What is a Shareholder Derivative Action?

A derivative action is a lawsuit against officers or directors brought by shareholders on behalf of the corporation. That is, the shareholders act as representative plaintiff for the corporation and sue the officers or directors for their actions resulting in harm to the corporation. While the objective of such a lawsuit is to halt certain actions by the defendants, any damages recovered in the action belong to the corporation (not the representative plaintiffs). The shareholders benefit indirectly as owners of the corporation.

What is the process for shareholders bringing a derivative action?

Shareholder begin the derivative action process by making a request to the board of directors to bring a legal action against the alleged wrongdoer. This is called making demand on the board. The board will then take one of the following actions:

File Suit – The board may grant the request of the shareholders and file a legal action against the officer or director allegedly causing harm to the corporation.

• Note: If the board brings a legal action, the individual shareholder cannot bring a direct action.

Reject the Shareholder Demand – The board may determine that bringing a legal action is not in the best interest of the corporation. The board impliedly rejects the demand or fails to respond to the demand within the statutory period (or a reasonable time). The decision of whether or not to bring a legal action is subject to the business judgment rule. As such, a boards decision of whether or not to sue is generally binding, unless the shareholders can demonstrate that the board is biased (not disinterested), not acting in good faith, acting recklessly, or acting to intentionally harm the corporation.

Appoint a Special Litigation Committee (SLC) – In some situations, the board will designate a special committee of disinterested directors to make the determination of whether to bring a legal action. Generally, this shields the board from allegations of bias, bad faith, or failing to meet the standards of the business judgment rule. It is difficult for shareholders to overcome a SLCs decision and this may foreclose the ability to bring a derivative action. In certain circumstances, shareholders may file suit without making demand to the board. If they can show that the directors have a conflict of interest, lack the independence to act in the best interest of the corporation, or have otherwise violated the business judgment rule, the court will allow shareholders to bring the derivative lawsuit without the board of directors approval. In other words, the court will rule that demand is futile.

• Note: As a practical matter, once a court rules that demand is futile, the shareholders have an advantage in the lawsuit, and the case almost always settles. On the other hand, if the court requires the shareholders make demand to the board, they are not likely to prevail and typically withdraw the case.