Shareholder Direct and Derivative Actions

Cite this article as: Jason Mance Gordon, "Shareholder Direct and Derivative Actions," in The Business Professor, updated June 14, 2016, last accessed April 8, 2020, https://thebusinessprofessor.com/knowledge-base/shareholder-direct-and-derivative-actions/.
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Shareholder Actions - Direct Actions and Derivative Actions
This video explains what is a direct shareholder action against the corporation or a derivative shareholder action against officers or directors of the company.

Next Article: Derivative Action Process

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How can shareholders enforce their rights?

Shareholders may generally enforce their rights against the corporation (or its officers and directors) in one of two ways.

Direct Actions – A shareholder may directly sue the corporation, an officer, or director if one of these individuals takes actions that result in direct harm to the shareholder. This situation is rare, because it’s difficult for a shareholder to demonstrate that she has suffered a specific harm as a result of actions by the officers or directors.

  • Example: ABC corporation denies a shareholder the right to convert her preferred shares into common shares in accordance with her contract rights. The shareholder may personally sue the corporation, officer, or director for the harm she suffers.

Shareholder Derivative Suits – In this type of shareholder litigation, the plaintiffs allege that the corporation itself was harmed by a defendant’s conduct. Shareholders sue the corporation’s directors or officers, alleging a breach of fiduciary duties of loyalty or care to the corporation. Any damages to the shareholders are indirect through the overall negative impact on the corporation.

  • Example: ABC Corporation CEO makes reckless decisions in several large corporate deals. These decisions have caused a significant decrease in stock price. Shareholders are angry and sue the CEO on behalf of the corporation. If the shareholders win, the corporation will receive a judgment against the CEO. All shareholders benefit equally from the litigation by recovering damages for the corporation.

Discussion: How do you feel about a shareholder’s options for protecting and enforcing her rights? Does the ability to bring a direct action or a derivative action adequately protect shareholder rights? Why or why not?

Practice Question: Mike is a director and CEO of Murphy Corp. When Mike decides to retire, he chooses his friend David to replace him as CEO. Mike has such control and power over the board that they hire David and offer him and incredible contract without seeking the expertise of executive compensation consultants. After one year of poor performance, the Board fires David and learns that it will have to pay out the value of his contract. Shareholders are angered by the poor performance and David’s payout. What are a shareholder’s options to protect her rights?

Proposed Answer

  • The shareholder may request that the board of directors elect to sue Mike and/or David for the poor decision-making and performance. If elect not to do so, the shareholders may seek to bring a derivative action. This allows the shareholders to redress harm to the corporation caused by bad management where it is unlikely the management will redress the harm itself. Normally, this requires that the shareholders first petition the board to sue. If they fail to sue, then the shareholders must demonstrate that the board is conflicted or biased. If they can show this, they will be able to file a derivative suit on behalf of the corporation. The purpose of a derivative action is to prove that the misconduct caused the corporation to suffer damages and that there is a wrongful refusal by the corporation or the management to redress the act.

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