Derivative Actions: What They Are and Who Can Bring Them

Shareholders as the Foundation of a Corporation

Shareholders are individuals who own a part of a company through their purchase and ownership of shares of that company. Shares represent ownership of a company:  When one purchasers shares in a company, he or she becomes one of its owners. Shareholders are, in essence, the life of a company: They provide support through their investments and act as owners of a corporation. They are involved in making important decisions, in electing board members and in company actions. Simply put: Shareholders play a vital role in the establishment and success of any company.

Shareholder investments are directly impacted by decisions that officers and executives of their corporation make. Because of this, the corporation’s actions officers and directors of a company owe a duty of loyalty to its shareholders. Under this fiduciary duty, they are expected to act in the best interests of shareholders above their own personal interests and other business interests. When directors, executives, and board members abuse their positions of power and fail to act in the interests of the corporation and its shareholders, the company and the shareholders are often harmed.

Derivative Actions: The Legal Remedy for Corporate Wrongdoing

A derivative action is a lawsuit brought by a shareholder on behalf of a corporation against a third party. This third party is usually a corporate insider, such as an executive officer, director, or board member. Shareholder suits provide a remedy to injured shareholders and are quite unique: under corporate law, management and leaders are responsible for bringing and defending their corporation against lawsuits. In a derivative action, shareholders take on this role of standing up for the company to obtain damages for legal wrongdoings within the corporation when managerial powers have failed to do so.

The Process and Requirements

Although individual jurisdictions may have slight differences in their procedures, the general procedure of a derivative suit goes something like this: first, the hopeful filing shareholder(s) must be “eligible.” This eligibility requirement is in place to establish that the shareholder(s) has/have standing to bring the suit. Among these requirements are minimum share values and duration of share possession. Additionally, only current shareholders can bring derivative action claims and must continue to hold their shares for the duration of the lawsuit. If a shareholder has sold the shares, he or she will not be eligible to bring a claim. Once the eligibility requirements be met, eligible shareholders must file a demand on the board. This is commonly known as the “demand requirement.” The board may then choose to reject, accept, or not act on the demand. If the board accepts the demand, the corporation will file the suit itself. If the demand has been rejected or not acted upon after some time, shareholders may file suit, launching a derivative action. In response, the board may appoint a special litigation committee that may move to dismiss and if this committee makes a required showing, the case will be dismissed. If the committee fails to make this showing, the shareholder suit may continue. While this is the standard procedure, this approach is followed to different degrees depending on the state.

Behaviors Warranting a Derivative Action

There are many actions that can give rise to a derivative suit, most of which involve fraudulent and deceitful behaviors and actions taken by corporate insiders. Some examples of the types of actions and behaviors that can result in the filing of a shareholder derivative action include the following:

• Breach of Fiduciary Duty by an Executive, Manager, or Board Member: when corporate insiders act in their own interests rather than acting in the best interests of the company and its shareholders, they breach their duty of loyalty.
• Conflicts of Interest: a conflict of interest occurs when an insider may benefit financially from a decision that he or she could make in their individual capacity as an insider. Conflicts of interest are discouraged because they are essentially self-interested transactions that benefit the insider and provide incentives to act in their own interests rather than the corporation’s.
• Backdating of Stock Options: backdating is a practice where a firm issues stock options to employees and uses an earlier date than the actual issue date in order to fix a lower exercise price, thus making the options more valuable. Backdating is considered to be an unethical practice and is subject to regulatory and legal enforcement since the passing of the Sarbanes-Oakley Act of 2002.[1] Further, in Ryan v. Gifford, 918 A.2d 341 (Del. Ch. 2007), the court held that deliberately backdating stocks in violation of the corporation’s approved stock option plan was an act of bad faith.
• Corporate Waste: corporate waste involves transactions in which the assets that the corporation acquires are so proportionally small that no reasonable business person would conclude that the corporation received adequate consideration in the transaction. For example, corporate waste was found where a corporation, Argo Group International Holding, failed to disclose benefits and unnecessary perks that were given to its former CEO.[2] The allegations included personal use of corporate jets, transportation for family members, club memberships, and luxury lodging adding up to $5.3 million over a course of four years-all on corporate dollar. The corporation was forced to pay out $900,000 to the Securities and Exchange Commission as a result. Another example of corporate waste of funds is found in Feuer ex rel. CBS Corp. v. Redstone, No. CV 12575-CB, 2018 WL 1870074, at *12 (Del. Ch. Apr. 19, 2018). CBS approved over a $13 million compensation to its former chairman despite the fact that he was no longer meaningfully contributing to the company. The court found that the former chairman was far from being “actively engaged” in the corporation’s business affairs and was providing no meaningful services to the company when most of the $13 million went towards his performance bonuses.
• Insider Trading: insider trading involves trade in a public company’s stock by an individual who has non-public, material information about that stock. Individuals with knowledge of material inside information have two options: they must either disclose this information to the public or refrain from trading the stock until the information is widely disseminated.[3] Trading when the material information is still non-public is illegal and carries harsh consequences.
• Insider Failure to Exercise Oversight: A defendant corporation can be held liable for an insider’s “sustained and systematic failure to exercise oversight.”[4] The fiduciary duty of a director, executive, or board includes a duty to attempt to monitor and assure that an adequate corporate information and reporting system exists to protect the corporation and its shareholders. These types of derivative actions are often called “Caremark ” To show a breach of duty for failure to monitor, a shareholder plaintiff must show that directors knew or should have known that violations of law were occurring, that directors too no steps in good faith to prevent or remedy the situation, and that the failure resulted in the loss complained of. A notable yet tragic case where a defendant corporation as held liable for a failure to monitor was In re Massey Energy Co., 2011 WL 2176479 (Del. Ch. May 31, 2011). In that case, a mine owned by corporate defendant Massey Energy Company exploded and caused the death of many miners. The board disregarded safety violations and criminal charges against it and failed to impose greater oversight. The court followed the Caremark standard and held the defendant liable because it actively, consciously, and knowingly failed to act and exercise oversight, which could have prevented the explosion.

Why are Derivative Suits Important to you as a Shareholder?

Derivative suits are important to not only seek remedies and compensation for shareholders for wrongs already committed, but to also prevent any future wrongdoings on behalf of the corporation. Atara and Twersky Law Group hold corporations and their insiders responsible for any value lost to shareholders and recover funds on behalf of the company while also demanding reform to deter future misconduct. If you’re a shareholder of a company and you believe the company lost value due to wrongful conduct of its officers or director, please contact please contact Atara Twersky: atwersky@aftlaw.com.