What is a shareholder derivative suit?
A shareholder derivative suit is a legal action initiated by a shareholder or a group of shareholders on behalf of the corporation against its directors, officers, or other parties who have breached their duties. The claim in a shareholder derivative suit is not personal, but rather belongs to the corporation. A shareholder can only bring a shareholder derivative suit when the corporation has a valid cause of action but has chosen not to pursue it. Any damages awarded in the shareholder derivative suit obtained by a lawyer go to the corporation, not the shareholder. The shareholder may request reasonable litigation costs.
Distinction between shareholder derivative suits and direct suits
In a direct suit, a shareholder can file a lawsuit against a director or officer if the corporation’s breach of duty directly caused their own harm. However, if the harm is solely a result of injury suffered by the corporation, the shareholder cannot make this claim. Any damages awarded in a direct suit go to the shareholder.
In a shareholder derivative suit filed by an attorney on behalf of a shareholder, the corporation could have brought the lawsuit itself, but failed to do so. Therefore, shareholders have the right to sue in order to protect the interests of the corporation. There must be genuine harm suffered by the corporation, such as a decrease in share value due to false statements made by the board of directors.
Requirements for initiating a shareholder derivative suit
- The shareholder must have been a shareholder or member of the corporation at the time of the act or omission that is the subject of the shareholder derivative suit or must have become a shareholder or member by operation of law.
- The shareholder must maintain their shareholder status throughout the entire legal process.
- The shareholder must effectively and adequately represent the interests of similarly situated shareholders or members in enforcing the corporation’s rights.
- The shareholder must submit a written demand requiring the corporation to take appropriate action before filing the lawsuit. Generally, a shareholder derivative suit can only be initiated 90 days after the written demand. However, it may be filed earlier if a) the corporation rejects the demand, or b) the corporation will suffer irreversible harm if the suit is delayed.
For more information, please contact our California shareholder derivative suit attorney in Los Angeles for a free consultation.
What should a shareholder derivative suit do?
- It is imperative that a shareholder derivative suit:
a) Is not collusive, aiming to establish jurisdiction in a U.S. court that it would not otherwise have, and
b) Contains a complaint that meticulously outlines the plaintiff’s efforts to seek the desired action from the directors or members, providing reasons for the plaintiff’s inability to obtain the action or for not making the effort. Refer to Rule 23.1 of the Federal Rules of Civil Procedure.
- For LLCs, the same prerequisites apply, with the following distinctions:
a) The action may be initiated within a reasonable timeframe after the demand instead of the standard 90 days, and
b) The demand requirement can be waived if it is deemed futile.
Additionally, in a member-managed LLC, the demand should be directed towards the other members. In a manager-managed LLC, the demand is made to the managers.
- Dismissal or settlement of a shareholder derivative suit:
A derivative proceeding should be dismissed if a majority of qualified directors, who do not have significant interests in the derivative suit, have, in good faith and after conducting a thorough inquiry, determined that the derivative proceeding is not in the best interests of the corporation. The court will effectuate the dismissal upon motion by the corporation. The shareholder derivative suit cannot be compromised or dismissed by a lawyer without the court’s approval. After dismissal or compromise, shareholders should be notified in accordance with the court’s directives.
Bases for Legal Action
Legal grounds (also known as the legal foundation to initiate a lawsuit) for addressing oppression by shareholders and various kinds of business misconduct may encompass:
- Violation of fiduciary duty: While shareholders do not possess a formal fiduciary bond with co-shareholders or a corporation’s directors or officers, there might be an informal fiduciary duty owed by co-shareholders in cases where trust stems from an existing relationship. This is frequently seen in corporations that are closely held.
- Contract breach or infringement of shareholder agreement: This legal basis may be pursued if a corporation member violates a provision outlined in the shareholder agreement. Claims of contract breach can lead to remedies like monetary damages.
- Conspiracy or fraud: This may occur when corporate insiders and majority shareholders acquire minority shareholder interests in contravention of obligations of fairness and complete disclosure.
- Quantum meruit: Under this legal basis, the plaintiff looks for compensation for services rendered under a contract that is implied, like remuneration for being on a committee or the board.
- Trade secret misappropriation: If a corporate officer or director unlawfully appropriates trade secrets for personal gain, there may be grounds for a claim.
