Derivative Action Explained

Derivative Action Explained

Investors increasingly rely on derivative actions to hold corporate executives accountable for misconduct. Because these complex lawsuits can put a tremendous strain on a corporation and its management team, it is imperative to have an experienced legal team on your side.

What Is a Derivative Action?

In a shareholder derivative suit, shareholders file suit against company officers and directors on behalf of the company itself. Unlike a direct lawsuit, the claims do not belong to the investors, but to the corporation. Accordingly, a shareholder can only pursue a derivative action when the corporation has a valid cause of action but has refused to bring it. If successful, any damages are awarded to the corporation rather than the shareholder.

Derivative actions are an important legal tool to hold corporate leaders responsible for potential wrongdoing. However, they put courts in the difficult position of second-guessing a company’s board of directors and can be prone to abuse.

As explained by the New York Court of Appeals in Bansbach v. Zinn, 1 N.Y.3d 1, 8 (2003), “On the one hand, derivative actions are not favored in the law because they ask courts to second-guess the business judgment of the individuals charged with managing the company. On the other hand, derivative actions serve the important purpose of protecting corporations and minority shareholders against officers and directors who, in discharging their official responsibilities, place other interests ahead of those of the corporation.”

Who Can Bring a Derivative Action?

A derivative action may be brought by a single shareholder or a group of shareholders. New York, as well as most other jurisdictions, requires that a derivative plaintiff be a shareholder of the company at the time of bringing the action, as well as at the time of the alleged misconduct. The rationale is that if the plaintiff is not a shareholder of the company, then he/she has no right to vindicate the company’s rights and obtain a judgment on its behalf.

Plaintiffs must also fairly and adequately represent the interests of the shareholders or members similarly situated in enforcing the right of the corporation. For instance, courts have found that a plaintiff may be disqualified if a conflict of interest is shown.

What Are the Requirements for Bringing a New York Shareholder Derivative Suit?

Shareholder derivative suits in New York are typically brought under the state’s Business Corporation Law. Pursuant to BCL § 626(c), the derivative complaint “shall set forth with particularity the efforts of the plaintiff to secure the initiation of such action by the board or the reasons for not making such effort.” This means that before bringing a shareholder derivative action, the plaintiff must make a demand upon the corporation’s board of directors to take action with respect to the wrongs alleged.

As explained by the New York Court of Appeals in Marx v. Akers, (N.Y. 1996), “The demand requirement thus relieves courts of unduly intruding into matters of corporate governance by first allowing the directors themselves to address the alleged abuses. The requirement also provides boards with reasonable protection from harassment on matters clearly within their discretion, and it discourages ‘strike suits’ commenced by shareholders for personal rather than corporate benefit.”

The demand requirement may be excused when the directors are incapable of making an impartial decision as to whether to bring suit. For instance, under New York law, the demand requirement is excused where a plaintiff pleads with particularity that (1) a majority of the directors are interested in the transaction, or (2) the directors failed to inform themselves to a degree reasonably necessary about the transaction, or (3) the directors failed to exercise their business judgment in approving the transaction.

The specific allegations of a derivative action vary. Many suits allege a breach of fiduciary duty by the board of directors or corporate executives. Other common claims include self-dealing, misappropriation, conversion, and unjust enrichment.

What Is the Business Judgment Rule?

The business judgment rule often arises in defense of direct and derivative shareholder lawsuits alleging that officers or directors violated their fiduciary duty to the corporation and caused the corporation to suffer financial losses. Under the business judgment rule, when business decisions are made in good faith based on reasonable business knowledge, decision-makers are immune from liability. The rationale behind the rule is to provide a company’s management with the leeway required to run the business, so long as they act in good faith. 

Under New York law, the business judgment rule prohibits judicial inquiry into the actions of corporate directors taken in good faith and the exercise of honest judgment in the lawful and legitimate furtherance of corporate purposes. Accordingly, stockholder-approved or ratified corporate actions are to be presumed correct. That means that questions related to management policy, contract execution, bylaw amendments, adequacy of consideration not grossly disproportionate, and lawful appropriation of corporate funds to advance corporate interests are generally left to the discretion of directors and officers so long as they are working within their delegated authority. 

Notably, the business judgment rule does not apply to directors who engage in fraud or self-dealing or when they make decisions affected by an inherent conflict of interest. In such cases, the burden shifts to the defendant to prove the fairness of the transaction. By way of example, if members of the board award themselves favorable contracts or approve excessive compensation packages for themselves, a court will likely find that this constitutes “self-dealing.” The burden of proof then shifts to the board to demonstrate that their decision-making was fair to the corporation and its shareholders.

Why Is It Important to Consult With an Experienced Corporate Governance Attorney?

Successfully defending a shareholder derivative suit requires a sophisticated legal team comprised of attorneys with a deep understanding of corporate law and proven litigation skills. Even meritless derivative actions can be extremely complex and, in some cases, the corporation and its executives may also be able to file a countersuit.

At Scarinci Hollenbeck, the attorneys of our Corporate Governance and Regulatory Compliance Practice have the resources and experience required to navigate shareholder derivative suits. If you or your company are facing a shareholder suit, we encourage you to contact us for a free consultation.