Derivative action

What Is Derivative Action?

A derivative action is a lawsuit brought by a shareholder on behalf of a corporation against a third party, typically the company's own board of directors, officers, or other insiders, for alleged wrongdoing that has harmed the corporation itself. This legal mechanism falls under the umbrella of corporate law and serves as an important tool for enforcing fiduciary duty and promoting sound corporate governance. Unlike a direct lawsuit where shareholders sue for harm to their own interests, a derivative action seeks to recover damages for the benefit of the company as a whole.

History and Origin

The concept of the derivative action has deep roots in common law, evolving significantly over centuries to address the challenge of holding corporate fiduciaries accountable. While some scholars and judges suggest the United States imported the shareholder derivative action directly from England, its development in the U.S. involved a distinct evolution from the English Court of Chancery's "necessary parties rule" in the 1800s. Early American courts recognized exceptions allowing representative lawsuits, which would later be categorized as both class action and derivative actions. For approximately the first 150 years in the United States, shareholders could bring lawsuits on behalf of themselves and other shareholders under certain circumstances. It was not until the late 1940s that courts consistently began to describe these lawsuits as being brought on behalf of the corporation.²²,²¹ This shift underscored the unique nature of derivative actions as a means to redress injuries to the corporate entity itself, rather than solely to individual shareholders. The mechanism emerged as a critical check on the power of directors and officers, recognizing that they might not hold themselves accountable for their own misconduct.²⁰

Key Takeaways

• A derivative action is a lawsuit filed by a shareholder on behalf of the corporation, not for the shareholder's direct benefit.
• The primary goal is to address harm caused to the company by its own directors, officers, or other fiduciaries.
• Any recovery obtained from a successful derivative action typically goes to the corporation.
• Shareholders must usually first demand that the company's board of directors take action, unless such a demand would be futile.
• Derivative actions are a vital aspect of corporate governance, providing a mechanism for accountability when management fails to act in the company's best interest.

Interpreting the Derivative Action

A derivative action is interpreted as a means for an equity holder to compel a company to pursue a legal claim it otherwise would not, often due to the alleged wrongdoers being those in control of the company. It essentially allows a shareholder to "step into the shoes" of the corporation. The success of a derivative action hinges on demonstrating that the company has suffered a quantifiable injury as a direct result of the defendants' actions, such as a breach of fiduciary duty. Courts often scrutinize such cases to ensure they genuinely benefit the corporation and are not merely vexatious litigation or an attempt by an individual shareholder to gain personal advantage. The legal standards, particularly regarding the "demand requirement," aim to balance the need for corporate accountability with deference to the board of directors' management prerogatives.¹⁹,¹⁸

Hypothetical Example

Imagine "Tech Innovations Inc." (TII), a publicly traded corporation, whose CEO and CFO are discovered to have engaged in a series of highly speculative and unauthorized investments using company funds, resulting in a $50 million loss for TII. A concerned shareholder, Sarah, learns of this through a leaked internal report.

Sarah first sends a formal demand to TII's board of directors, urging them to sue the CEO and CFO to recover the lost funds. However, a majority of the board members are close associates of the CEO and vote against pursuing legal action, citing potential "reputational damage" and claiming the investments were "good faith business decisions," despite clear evidence to the contrary.

Frustrated by the board's inaction, Sarah decides to initiate a derivative action. She files a lawsuit naming TII as the nominal plaintiff and the CEO and CFO as defendants. In her complaint, Sarah alleges that the CEO and CFO breached their fiduciary duty to TII by misusing company assets and that the board's refusal to act demonstrates its inability to protect the company's interests. If successful, any damages awarded by the court would be paid directly to Tech Innovations Inc., not to Sarah, thus replenishing the company's depleted funds.

