Shareholder Derivative Action Process - Explained
How Shareholders Sue on Behalf of the Corporation
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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.
Next Article: Corporate Proxies and Shareholder Votes Back to: CORPORATE GOVERNANCE
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.
How do you feel about the requirement to make demand to the board of directors to bring a lawsuit for the alleged legal violation? What standards do you think should apply to the board when making the decision of whether to pursue a legal action or no? What do you think a shareholder must show to convince the court that the board that demand is futile?
Thomas is upset by some decisions made by the CEO with regard to the sale of corporate assets. The CEO is also chairman of the board of directors. Thomas believes that the actions have significantly injured the corporation and its shareholders. If Thomas decides to bring a derivative action against the CEO, what is the process(es) that Thomas may follow in bringing the suit?
- A shareholder derivative action is filed pursuant to state law. However, generally to begin the process of derivative action, the eligible shareholders must first make demand on the board requesting that they bring a suit against the defendant. The board, upon receiving the request to bring the suit against the defendant, may grant the request to file the suit, dismiss the request, or appoint a special litigation committee. The board or special committee may decide that it is not in the best interest of the corporation to bring a legal action. If the shareholders are no satisfied with the boards response, they can only file a legal action if they can demonstrate that the board is biased or have a conflict of interest in making the decision.
- Corporate Governance Law (Intro)
- What is Business Governance?
- Berle-Means Thesis
- Corporate Governance Rating Definition
- Who are the members of a corporation?
- Corporate Charter
- Shareholder Register
- Common Stock
- Preferred Stock
- Par Value
- Authorized Shares
- Issued Shares of Stock
- Unissued Shares of Stock
- Outstanding Shares
- Institutional Shares
- Dual Class Shares
- What is a closely-held corporation?
- Close Corporation Plan Definition
- What is a Private Company vs a Public Company?
- What is the role and purpose of the corporation?
- What is the Agency theory of corporate governance?
- Shareholder-Centric Perspective
- Shareholder Value
What is the Stakeholder theory of corporate governance?
What is the role & rights of Shareholders in the corporation?
- Shareholder Democracy Definition
- Quorum Definition
- Class Voting Shareholders
- Changing the Voting Rules
- Supermajority (Voting)
- Shareholder Sponsored Proposal
- What are the variations on attributes of Ownership structure?
- Stock Split
- What are the fiduciary duties owed by shareholders?
- When is a shareholder personally liable for corporate obligations?
- Appraisal Rights
- Dissenter's Rights
- Say on Pay Rights
- How can shareholder enforce their rights (direct and derivative actions)?
- What is the process for bringing a Derivative action?
- What are corporate vote Proxies?
- Proxy Statement
- Proxy Fight or Contest Definition & Explanation
- What is Shareholder Activism and the significance of Institutional Investors?
- Activist Investor
- Overview of Board of Directors
- Board Decision Making
- Advisory Board (Observer Directors)
- What is the role of the Board of Directors?
- Board of Trustees
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- Outside Director
- Outside Director or Non-Executive Director Definition
- Independent Outside Director
- Budget Committee
- Audit Committee
- Compensation Committee
- Nomination Committee (Corporate Board)
- What standards govern the actions of the board of directors?
- Duty of Candor Definition
- Board Evaluation Definition
- What is the Business Judgment Rule?
- What is D&O insurance?
- Codetermination (Foreign)
- What is the role of Managers of the corporation?
- What standards govern manager actions?
- Chief Executive Officer (CEO)
- Chief Financial Officer
- Chief Information Officer (CIO)
- Chief Investment Officer (CIO)
- Chief Legal Officer
- Chief Operating Officer
- Chief Risk Officer
- Chief Security Officer
- Chief Technology Officer (CTO)
- What are the primary state and federal corporate governance laws?
- What is the role of the state in corporate governance?
- What is the role of Securities Laws in corporate governance?
- What is the role of the Foreign Corrupt Practices Act in corporate governance?
- What is the Sarbanes-Oxley Act (SOX) effect on corporate governance?
- Sarbanes-Oxley Act (SOX)
- What is the Dodd-Frank Wall Street Reform and Consumer Protection Act effect on corporate governance?
- Corporate Monitors
- What industry organization standards affect corporate governance?
- How do proxy advisory firms affect corporate governance?
- What is the role of ethics in corporate governance?
- What are the major causes of corporate governance issues?
- What are the access to information issues?
- What are decision-making structure issues?
- What are the power struggle or competition issues?
- Holding Company
- What are hostile takeovers and defenses to hostile takeovers?
- Williams Act
- Staggered Board
- Delay-Tactic Defenses?
- Legal Lockup Defenses?
- White Knight and Pac Man Defenses?
- Jonestown Defense
- Lady Macbeth Strategy
- Macaroni Defense
- Yellow Knight
- Back-end Plan Definition
- Backflip Takeover Definition
- Dead Hand Provision Definition
- Kamikaze Defense
- Operating Company Property Company Model
- Scorched Earth Policy Definition
- Revlon Rule
- What are benefit-alignment issues?
- Cadbury Rules Definition