What Is a Derivative Suit?

The board of directors, elected by shareholders, typically runs a corporation and appoints officers managing the operation of the company. Shareholders tend to have little or no say in the day-to-day operation of a company. However, if the board of directors fails to address wrongs or harms done to the company, investors can challenge the board or address the wrongful action by filing a derivative lawsuit. Derivative lawsuits, therefore, provide an important mechanism that can protect investors and the corporation.

One of the main reasons for shareholders to file a derivative lawsuit can be serious misconduct by a director or officers of the company. The need for legal action arises when directors are hesitant or unwilling to act against the responsible individuals. Notable examples of recent derivative litigation are the so-called “#metoo” lawsuits. While legal action alleging workplace harassment or misconduct is nothing new, the #metoo movement extended a company’s liability beyond the concepts of workplace discrimination. According to the American Bar Association (ABA), derivative lawsuits concerned with the #metoo movement generally alleged that the director defendants knew or willfully ignored the alleged sexual misconduct occurring at the corporation. 

There can be numerous reasons for filing derivative suits. However, litigation often evolves around wrongful action by directors or officers of the company, such as:

• Breach of contract by a director or officer
• Breach of fiduciary duty by a director or officer
• Conflicts of interest
• Insider dealing
• Fraud
• Misleading or false financial statements
• Wrongdoing by financial advisors or accountants 
• Disproportionate executive remuneration or bonuses
• Board decisions violating laws and regulations

Examples of reasons why officers and directors could become defendants in a derivative lawsuit can include but are not limited to:

Failing to Exercise Duty of Care 

Directors and officers of a corporation must manage a company prudently. If a director or officer made a business decision without exercising due care or acted in bad faith, they may have breached the duty of care and could be responsible for damages to the company.

Breaching Duty of Loyalty

Duty of loyalty describes the responsibility of directors and officers to make all decisions without putting their own financial interests above those of the company and shareholders. Examples for breaching the duty of loyalty can involve:

• Insider dealing or self-dealing
• Misusing corporate funds or assets
• Misusing corporate privileges

Irregular Mergers and Acquisitions 

Derivative suits frequently deal with improper mergers and acquisitions. If a merger that was approved by the board of directors diminishes the value of the company, shareholders could have legal recourse. A breach of fiduciary duty may have occurred in any merger or acquisition where directors failed to maximize shareholder value.

Accounting Mismanagement and Malpractice

Executives must not inflate or manipulate the earnings and profits of a company. Shareholders can potentially file a derivative lawsuit to:

• Remove the directors who knew of or collaborated with fraudulent activities
• Enforce stricter governance measures preventing malpractice in the future

When directors or officers allow aggressive or fraudulent accounting practices, our derivative lawsuit attorneys can assist shareholders with removing the complicit individuals and implementing stricter governance standards. 

Egregious Conduct Involving Employees or Consumers 

Derivative lawsuits based on egregious conduct towards employees or consumers often make headlines, such as the #metoo movement lawsuits or extensive data breaches such as the one involving Equifax in 2017. Derivative suits can also involve the following:

• Violations of environmental laws and regulations
• Violations of wage and hour laws 
• Violations of workplace safety regulations
• Violations of consumer safety laws

Shareholder derivative suits are an essential tool for those who hold considerable shares and investments in a company. Suits can identify fraud and wrongdoing in corporations and protect shareholders, employees, and even the public from getting harmed due to unscrupulous corporate practices. 

Generally, any damages recovered in a derivative lawsuit flow back into the corporation and not to those who have filed the suit, therefore benefitting all investors. Other benefits can include:

• The removal of the individuals harming the company
• Compensation to the company or investors
• Changes in corporate governance
• Protection of shareholder value
• Incentive awards for plaintiffs bringing the suit

The derivative lawsuit attorneys at Morgan & Morgan have extensive experience with representing shareholders in legal disputes. We could help you remove corrupt or unethical board members and protect shareholder value.

Although shareholders are generally entitled to file derivative suits, the legal process in most states involves another step before they can prosecute. According to state and federal laws, claimants cannot simply file a suit in court and must first make a “pre-suit demand” on the board of directors. The demand outlines the complaint and explains the wrongdoing or harm to the company, such as a breach of duty by members of the board of directors or management. 

After the demand has been issued, the board has some time to determine their next best steps and may consult legal counsel for assistance. The executive board members then make a decision whether to file a lawsuit against those who have breached their fiduciary duty or harmed the company. According to the Legal Information Institute (LII), shareholders can generally only commence with filing a derivative suit when the board refuses to take appropriate action.

