shareholder derivative suit

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A shareholder (stockholder) derivative suit is a lawsuit brought by a shareholder or group of shareholders on behalf of the corporation against the corporation’s directors, officers, or other third parties who breach their duties.The claim of the suit is not personal but belongs to the corporation. A shareholder can only sue when the corporation has a valid cause of action but has refused to use it, and the damage awards of the suit come to the corporation instead of the shareholder. The shareholder may ask for a reasonable cost paid for litigation.

A shareholder derivative suit is different from a direct suit:

  • Direct suit: A shareholder can bring a direct suit against a director or officer if the corporation breached its duty and caused their actual injury.  But if the injury is solely caused by an injury suffered by the corporation, the shareholder cannot assert this claim. Once the damage is awarded, it will be paid to the shareholder. 
  • Derivative suit: The suit could have been brought by the corporation, but it failed to do so, so the shareholders have the right to sue to protect the interest of the corporation. There should be real harm to the corporation. For instance, the corporation suffered share value loss due to the board of directors’ false statements

As a plaintiff of a derivative suit, a shareholder is required to:

  • Be the corporation’s shareholder or member at the time of the act or omission that the suit complained about, or become a shareholder or member by operation of law
  • Keep shareholder status during the entire judgment
  • Be fairly and adequately represent the interests of the shareholders or members similarly situated in enforcing the right of the corporation, and
  • Make a demand in writing requiring the corporation to take suitable action before the action (Generally, a derivative suit can only be filed 90 days after written demand. But it may be initiated ahead of time if a) the corporation rejects the demand, or b) the corporation will suffer irreparable harm if they wait).

A suit should:

  • Not be a collusive one to confer jurisdiction on a court of the U.S. which it would not otherwise have, and
  • Have a complaint that alleges with particularity any efforts made by the plaintiff to obtain the desired action from the directors or members and give reasons for “the plaintiff's failure to obtain the action or for not making the effort.” See Federal Rules of Civil Procedure Rule 23.1.

For LLC, all elements required are the same as above, but;

  • The action may be brought within a reasonable time after the demand instead of 90 days, and 
  • The demand requirement may be waived if the demand is deemed
  • futile. 
    • The demand should be made on the other members in a member-managed LLC. If it’s a manager-managed LLC, the demand is made to managers. 

Dismissal or compromise of derivative proceeding:

A derivative proceeding should be dismissed if most of the qualified directors, who do not have material interests in the derivative suit, have determined in good faith after conducting a reasonable inquiry that the derivative proceeding is not in the best interests of the corporation. The dismissal is made by the court on motion by the corporation. Without the approval of the court, the suit will not be compromised or dismissed. Once dismissed or compromised, a notice should be given to shareholders as the court directs.

[Last updated in June of 2022 by the Wex Definitions Team]