- Compelling investigation of records and books: Shareholders are entitled to review fundamental documents like records of board meetings and company bylaws. If the corporation declines, a lawsuit can be filed seeking court intervention to compel full compliance.
- Property conversion: Since stock is categorized as personal property, shareholders can safeguard their rights to property through the cause of action for conversion, asserting that the defendant purposefully interfered with the value of the plaintiff’s property.
- Dividend-related actions: Stockholders possess a legal entitlement to corporate dividends and a fair share of corporate profits. They may seek recourse for the manipulation or suppression of dividends.
- Unfair enrichment: This legal basis operates on the principle that no person should be allowed to unjustly benefit at another’s expense without providing compensation.
- Ultra vires: Any action that abuses or surpasses a corporation’s authorized powers and objectives, typically defined by state law or outlined in its articles of incorporation.
- Violation of trust: A distinct legal basis for breach of trust can come from a corporation that infringes upon shareholders’ rights or the duties owed to them.
What Constitutes a Shareholder Derivative Lawsuit?
Since shareholders are the proprietors of a company that, by legal definition, cannot act on its own behalf, there may arise a necessity to uphold the legal obligations that corporate officers and directors owe to the shareholders and the corporation. Shareholder derivative suits are legal actions initiated by a lawyer on behalf of shareholders who serve as representatives on behalf of the corporation.
Shareholder derivative suits filed by an attorney can address various forms of wrongdoing and fraudulent activities, including:
- Breach of fiduciary duty: Corporate directors and officers are obligated to uphold a fiduciary duty to the company they serve, and they may be held accountable if they fail to fulfill this duty.
- Fraud and illicit activities
- Self-dealing
- Unjust enrichment
- Insider trading
- Issuance of misleading or false financial statements
- Corporate mismanagement or waste
As well as pursuing claims against former or current directors and officers of a company, additional third parties, such as lawyers or accountants, can also be named as defendants if their actions resulted in damage to the business and subsequent indirect losses for shareholders.
Shareholder Derivative Suits in Closely Held Companies
The procedural obstacles, especially the demand requirement, often pose challenges for the viability of many shareholder derivative claims. That said, for closely held companies, these protections are waived. This means that owners of LLCs or companies with fewer than thirty-five shareholders, which are not traded publicly, are exempt from meeting the aforementioned requirements. Consequently, minority shareholders of closely held businesses have an obvious path to pursue shareholder derivative suits for the corporation, treat those suits as direct claims “if justice requires,” and successfully seek personal recovery for damages that would otherwise have been channeled through the business and subject to taxation.
For the above reasons, shareholder derivative suits have become a fundamental element in litigating both majority and minority shareholder disputes in closely held companies.
Defending Against or Preventing Shareholder Derivative Suits
Officer and directors can reduce the likelihood of facing shareholder derivative suits – and often successfully defend against shareholder derivative suits – by adhering to sound corporate governance practices, consistently prioritizing the business’ best interests, and engaging with shareholders in an honest and transparent manner.
You might be able to sidestep shareholder derivative suits or build a robust legal defense by implementing the following good governance measures:
- Timely communicate significant information to shareholders, like notifications of investigations or legal proceedings.
- Exercise caution when managing corporate assets. Excessive or inappropriate executive compensation arrangements, for instance, frequently lead to accusations of mismanagement of corporate resources.
- Fulfill your oversight responsibilities diligently. Neglecting due diligence in transactions or ignoring warning signs may result in allegations of oversight failures. Be prepared to substantiate board decisions with solid evidence and rational justifications.
- Be vigilant about identifying and addressing conflicts of interest. If you find yourself in a situation where you have a conflict, it is crucial to recuse yourself from the process of decision-making.
https://california-business-lawyer-corporate-lawyer.com/wp-content/uploads/2025/03/Best-Free-Payroll-Software-for-Small-Businesses-and-Startups-in-2025.jpg
787
1195
Amit
http://california-business-lawyer-corporate-lawyer.com/wp-content/uploads/2022/05/Nakase-Wade-logo-transparent-200x54px.png
Amit2025-03-28 04:26:542025-03-28 04:26:56Best Free Payroll Software for Small Businesses and Startups in 2025