Proving Standing to Bring the Lawsuit

Most jurisdictions insist on a shareholder proving their standing for bringing derivative legal action. Proving standing can entail meeting certain requirements, such as:

• Maintaining a minimum value of shares in the company
• Having acquired stock in the corporation before the wrongful conduct happened
• Holding shares for the duration of the suit 

If a plaintiff in a derivative suit sells their shares during the pending lawsuit, they generally lose interest in the litigation in addition to their shareholder rights. Therefore, if the lead plaintiff sells their shares before the lawsuit has concluded, a court will most likely ask for the appointment of another lead plaintiff. 

The specific laws governing derivative lawsuits can diverge considerably between states and tend to involve complicated legal issues. For example, while a pre-suit demand is essential in some states, in others, such a demand could cause a lawsuit to fail. Therefore, working with an experienced and determined attorney can be crucial for shareholders hoping to bring a successful derivative suit. An attorney from our firm can advise you comprehensively and inform you of your options.

As a plaintiff, your main responsibility is acting in the interests of the corporation and all investors rather than your own. Depending on the state your case is filed in, you most likely have to hold stock in the company throughout the pending litigation in order to keep pursuing the claim. As a lead plaintiff bringing the suit, you are generally responsible for conferring with the attorney and staying informed about any developments that may require your input or decision. 

Generally, if money is recovered as the result of a derivative suit, the proceeds will benefit the harmed company and, therefore, all shareholders equally. In some cases, the lead plaintiff who brought the suit can receive some compensation for their time and effort. 

As discussed above, shareholders are typically only able to file a case when the corporation decides not to file a lawsuit against the alleged wrongdoers. In most states, shareholders must provide the company with the opportunity to file suit by issuing a pre-suit demand. Once a specific time period has passed, 90 days in some cases, a shareholder can generally file a derivative lawsuit. However, since state laws differ markedly, you should consult with an attorney to determine the correct procedure for filing a suit.

Generally, to have a case and bring a derivative suit, plaintiffs must prove that:

• Directors or officers pursued their own interests with regards to the alleged wrongful action

OR

• The alleged wrongful action resulted from failing to exercise sound business judgment. 

Companies and boards can protect themselves to a certain extent by focusing their energy on important issues such as customer care, consumer rights, employee safety, and prudent financial decisions. However, even when a corporation focuses on doing everything right, individual board members could act in unscrupulous ways. Rather than sheltering unethical board members, executives should take decisive and timely action before shareholders are forced to initiate litigation to protect their interests. 

If a plaintiff can prove that directors or officers acted in bad faith, for example, by deliberately advancing their personal interests rather than those of the business and shareholders, they could have a good case.

No, you do not incur any costs when filing a derivative lawsuit. Our attorneys handle these cases on a contingent fee basis and have the resources to advance any expenses associated with a derivative suit. We will get paid, by the defendants, if we win the case and reach a successful outcome benefitting the corporation. The shareholders bringing the suit will not be responsible for any attorney’s fees or expenses. 

As a shareholder of a corporation, you might not know how to go about filing suit after discovering mismanagement or wrongful actions. Your first best step can be to speak to an experienced attorney in the field. If you are hoping to hold board members or officers of a company to account, having a business litigation attorney in your corner can be crucial. 

Morgan & Morgan’s determined attorneys can advise you comprehensively, prepare a pre-suit demand, gather the necessary evidence to prove your case, and much more. Our lawyers know the relevant laws and corporate regulations applicable to derivative suits.

Derivative suits can potentially be brought against private and public companies. Further, derivative litigation is not necessarily limited to corporations and can, in most cases, deal with other entities such as limited liability companies and limited partnerships. However, some companies could have corporate governance provisions limiting their exposure to derivative lawsuits. If you are not sure whether you could file a lawsuit against a specific company’s directors or management, a business litigation lawyer from our firm can provide clarity.

Shareholders have the right to expect company executives to act prudently and exercise sound business judgment. When this is not the case, shareholders can and should take action to protect their investments. If you are aware of an officer or director willfully damaging a company, for example, by supporting inappropriate mergers, conducting insider dealing, misusing company assets, or for other reasons, you could have a case and potentially file a derivative lawsuit.

Our business litigation attorneys can represent individual shareholders and institutional investors. Contact us now for a free, confidential, no-obligation consultation.