Derivative Action Explained

A shareholder derivative action is a lawsuit brought by one or more shareholders on behalf of the corporation, usually against its officers or directors, when the company has a valid claim but refuses to pursue it. Any recovery goes to the corporation, not the shareholder who filed suit.

Key takeaways

• The claim belongs to the corporation, so the shareholder is suing to enforce the company’s rights, not their own.
• In New York, the plaintiff generally must first demand that the board act, or explain with particularity why demand would be futile.
• The business judgment rule protects directors’ good-faith decisions, but not fraud, self-dealing, or conflicted transactions.
• Whether you are the shareholder considering suit or the company defending one, the first question is what is at stake for the business beyond the legal claim.

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 experienced litigation counsel on your side.

What is a shareholder derivative action?

In a shareholder derivative suit, shareholders sue 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 pursue a derivative action only when the corporation has a valid cause of action but refuses to bring it. If successful, the court awards any damages 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 abused.

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, the plaintiff 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 similarly situated shareholders or members in enforcing the corporation’s rights. For instance, courts have found that a plaintiff may be disqualified if a conflict of interest is shown.

What are the requirements for a New York shareholder derivative action?

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 directors are incapable of making an impartial decision about 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 financial losses. Under the business judgment rule, when decision-makers make business decisions in good faith and based on reasonable business knowledge, they are immune from liability. The rationale behind the rule is to give a company’s management the leeway needed to run the business, so long as they act in good faith.

Under New York law, the business judgment rule prohibits judicial inquiry into actions taken by corporate directors in good faith and in the exercise of honest judgment in the lawful and legitimate furtherance of corporate purposes. Accordingly, courts presume stockholder-approved or ratified corporate actions are correct. This means questions about 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 act 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 transaction was fair. For example, if board members award themselves favorable contracts or approve excessive compensation packages, 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.

What should you consider before a derivative suit is filed?

A shareholder derivative action is rarely just a legal question. For the shareholder, it may be the only way to stop conduct that is draining the company, but it also means suing the people who run the business you own a piece of. For the company and its directors, even a meritless suit consumes management time, strains board relationships, and can unsettle lenders, customers, and employees.

Before either side commits to litigation, it is worth identifying what actually needs protecting: the value of the company, a specific asset or contract, the board’s ability to function, or a relationship among owners that will have to survive the dispute. That answer often shapes whether the right path is a pre-suit demand, a negotiated governance change, or a filed complaint.

Frequently asked questions

What is the difference between a direct and a derivative shareholder claim?

A direct claim seeks to remedy harm to the shareholder personally, such as being denied the right to vote or inspect records. A derivative claim seeks to remedy harm to the corporation, and any recovery goes to the company.

Do I have to ask the board to act before I can sue?

In New York, generally yes. The complaint must describe with particularity the demand made on the board or explain why demand would have been futile, for example, because a majority of the directors were interested in the transaction.

Can directors be held liable for a business decision that turned out badly?

Usually not. The business judgment rule protects decisions made in good faith, on an informed basis, and without a conflict of interest. It does not protect fraud, self-dealing, or decisions the directors never actually deliberated.

Who pays the legal fees in a derivative action?

It depends on the outcome and the governing documents. A successful plaintiff may be awarded fees from the corporation because the suit benefited the company, and directors are often entitled to indemnification or advancement under the bylaws or an indemnification agreement. Counsel can evaluate the applicable provisions.

How Scarinci Hollenbeck can help

Successfully prosecuting or defending a shareholder derivative suit requires 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.

Michael B. Mietlicki, Counsel in the firm’s Litigation practice, represents shareholders, companies, and their directors in fiduciary-duty, corporate-governance, and ownership disputes. His approach begins with understanding the business, the interests driving the dispute, and what the client is ultimately trying to protect. If you or your company are facing a shareholder derivative action, contact Mr. Mietlicki or another member of the firm’s Commercial Litigation Group to discuss your options.