What is shareholder derivative litigation and why is it so important?

A shareholder who brings a derivative lawsuit can make a big difference for the company.  

A shareholder derivative action is a lawsuit brought by a stockholder or group of stockholders to challenge the breaches of fiduciary duty by officers and directors of the corporation. Directors are responsible for pursuing legal action when a company is harmed; however, they often ignore their responsibilities to cover up their own wrongdoing. When this happens, a shareholder can step in and file a lawsuit on behalf of the company to hold the wrongdoers accountable. A successful lawsuit can improve the company's corporate governance practices, hold individual wrongdoers accountable, return lost assets to the company, and prevent repeat offenses.

What type of conduct can be corrected through a derivative action?

Myriad types of misconduct by corporate fiduciaries can cause harm to the company and its shareholders, including, but not limited to:

• Breaches of fiduciary duty
• Breaches of duty of loyalty
• Fraud
• Waste of Corporate Assets
• Self-Dealing
• Financial misstatements, lack of internal controls, and other bad faith accounting practices
• Excessive executive compensation
• Improper mergers and acquisitions

When poor decisions, disregard for corporate policies, and blatant misconduct by officers and directors such as these cause the value of the company's stock to decline, a successful shareholder derivative action can repair the company.

What are the requirements for bringing a shareholder derivative action?

Shareholders who are motivated to curb corporate wrongdoing must meet certain requirements:

• Shareholders must have been owners at the time of the alleged improper conduct;
• Shareholders must continue to be owners throughout the legal process;
• Shareholders must prove they can fairly represent the company; and
• In most cases, shareholders must formally demand, in writing, that the board act based on the suspected misconduct (also known as a litigation demand).

What is the process of bringing a shareholder derivative action?

Prefiling Inspection Demand

Before filing a complaint, in many cases shareholders are required to exercise their statutory right to make a "books and records" or inspection demand on the company. This demand is a letter to the company's board of directors that seeks internal non-public documents that allow the shareholder to better evaluate their concerns. If the documents reviewed support the shareholder's beliefs, the shareholder can use the information to support their allegations set forth in the complaint.

Jurisdiction & Venue

Once a shareholder is ready to file their complaint, they must determine which court has authority to hear the case. The court you file in must have power over the defendants that you are suing, which is known as personal jurisdiction, and it must have the power to resolve the legal issues in the case, which is known as subject matter jurisdiction.  Once you figure out which state and court to file in, you must make sure you file your case in the correct court county, or venue. Venue is usually proper in the county where the person you are suing lives or does business, or where the dispute arose.

Filing a complaint

If the board decides to act against the wrongdoers, it will file a case on behalf of the company to recover for the wrongdoing. In this instance, the stockholders no longer participate in the case.

If the board rejects the litigation demand and refuses to act, a shareholder can file a complaint on behalf of the company alleging that the board was not independent, had a conflict of interest, or breached the business judgment rule. A shareholder can also file a complaint if they can allege that making a demand on the board would be futile for the same reasons.  

Defendants' response

Defendants will respond to the complaint by answering, or more than likely, by asserting that the complaint does not properly allege the causes of action asserted through either a motion to dismiss or demurrer. In response, the shareholder will oppose the motion, arguing why the complaint is sufficiently pled, or will file an amended complaint to cure the defects noted by defendants. If an opposition is filed, defendants have a chance to reply. The court will either rule on the arguments submitted in the papers or schedule a time for the parties to appear for oral argument. If the court denies the motion to dismiss the matter will proceed to discovery. If the court grants the motion to dismiss, it can be with or without an opportunity to amend the complaint. If the court grants leave to amend, the shareholder will file a new complaint and the process will start all over. If the court does not grant leave to amend, the case will be dismissed. The shareholder then has an opportunity to appeal the dismissal.

Discovery

If the court denies defendants' motion to dismiss, the parties will move on to the discovery phase. Discovery includes: (i) interrogatories, or questions posed to one party by another party; (ii)  requests for production of documents, in which one party asks another party for documentation supporting their arguments; (iii) requests for admission, in which one party asks another party to admit to certain facts; and (iv) depositions, which is an opportunity for a party to ask another party or third party witness questions about the case.

Settlement

If the case makes it to discovery, that is a good sign that the shareholder and company will negotiate a settlement. A settlement in a shareholder derivative action will involve corporate governance changes to address the wrongdoing and will often include a monetary aspect to recoup lost assets for the company. Any settlement reached in a shareholder derivative action must be approved by the court. A settlement will first be preliminarily approved. Then, notice of the settlement will be provided to all known shareholders of record. The last step is for the court to grant final approval of the settlement. Once final approval is granted, the company will implement the agreed-up reforms, and defendants will pay any monetary penalties, plus attorneys' fees and expenses. 

How do you determine if a shareholder derivative action is right for you?

Robbins LLP will help you with this decision. If you have concerns about questionable conduct by the board of directors at the companies you own, let us know. We can offer you a free evaluation of the company and advise whether the conduct is so egregious that it rises to an actionable level.  Our experienced attorneys will provide you with your options. Should you choose to take action, they will be by your side during litigation, advocating for the Company and its shareholders.

The information provided here is for general purposes and should not be considered as legal, financial, or investment advice.