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What is the process for shareholders bringing a “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.
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 board’s 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 SLC’s 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.
Discussion: 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?
Practice Question: 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 board’s 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.