Derivative actions are a type of legal mechanism where shareholders of a corporation initiate a lawsuit on behalf of the corporation. These actions are typically taken to address harm or injury done to the corporation, which indirectly affects shareholders by potentially diminishing the value of their shares. The primary aim is to rectify wrongs that management has failed to address, ensuring corporate management adheres to fiduciary duties and promoting overall corporate governance.
Historical Context
The concept of derivative actions originates from common law traditions and has evolved over centuries. Historically, courts recognized the potential for conflicts of interest where those in control of a corporation could fail to act against wrongdoings that they or their associates committed. To counterbalance this, derivative actions offered shareholders a legal avenue to hold management accountable and protect the corporation’s interests.
Purpose and Applicability
Protection of Shareholder Interests
While derivative actions are intended to redress harm to the corporation, the downstream effect is the protection of shareholder interests. By directly addressing harms inflicted on the corporation, the actions safeguard the value of shareholders’ holdings.
Corporate Governance
Derivative actions are also pivotal in enhancing corporate governance. They serve as a check on corporate officers and directors, ensuring they do not escape liability for breaches of fiduciary duties.
Fiduciary Duties
Corporate officers and directors owe fiduciary duties to the corporation, including duties of care, loyalty, and good faith. Derivative actions can be pursued when these fiduciary duties are breached, such as through self-dealing, fraud, or gross negligence.
Types of Derivative Actions
Common Law Derivative Actions
Common law derivative actions are derived from judicial precedents and are prominent in jurisdictions with a common law tradition. They are grounded in the principle that shareholders can seek redress for wrongs that harm the corporation.
Statutory Derivative Actions
In many jurisdictions, statutory frameworks supplement common law by providing specific rules and procedures for derivative actions. These statutes often outline the necessary steps shareholders must take before initiating a derivative lawsuit, such as making a demand on the board of directors to address the issue.
Special Considerations
Demand Requirement
Most jurisdictions require shareholders to make a demand on the corporation’s board of directors, requesting them to address the alleged wrong before filing a derivative lawsuit. This requirement respects the board’s managerial prerogative and gives the board a chance to rectify the issue internally.
Standing
Not all shareholders can bring a derivative action. Typically, the plaintiff must have been a shareholder at the time of the alleged wrongdoing and must continue to be a shareholder throughout the litigation process.
Court Approval
Derivative actions often require court approval for settlement or dismissal, ensuring that any resolution is in the best interest of the corporation and its shareholders.
Examples
Case Study: Smith v. Brown Corp.
In the case of Smith v. Brown Corp., a shareholder filed a derivative action alleging that the company’s directors engaged in self-dealing and breached their fiduciary duties. The court ultimately ruled in favor of the shareholder, consequently mandating the directors to compensate the corporation and establishing stricter governance policies to prevent future breaches.
Comparison with Direct Actions
Direct Actions
Direct actions are lawsuits filed by shareholders to address harms done directly to them, rather than to the corporation. In contrast, derivative actions address harm to the corporation itself.
Legal Standing
While any shareholder may have standing to bring direct actions for personal harm, they must meet specific criteria to bring derivative actions, such as continuous ownership of shares.
Related Terms
- Fiduciary Duties: Legal obligations of officers and directors to act in the corporation’s best interest, encompassing duties of care, loyalty, and good faith.
- Shareholder Rights: Rights that protect the interests of shareholders, including the right to vote on major corporate decisions, receive dividends, and inspect corporate records.
- Corporate Governance: The framework of rules, practices, and processes by which a corporation is directed and controlled, focusing on the relationship between the corporation’s management, its board, shareholders, and other stakeholders.
FAQs
What is the primary aim of derivative actions?
Can any shareholder file a derivative action?
What are fiduciary duties?
How do courts ensure derivative actions are in the corporation’s best interest?
What is a demand requirement in derivative actions?
References
- “The Law of Corporations and Other Business Organizations,” by Angela Schneeman
- “Cases and Materials on Corporations,” by Robert W. Hamilton and Jonathan R. Macey
- “Corporate Governance: Board Duties and Liabilities,” by Paul P. Davies
Summary
Derivative actions are a crucial legal mechanism that enables shareholders to sue on behalf of the corporation, targeting wrongs indirectly affecting shareholder interests. By ensuring corporate management adheres to fiduciary duties and promoting better corporate governance, derivative actions safeguard the value of shareholders’ investments and foster a more accountable corporate environment. Understanding the nuances, requirements, and consequences of derivative actions is essential for legal practitioners, corporate officers, and shareholders alike.
