The Shareholder Derivative Suit

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A shareholder derivative suit—otherwise known as a derivative suit or a shareholder lawsuit—is a suit brought by a shareholder or group of shareholders against third parties on behalf of the corporation. Derivative suits are generally brought by shareholders against the executive management of the company.

Standing to Bring a Shareholder Derivative Suit

Only a shareholder—that is someone actually holding an equity interest in the company—may bring a derivative suit. Generally speaking, however, an individual wanting to bring a derivative suit may not simply go buy a share of stock and then file suit. The Contemporaneous Ownership Rule states that only shareholders who were shareholders at the time that the alleged harm occurred may file a shareholder derivative suit.

There are, however, some exceptions to this general rule:

1. If there is a statute that allows the bringing of a suit in violation of the Contemporaneous Ownership Rule.
2. If the shareholder acquires the shares by operation of law, the shareholder steps into whatever standing the previous owner had. Such operations of law include inheritance, bankruptcy, or divorce.
3. If the alleged wrong is ongoing and continues after the time the shareholder has acquired his or her shares.

The exceptions vary by jurisdictions, but these are just a few of the main exceptions.

Requirements of Being Representative

Many jurisdictions require that the plaintiff bringing the shareholder derivative suit be representative of the interests of other similarly situated shareholders. The United States Supreme Court laid out the rationale for this rule in Cohen v. Beneficial Industrial Loan, stating that a shareholder bringing a derivative suit

sues, not for himself alone, but as representative of a class comprising all who are similarly situated.  The interests of all in the redress of the wrongs are taken into his hands, dependent upon his diligence, wisdom and integrity. And while the stockholders have chosen the corporate director or manager, they have no such election as to a plaintiff who steps forward to represent them. He is a self-chosen representative and a volunteer champion.

Because of this, it is reasonable to impose “standards of responsibility, liability and accountability” on the plaintiff that will protect the interests of all the shareholders.

Demand on Directors

Before filing a shareholder derivative suit, the shareholder must first demand that that corporation itself bring the action. This serves to give the corporation the opportunity to pursue the action on its own, as the action will be brought on behalf of the corporation whether the corporation or the shareholder pursues it. Such demands should be made upon the board of directors.

Generally, if the Board of Directors decides not to pursue action and that decision is supported by the Business Judgment Rule, then many jurisdictions will not allow the shareholder to bring action. Generally, however, if the company leaders that made the decision not to pursue the action are the same individuals that are the subject of the action, the Business Judgment Rule will not apply. Where the Business Judgment Rule does not apply, the shareholder may pursue a derivative action.

Recovery in a Shareholder Lawsuit

The shareholder derivative suit is unique in the sense that, though pursued by a shareholder, since the shareholder pursues the action on behalf of the corporation, any recovery won belongs to the corporation, not the shareholder.

Generally, however, a successful shareholder lawsuit will entitle the shareholder to recovery of attorney fees.

Shareholder lawsuits and the rules surrounding them can be quite complex, and this article seeks only to provide a basic overview. If you are a shareholder of a company that has been defrauded or otherwise wronged by its leadership and you think a derivative suit may be appropriate, you should speak with a competent attorney about your potential options.

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See Also:

The Corporation

Shareholders and Directors