Definition
Derivative Action is a legal remedy that allows a shareholder to sue on behalf of a corporation. This type of lawsuit is brought forward when the corporation itself fails, deliberately or otherwise, to enforce its rights. The shareholder steps into the shoes of the corporation to protect the corporation and its shareholders from harm caused by a third party, often a director or officer of the corporation, who has failed in their fiduciary duties.
Examples
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Breach of Fiduciary Duty: A company’s directors engage in self-dealing by entering into lucrative contracts with businesses they own without disclosing the interests to the corporation.
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Mismanagement: The executives in a corporation make poor decisions that result in significant financial losses, and the corporation’s board refuses to take action against them.
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Fraud: A CEO falsifies financial documents to present a better picture of the company’s financial health. When this falsification is discovered, and the corporation does not pursue legal actions, a shareholder may initiate a derivative action.
Frequently Asked Questions
What is the purpose of a derivative action?
The primary purpose is to protect the corporation and its shareholders from harm when the corporation’s management fails to act. It ensures that the corporation can seek redress for wrongs committed against it.
Who can bring a derivative action?
Generally, any shareholder with sufficient standing can bring a derivative action. This means the shareholder must have been a shareholder at the time of the alleged wrongdoing and must fairly and adequately represent the interests of the corporation.
What are the procedural requirements for initiating a derivative action?
The shareholder must first make a demand on the corporation’s board of directors to address the issue unless such a demand is deemed futile. If the board refuses, or if a demand is not required, the shareholder can file the derivative lawsuit in court.
Can shareholders benefit personally from a derivative action?
No, any recovery from a derivative action goes to the corporation, not to the individual shareholder who brought the suit. However, the shareholder may be entitled to reimbursement for legal fees.
How is a derivative action different from a direct lawsuit?
A derivative action is on behalf of the corporation for harm done to the corporation, while a direct lawsuit is initiated by shareholders for harm done directly to them.
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Fiduciary Duty: The legal obligation of one party to act in the best interest of another. In corporate settings, this duty involves the directors and officers acting in the best interest of the corporation and its shareholders.
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Shareholder Rights: The rights held by individuals or entities that own shares in a corporation, which include voting rights, dividends, and access to important company information.
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Corporate Governance: The mechanisms, processes, and relations used to control and to direct corporations, typically involving the board of directors, managers, shareholders, and other stakeholders.
Online References
- Cornell Law School - Legal Information Institute: Derivative Action
- Investopedia: Derivative Suit
- American Bar Association - Derivative Lawsuits: By the Shareholders, for the Corporation
Suggested Books for Further Studies
- “Smith and Roberson’s Business Law” by Richard A. Mann and Barry S. Roberts
- “Corporate Law and Governance” by Jeffrey N. Gordon and Wolf-Georg Ringe
- “Principles of Corporate Governance” by Donald Nordberg
Fundamentals of Derivative Actions: Business Law Basics Quiz
### What is a derivative action primarily intended to address?
- [ ] Personal grievances of shareholders.
- [x] Harm done to the corporation when management fails to act.
- [ ] Regulatory compliance issues.
- [ ] Expansion of shareholder rights.
> **Explanation:** A derivative action is intended to allow shareholders to sue on behalf of the corporation to address harm done to it, typically due to management's failure to enforce corporate rights.
### Who typically brings a derivative action?
- [ ] Corporate executives.
- [x] Shareholders.
- [ ] Board of directors.
- [ ] Government regulators.
> **Explanation:** Shareholders bring derivative actions on behalf of the corporation when they believe that the management has failed to address wrongs committed against the corporation.
### Before initiating a derivative action, what must a shareholder typically do?
- [ ] Resign from their position.
- [ ] Seek approval from the CEO.
- [x] Make a demand on the corporation's board of directors.
- [ ] Obtain a court order.
> **Explanation:** Shareholders are typically required to first make a demand on the board of directors to take action unless doing so is deemed futile.
### Who benefits directly from a derivative action?
- [ ] Shareholder who brings the suit.
- [x] The corporation itself.
- [ ] Other investors.
- [ ] Corporate executives.
> **Explanation:** The outcome of a derivative action benefits the corporation as any recoveries or remedies go to the corporate entity, not to the individual shareholder.
### In a derivative action, the shareholder is acting on behalf of:
- [ ] Themselves.
- [ ] The board of directors.
- [x] The corporation.
- [ ] The government.
> **Explanation:** The shareholder is acting on behalf of the corporation to address damages that management has failed to rectify.
### Which of the following is NOT a typical reason for a derivative action?
- [ ] Mismanagement.
- [ ] Fraud.
- [ ] Breach of fiduciary duty.
- [x] Decline in stock price due to market conditions.
> **Explanation:** Typical reasons for a derivative action include mismanagement, fraud, and breach of fiduciary duty. A decline in stock price due to market conditions would not generally be a basis for such a suit.
### How are legal fees handled in a derivative action?
- [ ] They are paid by individual shareholders.
- [ ] The corporation reimburses the shareholder if the case is successful.
- [x] Reimbursement for legal fees can be awarded to the shareholder if the case is successful.
- [ ] The fees are derived from the corporate profits.
> **Explanation:** If the shareholder who brings the derivative action prevails, they may be entitled to reimbursement for legal fees from the corporation.
### What constitutes a successful derivative action?
- [ ] Personal compensation to the shareholder.
- [x] A legal remedy or financial recovery for the corporation.
- [ ] Dismissing the current CEO.
- [ ] Introducing new corporate policies.
> **Explanation:** A successful derivative action results in a legal remedy or financial recovery that benefits the corporation.
### What must a shareholder demonstrate to gain standing in a derivative action?
- [ ] Ownership of the majority shares.
- [x] They were shareholders at the time of the alleged wrongdoing.
- [ ] Direct financial loss.
- [ ] Support from other shareholders.
> **Explanation:** The shareholder must demonstrate that they were shareholders at the time of the alleged wrongdoing to have standing for a derivative action.
### What is one main difference between a derivative action and a direct lawsuit?
- [x] A derivative action is on behalf of the corporation, while a direct lawsuit addresses personal grievances of shareholders.
- [ ] A derivative action can only be filed by executives.
- [ ] A direct lawsuit does not involve legal fees.
- [ ] A derivative action results in personal compensation.
> **Explanation:** A derivative action seeks to address wrongs done to the corporation for its benefit, whereas a direct lawsuit seeks to address personal grievances of shareholders.
Thank you for exploring the complexities of derivative actions and testing your knowledge with our quiz. Take charge of your corporate governance understanding!
