nearly all jurisdictions, any damages or other proceeds collected as a result of a successful shareholder derivative lawsuit are retained by the corporation, rather than the shareholder who initiated the suit.