A derivative suit is a type of lawsuit initiated by shareholders on behalf of the corporation against third parties, often including its own executives or directors, for actions that harm the corporation. Unlike direct suits by shareholders which seek to address personal grievances or losses, derivative suits are intended to vindicate the rights of the corporation itself and recover damages on its behalf.
Legal Foundations and Importance
Derivative suits play a crucial role in ensuring corporate accountability and governance. They enable shareholders to hold management accountable when it acts against the corporation’s best interests, thus acting as a regulatory mechanism for corporate conduct.
Detailed Definition
A derivative suit is typically brought under the following conditions:
- Wrongdoing: Actions by executives, directors, or third parties that have harmed the corporation.
- Demand Requirement: Shareholders must first demand that the corporation’s board of directors address the alleged wrongdoing. If the board fails to act, the shareholders may proceed with the lawsuit.
- Standing: Only shareholders who were affected by the wrongdoing (i.e., those holding shares during the event in question) can file a derivative suit.
Historical Context
The concept of the derivative suit has its origins in English common law and has evolved significantly over time. In the United States, landmark cases such as Cohen v. Beneficial Industrial Loan Corp. (1949) and Zapanta v. Universal Savings Bank (1986) have shaped the current legal framework, balancing the rights of shareholders with the need to protect corporations from frivolous lawsuits.
Process of Filing a Derivative Suit
- Pre-Litigation Demand: Shareholders must submit a formal demand to the board of directors asking them to remedy the alleged harm.
- Board Investigation: The board is obliged to investigate the claims. If they find merit, they may choose to take action. If they decline, shareholders may proceed with the lawsuit.
- Court Approval: The court must determine whether the shareholders have standing and whether the board’s refusal to act was in bad faith.
- Litigation: If approved, the case proceeds, with potential outcomes including monetary damages, injunctive relief, or changes in corporate governance practices.
Real-World Examples
- Enron Corporation: Shareholders filed derivative suits against the company’s executives for fraudulent financial practices that led to significant losses.
- Walt Disney Company: A notable derivative suit was filed regarding the hiring and firing of Michael Ovitz, the company’s president, which resulted in substantial financial loss.
Comparisons and Related Terms
- Direct Suit: Unlike derivative suits, direct suits are filed by shareholders for personal damages rather than on behalf of the corporation.
- Class Action Suit: A lawsuit filed by a group of shareholders collectively addressing common grievances, which can be either direct or derivative in nature.
FAQs
What differentiates a derivative suit from a direct suit?
What are the typical outcomes of a derivative suit?
Is court approval necessary to pursue a derivative suit?
References
- Kraakman, R., Hansmann, H., & Kahan, M. (2009). “The Anatomy of Corporate Law: A Comparative and Functional Approach”. Oxford University Press.
- Bainbridge, S. M. (2006). “Corporation Law and Economics”. Foundation Press.
- “Cohen v. Beneficial Industrial Loan Corp., 337 U.S. 541 (1949)”.
Summary
A derivative suit is a powerful tool empowering shareholders to protect the interests of the corporation by holding its executives and third parties accountable for any wrongdoing. By demanding corporate accountability, derivative suits underpin the structure of corporate governance and ensure that management acts in the best interest of the corporation at all times.
