The Derivative Suit

Overview to Derivative Actions

The final weapon in the arsenal of the shareholders is the “shareholder derivative suit” (a.k.a. derivative action). The discussion of the derivative action returns us to our introductory section of the corporation – the corporate Camelot. If you recall, we discussed early on that the corporation is the castle itself. However, a castle on its own has little to no value. Despite its high walls and fortifications, a castle is not capable of defending itself. Moreover, there are some occasions when the knights are either not in the castle, choose not to protect it or hope to use it for their own ends. In this circumstance, it is up to the populace to get together and find its own means of insuring the safety of the firm.

Enter the derivative action. At its essence, a derivative suit is used as a means for a shareholder or group of shareholders, acting on behalf of the corporation, to reclaim value lost to the corporation by its management. Essentially, the form of a derivative action is the same as the form of any other lawsuit. On the plaintiff's side are two parties – the complaining shareholder and the corporation itself. On the defendant's side are management and the corporation again – this time as a “nominal” defendant (a defendant as a formality only). In the suit, the plaintiff shareholder will state a claim based on an argument that the corporation, via management, either took or failed to take some action that cost the corporation value. For their part, the defendant management will attempt to show how its actions were either necessary or protected under the Business Judgment Rule. See Federal Rules of Civil Procedure, Rule 23.1.

EXAMPLE: Nicole is a shareholder in XYZ Co. She has discovered that the company has been consistently losing money because the firm keeps allowing managers to use the corporate jet and various corporate cars and houses without including it in their compensation packages. Because of managements’ excesses, the company is accumulating annual bills in amounts of hundreds of thousands of dollars. As such, Nicole requests that those managers cease and desist from their abusive practices. If the board refuses to do so, Nicole can file a shareholder action to reclaim the lost value.

Note that many states require that the plaintiff be a shareholder at the time that the alleged improper actions were taken in order to bring a derivative action. See 8 Del. C. § 327. This rule was designed principally to prevent the purchasing of stock to be used for the purpose of filing a derivative action attacking transactions occurring prior to such purchase. See Maclary v. Pleasant Hills, Inc., 35 Del. Ch. 39 (1954).

Presenting Claims to the Board

Prior to commencing a shareholder derivative suit, the plaintiff shareholder must first formally demand (written demand) of the company’s board that it act in the manner that the shareholder requires. Thus, if the shareholder’s goal is to stop the board from engaging in some action, she must first request that the board refrain from doing the act. Conversely, if the shareholder is requesting that the board perform some certain act, that request must likewise be made prior to commencing the suit. Note that this “demand” requirement could be waived if the suing shareholder could show that such a demand would have been futile; See Aronson v. Lewis, 473 A.2d 805 (Del. Sup. Ct. 1984); however, under the RMBCA today, this exception does not necessarily apply, as the provision is not written into the RMBCA, and the demand could give directors an opportunity to resolve the issue through means other than litigation.

After the shareholder has made the necessary request or demand to the board, the board is given an appropriate amount of time to determine the proper course of action. At this juncture, the board will often seek outside counsel and/or create a committee of disinterested directors who were not involved in the transaction about which the shareholder is complaining. This group of managers will then be tasked with making a determination, on behalf of the corporation, as to whether or not the action suggested by the shareholder should be pursued. It is important to realize that this committee, often termed a special investigation or special litigation committee needs to be as removed as possible from the conflict in order for its opinion to be of any value. See Rales v. Blasband, 634 A.2d 927 (Del. Sup. Ct. 1993).

After the committee has had sufficient opportunity to meet and discuss the issue of the suit, the committee will then make a recommendation to the board as to whether or not it should support the derivative action. If the committee’s suggestion is to support the action, then the board will likely enter the suit and take up the action against the directors who have pursued or are pursuing the illegal or improper course of conduct. If, however, the committee makes the recommendation that the board should not pursue the action and that the potential cost of the action will outweigh its benefits, then the individual shareholder reenters the picture. If the shareholder so chooses, she may continue the action on her own. However, if she chooses to do so, she will be responsible for the full cost of the litigation, though she will probably be entitled to indemnification for her costs if she wins. If the shareholder loses the action, she may be required to pay the legal expenses of the corporation.

EXAMPLE: The board of HighTop Co. has recently been requested, by a shareholder threatening a derivative suit, to discontinue the issuance of favorable credit terms to a number of companies, some owned by board members, that have failed to pay their bills in a timely fashion in the past. Upon announcement of the suit, the board convened a special litigation committee to investigate the merits of the claim. The committee consisted of several board members, none of whom were implicated in the suit, and the company’s general counsel. After hearing evidence on the suit, the committee ultimately determined that the claim lacked merit. However, the shareholder persisted in the action and was ultimately successful in court. As a result, the directors who had received the unfair terms were held liable for their actions, and the company was forced to pay for the shareholder’s legal expenses.

The Action Process

In form, the derivative action takes on the characteristics of a class action suit. After the board makes a determination, the complaining shareholder files the suit as an individual and on behalf of the corporation. From there, he is then required to provide notice, either on his own or (if so ordered by the court) at the expense of the corporation, to all other shareholders that the action has been commenced, and must provide them the option to join the suit.

At this point, the suit is commenced, and it follows the normal path of any similar civil action. The shareholder will present the corporation’s case, making the relevant arguments to show that the members of the board have been acting in a manner that is inconsistent with their fiduciary duties. The management will respond by trying to show either the propriety of their actions or the fact that their actions are protected by the business judgment rule.

Results of the Suit

A shareholder suit results in one of two possible outcomes. The corporation and its board may win; in which case all returns to normal for the firm. If, on the other hand, the shareholder wins, then one of several results may ensue. First, it is assumed that the shareholders request will be fulfilled. Additionally, it is typical that the shareholder will receive his or her legal expenses from the corporation. See Ramey v. Cincinnati Enquirer, Inc., 508 F.2d 1188 (6th Cir. 1974). 

EXAMPLE: After filing and winning a derivative action suit, the court awarded a personal liability judgment against several of the firm’s directors in an amount approximating their ill-gotten gains. Ultimately, these funds were paid over to the corporation, minus litigation expense paid to the shareholders who had brought the suit.