“Derivative suit” is the term for legal action filed by the shareholder of a company to address any harms or wrongs done to the company. A derivative lawsuit is generally filed on behalf of the company against executives or board members.
Typically, directors of a company are responsible for pursuing legal action when the company has come to harm. However, if the board of a company failed to address the wrongful action, you, as a shareholder, could step in and file a derivative lawsuit. It is important to note that only shareholders of a company can file derivative lawsuits.
If you are an investor and find that there is willful mismanagement, insider dealing, or other wrongful acts impacting the company, you could take action. Our experienced business litigation attorneys can help. Contact us now, and we will evaluate your case for free.
Why File a Derivative Suit?
The board of directors, elected by shareholders, typically runs a corporation and appoints officers managing the operation of the company. Shareholders tend to have little or no say in the day-to-day operation of a company. However, if the board of directors fails to address wrongs or harms done to the company, investors can challenge the board or address the wrongful action by filing a derivative lawsuit. Derivative lawsuits, therefore, provide an important mechanism that can protect investors and the corporation.
One of the main reasons for shareholders to file a derivative lawsuit can be serious misconduct by a director or officers of the company. The need for legal action arises when directors are hesitant or unwilling to act against the responsible individuals. Notable examples of recent derivative litigation are the so-called “#metoo” lawsuits. While legal action alleging workplace harassment or misconduct is nothing new, the #metoo movement extended a company’s liability beyond the concepts of workplace discrimination. According to the American Bar Association (ABA), derivative lawsuits concerned with the #metoo movement generally alleged that the director defendants knew or willfully ignored the alleged sexual misconduct occurring at the corporation.
Types of Derivative Lawsuits
There can be numerous reasons for filing derivative suits. However, litigation often evolves around wrongful action by directors or officers of the company, such as:
- Breach of contract by a director or officer
- Breach of fiduciary duty by a director or officer
- Conflicts of interest
- Insider dealing
- Misleading or false financial statements
- Wrongdoing by financial advisors or accountants
- Disproportionate executive remuneration or bonuses
- Board decisions violating laws and regulations
Officers and Directors Are Responsible for Their Actions
Examples of reasons why officers and directors could become defendants in a derivative lawsuit can include but are not limited to:
Failing to Exercise Duty of Care
Directors and officers of a corporation must manage a company prudently. If a director or officer made a business decision without exercising due care or acted in bad faith, they may have breached the duty of care and could be responsible for damages to the company.
Breaching Duty of Loyalty
Duty of loyalty describes the responsibility of directors and officers to make all decisions without putting their own financial interests above those of the company and shareholders. Examples for breaching the duty of loyalty can involve:
- Insider dealing or self-dealing
- Misusing corporate funds or assets
- Misusing corporate privileges
Irregular Mergers and Acquisitions
Derivative suits frequently deal with improper mergers and acquisitions. If a merger that was approved by the board of directors diminishes the value of the company, shareholders could have legal recourse. A breach of fiduciary duty may have occurred in any merger or acquisition where directors failed to maximize shareholder value.
Accounting Mismanagement and Malpractice
Executives must not inflate or manipulate the earnings and profits of a company. Shareholders can potentially file a derivative lawsuit to:
- Remove the directors who knew of or collaborated with fraudulent activities
- Enforce stricter governance measures preventing malpractice in the future
When directors or officers allow aggressive or fraudulent accounting practices, our derivative lawsuit attorneys can assist shareholders with removing the complicit individuals and implementing stricter governance standards.
Egregious Conduct Involving Employees or Consumers
Derivative lawsuits based on egregious conduct towards employees or consumers often make headlines, such as the #metoo movement lawsuits or extensive data breaches such as the one involving Equifax in 2017. Derivative suits can also involve the following:
- Violations of environmental laws and regulations
- Violations of wage and hour laws
- Violations of workplace safety regulations
- Violations of consumer safety laws
The Benefits of Derivative Lawsuits
Shareholder derivative suits are an essential tool for those who hold considerable shares and investments in a company. Suits can identify fraud and wrongdoing in corporations and protect shareholders, employees, and even the public from getting harmed due to unscrupulous corporate practices.
Generally, any damages recovered in a derivative lawsuit flow back into the corporation and not to those who have filed the suit, therefore benefitting all investors. Other benefits can include:
- The removal of the individuals harming the company
- Compensation to the company or investors
- Changes in corporate governance
- Protection of shareholder value
- Incentive awards for plaintiffs bringing the suit
The derivative lawsuit attorneys at Morgan & Morgan have extensive experience with representing shareholders in legal disputes. We could help you remove corrupt or unethical board members and protect shareholder value.
Derivative Lawsuits Can Be Complex
Although shareholders are generally entitled to file derivative suits, the legal process in most states involves another step before they can prosecute. According to state and federal laws, claimants cannot simply file a suit in court and must first make a “pre-suit demand” on the board of directors. The demand outlines the complaint and explains the wrongdoing or harm to the company, such as a breach of duty by members of the board of directors or management.
After the demand has been issued, the board has some time to determine their next best steps and may consult legal counsel for assistance. The executive board members then make a decision whether to file a lawsuit against those who have breached their fiduciary duty or harmed the company. According to the Legal Information Institute (LII), shareholders can generally only commence with filing a derivative suit when the board refuses to take appropriate action.
Proving Standing to Bring the Lawsuit
Most jurisdictions insist on a shareholder proving their standing for bringing derivative legal action. Proving standing can entail meeting certain requirements, such as:
- Maintaining a minimum value of shares in the company
- Having acquired stock in the corporation before the wrongful conduct happened
- Holding shares for the duration of the suit
If a plaintiff in a derivative suit sells their shares during the pending lawsuit, they generally lose interest in the litigation in addition to their shareholder rights. Therefore, if the lead plaintiff sells their shares before the lawsuit has concluded, a court will most likely ask for the appointment of another lead plaintiff.
The specific laws governing derivative lawsuits can diverge considerably between states and tend to involve complicated legal issues. For example, while a pre-suit demand is essential in some states, in others, such a demand could cause a lawsuit to fail. Therefore, working with an experienced and determined attorney can be crucial for shareholders hoping to bring a successful derivative suit. An attorney from our firm can advise you comprehensively and inform you of your options.