Practical Applications

Derivative actions are prevalent in situations where corporate insiders, such as the board of directors or executive officers, are accused of wrongdoing that harms the corporation itself. These lawsuits commonly arise in areas such as:

• Breach of Fiduciary Duty: Allegations that directors or officers have violated their duties of loyalty or care, leading to financial losses for the company. This can include instances of self-dealing, excessive compensation, or negligence.¹⁷
• Corporate Mismanagement: When management decisions are so egregious they are considered a breach of duty rather than simply poor business judgment rule.
• Securities Violations: Derivative actions often follow major events leading to stock price declines, such as alleged misrepresentations in offering documents or securities fraud, where the company itself is harmed by the actions of its fiduciaries.¹⁶
• Accounting Fraud: Cases where executives manipulate financial statements, causing the company significant harm and potential liability.
• Failure of Oversight: Claims that directors failed to implement or oversee adequate internal controls, leading to company losses or regulatory penalties.

These actions serve as a critical mechanism for accountability within the corporate structure, particularly when the company's direct leadership is unwilling or unable to pursue claims against its own members.¹⁵

Limitations and Criticisms

Despite their importance, derivative actions face several limitations and criticisms. A significant challenge lies in balancing the goal of incentivizing shareholders to pursue actions that enhance corporate governance with preventing their abuse.¹⁴ Courts often exercise caution, particularly where the directors' decisions fall within a spectrum of reasonable alternatives, invoking the business judgment rule to protect management decisions from unwarranted judicial second-guessing.¹³

One common criticism is the high cost and complexity involved. The process can be lengthy, expensive, and often results in little direct economic benefit for the plaintiff shareholder. Furthermore, there's concern about "strike suits," where lawsuits are filed primarily to extract a quick settlement rather than genuinely pursue corporate benefit. Some derivative actions are criticized for being frivolous or for interfering with the legitimate operation of the corporation.¹² Additionally, issues arise in complex international scenarios, where different jurisdictions apply varying standards regarding standing and the "internal affairs doctrine," which dictates that the law of the company's place of incorporation generally governs disputes concerning shareholder and manager rights. For instance, New York's highest court has affirmed dismissals of derivative suits against non-U.S. companies based on their home countries' laws, emphasizing comity and predictability in cross-border litigation.¹¹

Derivative Action vs. Class Action

The terms derivative action and class action are often confused due to their similar nature as representative lawsuits, but they differ fundamentally in who is harmed and who benefits from the outcome.

In essence, a derivative action seeks to enforce a right belonging to the corporation that its management has failed to pursue. A class action, conversely, seeks to remedy a harm directly inflicted upon a group of individuals who share a common injury. While both involve representative litigation and may involve shareholders, the critical distinction lies in the identity of the aggrieved party and the recipient of any awarded compensation. Often, a securities class action against a corporation and its officers will be followed by a derivative action on the same underlying facts, though the derivative action will typically focus on breaches of fiduciary duty to the company.¹⁰,⁹

FAQs

Who can bring a derivative action?

A shareholder of the corporation can bring a derivative action. Typically, the shareholder must have held shares at the time of the alleged wrongdoing and must continue to hold them throughout the litigation.⁸,⁷

What is the "demand requirement" in a derivative action?

Before filing a derivative action, the shareholder is usually required to make a formal demand to the company's board of directors, asking them to take the desired action (e.g., sue the alleged wrongdoers). If the board refuses or fails to act, or if the shareholder can show that such a demand would be "futile" (e.g., because the board members are implicated in the wrongdoing), then the shareholder may proceed with the lawsuit.⁶,⁵

What happens if a derivative action is successful?

If a derivative action is successful, any monetary recovery, such as damages or a settlement payment, is generally awarded to the corporation itself, not directly to the individual shareholder who brought the suit. The shareholder may, however, be reimbursed for legal expenses if the lawsuit provided a substantial benefit to the company.⁴

Can a derivative action be settled?

Yes, derivative actions can be settled, often after extensive negotiations. Court approval is typically required for any settlement to ensure that it is fair and reasonable and serves the best interests of the corporation and its shareholders, not just the individual plaintiff and their attorneys.³

Are derivative actions common?

While the legal framework for derivative actions exists in many jurisdictions and they are an important part of corporate law, their actual occurrence can fluctuate. They are often complex and costly, and in some jurisdictions, they remain relatively rare compared to other forms of litigation.²,¹