Direct v. Derivative Law Suits

If someone causes damages to the corporation and the corporation does not sue, the shareholders may be allowed to bring a lawsuit against the corporation to make it to sue the wrongdoer. This is called a derivative suit (because shareholders’ loss is derivative to the corporation’s loss). If a shareholder sues a corporation and claims that the actions of the management harmed him individually, it is a direct lawsuit.

 

Test to decide whether a lawsuit is a direct or derivative:

 

1) Who was harmed: a corporation or a shareholder? And

2) Who would receive the benefits of recovery: a corporation or a shareholder?

 

Why does it matter whether a lawsuit is a direct or derivative one? The law imposes different requirements on the process and the ability of the parties to sue.

 

Shareholders are required to make a demand on the directors to bring a lawsuit before they can file a complaint themselves if a lawsuit is a derivative one. Demand is not required in a direct lawsuit. Directors represent a corporation and they make all decisions, including litigation matters. Therefore, a demand to sue is required. If a board says no, shareholder cannot bring the same claim on behalf of the corporation unless they can prove a wrongful refusal.

 

If shareholders made a demand and received a board’s refusal they cannot assert later that the demand was futile. It has to be stated beforehand. Demand requirement may be excused under the demand futility exception if majority of the board is interested or not independent or if the original decision will not receive a business judgment rule protection (e.g. a breach of duty of loyalty (including good faith) or duty of care is claimed).

 

Even if demand is excused as futile, the boards can still take steps to stop the litigation by establishing a committee of disinterested directors to take a fresh look – Special Litigation Committee. When deciding whether to uphold the decision of the committee the court applies a two-prong test:

 

1. Inquires into independence & good faith of the committee; and

2. Finds a balance between legitimate corporate claim & corporation’s best interests in not to sue applying court’s own judgment.

 

Summary:

 

If a lawsuit is direct, sue away!

If derivative:

·         Is demand required?

o   Yes – plaintiff must make a demand, which is likely to be denied, meaning plaintiff loses (subject to the wrongful refusal claim)

o   No

·         Did Company form a special litigation committee?

o   No – sue away!

 

o   Yes – apply a two-part test if special litigation committee would dismiss a demand 

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