Dropping Knowledge: Shareholder Derivative Cases

February 7, 2011

A derivative action is a useful device for shareholders of both private and public companies who believe that directors and officers are breaching fiduciary duties, approving wasteful transactions, or committing other torts that are harming the company, and therefore, stockholders’ investment.  It is a legal fiction, where shareholders sue on behalf of the company.

Specifically, federal and state laws allow stockholders to pursue claims on behalf of their company against the company’s directors, officers, and other parties for which the company has a claim.  But because shareholders elect directors to manage the company’s business, the stockholder must either 1) make a demand for action on the company’s board; or 2) show that demand is excused because the company’s board cannot, in good faith, consider such a demand.

Making a demand concedes that the board is independent enough to consider a demand, while showing that demand is excused is, basically, showing that the board has a disabling interest in considering a demand.  A stockholder can demonstrate “demand futility” by alleging facts to show that directors will not sue themselves for their own malfeasance, and/or there is a concrete reason they won’t sue executives and/or third parties for those parties’ malfeasance.   The “demand futility” inquiry is highly fact specific, and is a tough standard for a stockholder to overcome.  But once the stockholder shows that demand is futile for a particular claim, he or she can stand in the company’s shoes against its officers and directors.

Any monetary recovery obtained does not go back to shareholders, but to the company, theoretically making the company’s value increase.  Often, however, the more important achievement  in a derivative case is corporate governance reforms that will help the company remedy the objectionable behavior, and prevent similar harm to the company in the future.

This is an oversimplified summary, but a stockholder who wants to bring a derivative action should seek counsel familiar with derivative cases.


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