Shareholder derivative suits are a crucial mechanism in corporate law, allowing shareholders to take legal action on behalf of a company when those in control—such as officers, directors, or controlling shareholders—fail to act in the company’s best interest. These lawsuits are particularly important in protecting the integrity of corporate governance and ensuring that the company’s management is held accountable for any wrongdoing or negligence that harms the corporation. A shareholder derivative suit is a legal action brought by shareholders on behalf of a corporation to address harm caused by its directors, officers, or controlling shareholders when the company’s leadership fails to act.
In a derivative action, the suit is filed not in the name of the individual shareholder but on behalf of the corporation itself. The damages or remedies obtained from a successful derivative suit are awarded to the company rather than to the individual shareholders who initiated the lawsuit. This distinction is fundamental because it highlights the representative nature of derivative actions, where shareholders step in to protect the interests of the corporation when the company’s leadership fails to do so. A knowledgeable commercial litigation attorney is essential in navigating the complexities of derivative suits, ensuring that shareholders’ actions are properly executed to protect the corporation’s interests.
The Purpose and Function of Derivative Actions
The purpose of derivative suits, as outlined in Illinois law and exemplified by the Illinois Supreme Court in Brown v. Tenney (1988), is to provide shareholders with a means to hold corporate officers and directors accountable for misconduct or negligence that harms the company. This legal mechanism ensures that shareholders have a way to address abuses of power within the corporation, particularly in situations where those who are supposed to act in the best interest of the company fail to do so.
In Brown v. Tenney, the court described the derivative suit as a tool to protect shareholders against corporate abuses, ensuring corporate accountability. The case emphasizes that derivative actions involve two causes of action: one against the directors for failing to sue on behalf of the company, and the second based on the right belonging to the corporation itself. Typically, these actions are brought by minority shareholders because majority or controlling shareholders are often in a position to influence the company to file a suit on its own behalf.
Procedural Requirements for Filing a Derivative Suit
Before shareholders can file a derivative lawsuit, they must meet several procedural requirements. One of the most critical prerequisites is making a demand on the board of directors to file the lawsuit. This demand is necessary because the decision to initiate legal action on behalf of the company typically lies with the board. However, if the shareholders can demonstrate that such a demand would be futile—such as in cases where the directors themselves are the alleged wrongdoers—this requirement may be waived.
Another important procedural aspect is that the shareholder must have owned shares at the time of the alleged wrongdoing. This “contemporaneous ownership” rule ensures that only those who were shareholders during the time of the alleged injury to the company can bring a derivative suit. However, Illinois law provides exceptions to this requirement under certain circumstances.
Direct Actions vs. Derivative Suits: Key Distinctions
In corporate law, it is essential to distinguish between direct actions and derivative suits. A shareholder may suffer an injury either directly, which affects them individually, or indirectly, which affects the corporation and, consequently, the shareholder’s investment in the company. Understanding this distinction is crucial because it determines the type of legal action a shareholder can pursue.
Direct actions are brought by shareholders who have suffered a unique injury, distinct from that suffered by other shareholders. For example, in cases of a “freeze-out” or “squeeze-out,” where controlling shareholders or directors take actions that directly harm a minority shareholder’s interests, the affected shareholder may file a direct lawsuit.
On the other hand, derivative suits are appropriate when the injury is to the corporation, and the shareholders suffer indirectly as a result. For instance, if corporate officers or directors breach their fiduciary duties, leading to a loss in the value of the company’s assets, the shareholders’ recourse is through a derivative suit because the harm is to the corporation as a whole, not just to individual shareholders.
Illinois courts have provided guidance on how to determine whether a claim is direct or derivative. A useful approach is to consider what must be proven to succeed on the claims asserted. If the shareholder can only succeed by showing an injury to the corporation or a breach of duty to the corporation, the action is derivative. Conversely, if the shareholder can succeed without demonstrating an injury or breach to the corporation, the action may be direct.
Grounds for Derivative Suits: Common Causes and Examples
Derivative suits can arise from a variety of situations where corporate officers or directors fail in their duties. Some common grounds for derivative actions include:
Failing to Exercise Duty of Care
Corporate directors and officers are expected to manage the company prudently and with due diligence. When they fail to exercise this duty of care, resulting in harm to the company, they can be held liable through a derivative suit. For instance, if a director makes a business decision without proper investigation or acts in bad faith, they may have breached their duty of care, making them liable for any resulting damages.
Breaching the Duty of Loyalty
The duty of loyalty requires that corporate directors and officers prioritize the interests of the company and its shareholders over their personal financial interests. Breaches of this duty can include insider trading, self-dealing, or the misuse of corporate funds and assets. When such breaches occur, shareholders may file a derivative lawsuit to hold the wrongdoers accountable and to recover losses for the company.
Irregular Mergers and Acquisitions
Derivative suits frequently involve challenges to mergers and acquisitions that are detrimental to the company’s value. If the board of directors approves a merger that diminishes the value of the corporation, shareholders may have grounds to file a derivative suit. Such actions often allege that the directors failed to maximize shareholder value or engaged in self-serving conduct that harmed the company.
Accounting Mismanagement and Malpractice
Shareholders may also bring derivative suits in cases of accounting mismanagement or fraudulent financial practices. Corporate executives who inflate or manipulate earnings, thereby misleading shareholders and the public, can be removed from their positions through a derivative action. These lawsuits also often seek to implement stricter governance measures to prevent future malpractice.
Egregious Conduct Involving Employees or Consumers
Derivative lawsuits can also be based on egregious conduct towards employees or consumers, which can have significant legal and financial consequences for the company. Examples include violations of environmental laws, wage and hour laws, workplace safety regulations, or consumer safety standards. High-profile cases, such as those involving the #MeToo movement or large-scale data breaches like the Equifax incident in 2017, illustrate how derivative suits can be used to address serious corporate misconduct.
Attorney’s Fees in Derivative Actions
An important aspect of derivative suits is the potential for the awarding of attorney’s fees. Illinois courts have generally recognized that successful shareholders in derivative actions are entitled to recover attorney’s fees, even in cases involving only two shareholders. This is based on the “common fund” doctrine, which allows for the distribution of litigation costs among those who benefit from the legal action.
Typically, attorney’s fees are paid from the common fund created by the successful litigation. However, in certain cases, the court may order the defendant to pay these fees personally, especially if the defendant’s conduct was particularly egregious.
Conclusion: The Significance of Derivative Suits in Corporate Governance
Shareholder derivative suits play a vital role in maintaining corporate accountability and protecting shareholder interests. By allowing shareholders to step in when corporate officers and directors fail to act in the company’s best interest, derivative actions serve as an essential check on corporate power. These lawsuits not only provide a remedy for corporate misconduct but also reinforce the principles of fiduciary duty and responsible corporate governance.
As the landscape of corporate law continues to evolve, derivative suits remain a critical tool for shareholders seeking to ensure that corporations operate transparently, ethically, and in the best interest of all stakeholders. Whether addressing breaches of duty, mismanagement, or other forms of corporate wrongdoing, derivative actions empower shareholders to uphold the integrity of the corporations in which they invest.
