Stockholder's Derivative Suit

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STOCKHOLDER'S DERIVATIVE SUIT

A legal action in which a shareholder of a corporation sues in the name of the corporation to enforce or defend a legal right because the corporation itself refuses to sue.

A stockholder's derivative suit is a type of litigation brought by one or more shareholders to remedy or prevent a wrong to the corporation. In a derivative suit, the plaintiff shareholders do not sue on a cause of action belonging to themselves as individuals. Instead, they sue in a representative capacity on a cause of action that belongs to the corporation but that for some reason the corporation is unwilling to pursue. The real party in interest is the corporation, and the shareholders are suing on its behalf. Most often, the actions of the corporation's executives are at issue. For example, a shareholder could bring a derivative suit against an executive who allegedly used the corporation's assets for personal gain.

A derivative suit is different from a direct suit brought by a shareholder to enforce a claim based on the shareholder's ownership of shares. These direct suits involve contractual or statutory rights of the shareholders, the shares themselves, or rights relating to the ownership of shares. Such direct suits include actions to recover dividends and to examine corporate books and records.

The principal justification for permitting derivative suits is that they provide a means for shareholders to enforce claims of the corporation against managing officers and directors of the corporation. Officers and directors, who are in control of the corporation, are unlikely to authorize the corporation to bring suit against themselves. A derivative suit permits a shareholder to prosecute these claims in the name of the corporation. Other justifications for derivative litigation are that it prevents multiple lawsuits, ensures that all injured shareholders will benefit proportionally from the recovery, and protects creditors and preferred shareholders against diversion of corporate assets directly to shareholders.

In a derivative suit, the shareholder is the nominal plaintiff, and the corporation is a nominal defendant, even though the corporation usually recovers if the shareholder prevails. Nevertheless, derivative litigation is essentially three-sided because the defendants include the persons who are alleged to have caused harm to the corporation or who have personally profited from corporate action. The claim of wrongdoing against these defendants is the central issue in a derivative suit, and the interest of the corporation is usually adverse to these defendants. Thus, individual defendants are usually represented by attorneys other than the attorneys for the corporation. The corporation may play different roles in a derivative suit. It may be an active party in the litigation, be entirely passive, or side with the individual defendants and argue that their conduct did not harm the corporation.

Generally, the plaintiff shareholder is not required to have a large financial stake in the litigation. As a result, the plaintiff's attorney is often the principal mover in filing a derivative suit; the attorney locates a possible derivative claim and then finds an eligible shareholder to serve as plaintiff. Consequently the attorney may have a much more direct and substantial financial interest in the case and its outcome than the plaintiff shareholder who is a purely nominal participant in the litigation. Because most derivative suits are taken on a contingent fee basis, the plaintiff's attorney will receive compensation only on the successful prosecution of the suit or by its settlement. Such a recovery is justified on the theory that it encourages meritorious shareholder suits.

Most derivative suits are settled and thus do not go to trial and appeal. The lead attorney for the plaintiff usually determines whether a proposed settlement is acceptable. The fee to be paid to the lead attorney is usually negotiated as part of the overall settlement of a derivative suit. All aspects of the settlement are subject to judicial review and approval, however.

Derivative suits have proved controversial. Corporations complain that most litigation is brought at the behest of entrepreneurial attorneys who first find a potential violation and then find a shareholder qualified to maintain the derivative suit. Critics charge that the objective of these suits is to obtain a settlement with the principal defendants and the corporation that provides the attorney with a generous fee. In return for the attorney's fee, the plaintiff "goes away."

Derivative suits involve shareholder enforcement of corporate obligations, which may intrude on the traditional management powers of the board of directors. Since the 1980s boards of directors have had considerable success in reasserting control over derivative litigation.

States have enacted laws that put a financial roadblock in the way of derivative actions. A minority of states require that the plaintiff make a demand on the shareholders, which is very expensive, before a derivative suit is filed. The shareholder demand requirement may be excused if the plaintiff can show adequate reasons for not making the effort. Many states require certain plaintiff shareholders in derivative suits to give the corporation security for reasonable expenses, including attorneys' fees, that the corporation or other defendants may incur in connection with the lawsuit. Despite these efforts to restrain derivative actions, they have not prevented the filing of doubtful claims by attorneys seeking a quick settlement.

Almost all states require the plaintiff to allege and prove that he first made a good faith effort to obtain action by the corporation before filing a derivative suit. This good faith demand requirement is contained in state corporation laws and rules of court. A typical provision is Rule 23.1 of the Federal Rules of Procedure, which states that the plaintiff's complaint must "allege with particularity the efforts, if any, made by the plaintiff to obtain the action he or she desires from the board of directors or comparable authority and the reasons for his or her failure to obtain the action or for not making the effort."

Plaintiffs have generally not made these demands, however, and have instead sought to convince the court that there were good reasons for not doing so. Much of this reluctance to make a demand can be traced to changes in the corporate law of Delaware in the 1980s. Delaware, which is the principal state of incorporation for the vast majority of publicly held corporations, empowers a corporation to appoint a litigation committee from its board of directors to review shareholder demands. If the litigation committee finds no merit in a demand, it can decide that the suit should not be pursued, and the court must accept the committee's decision and dismiss the case. The development of the litigation committee has expedited the disposition of many doubtful derivative claims and possibly some meritorious ones as well.