Derivative Lawsuits and the Closely Held Corporation

In general, shareholders are not permitted to sue corporations on their own behalf seeking damages for themselves. Instead, they are required to bring an action against wrongdoers (usually the officers and/or directors of the corporation) on behalf of the corporation in what is termed a “derivative” lawsuit. Where the corporation has a legal claim that the officers and/or directors refuse to prosecute on behalf of the corporation, the shareholders may do so derivatively. The damages recovered from a derivative lawsuit go to the corporation which in theory results in increasing share value. The idea of a derivative lawsuit may seem an oddity or even absurd to the average investor, especially shareholders in small closely held corporations where it’s officers or directors are stealing from the company.

944870_oak_tree.jpgThe public policy behind derivative actions is to protect corporations (especially publicly traded corporations) from the whims of fickle shareholders unhappy with share values. Even though it may be difficult for these fickle shareholders to win, the ability to bring actions without limitation can create significant waste. In essence, the goal is to reduce the number of frivolous suits and to encourage informal resolution, and there is a plethora of corporate law dictating the procedures necessary for bringing derivative actions. In general, derivative law requires shareholders to make a written demand on the corporate officers requesting that action be taken to investigate and if necessary file a lawsuit on the corporation’s behalf seeking to remedy the wrongs. This gives the corporation the opportunity to address the shareholders’ concerns in an effort to avoid costly litigation. The problem, especially for shareholders in smaller corporations, is that making written demands and allowing reasonable time for the corporation to act wastes important time especially if the officers and directors are all part of the problem. Nonetheless, where a derivative action is required, the demand is mandatory (except where the shareholders can show that due to the dominant control of the corporation by its officers, such demand would be futile). Pleading futility however requires more than simply naming all of the officers. The shareholders must be more specific. There are also potential bond requirements in derivative actions. If the corporation can show that there is no reasonable possibility that the lawsuit will benefit the corporation or its shareholders, the court may require the shareholders to post a bond up to $50,000. This can be prohibitory for many litigants. Moreover, because derivative actions are equitable actions, they are heard by judges and not juries. On the other hand, shareholders do benefit from derivative actions because they are able to recover attorney fees if they are ultimately found to be the prevailing party.

Derivative law for the most part isn’t necessarily ideal for small non-publicly traded or closely held corporations. This does not mean that shareholders in smaller corporations are without options. A shareholder may bring a direct action against an officer or director who committed fraud against the shareholder specifically – for instance, intentionally lying to the shareholder to induce him into purchasing shares knowing that the lies misled the purchaser regarding the true value of the company. Similarly, a shareholder may bring any other direct action against the corporation or its officers and directors where the injury is to the shareholder personally and not to the corporation. Stealing from the corporation, breaching fiduciary duties to the corporate shareholders and mismanaging corporate assets are all generally considered injuries to the corporation requiring a derivative action. As explained above, this matters because of the additional procedural hurdles required to pursue derivative actions.

The problem becomes more complicated for minority shareholders in smaller corporations where the injury to the corporation is effectively an injury to the minority shareholders.  Take for example a corporation that has four shareholders, two that actively manage the corporation as officers and two that take a more passive role.  If the two officers are also majority shareholders of the corporation with the voting power necessary to completely control the business of the corporation, there’s nothing the minority shareholders can do to effect a change.  In this narrow circumstance, some jurisdictions allow the minority shareholders to bring a direct action and circumvent the procedures necessary to bring a derivative action.  Essentially, it becomes a partnership dispute.  Currently, California law is unclear when it comes to a minority shareholder’s ability to file a direct action in such circumstances, and determining whether a direct action brought by a minority shareholder is permissible is a difficult task.  Making the wrong choice can have devastating consequences.  Failing to make a formal demand of the corporation based on the minority shareholder’s claim that that a direct action is permissible could lead to a dismissal with prejudice foreclosing the shareholders rights to do anything.  Doing so while the law is in flux comes with inherent risk. Finally, in some instances, a mixed derivative and direct action may be the right strategic approach.  

Litigation is risky in any context.  Bringing or defending a lawsuit in a derivative action adds a layer of complexity that requires considered analysis.  In such circumstances, consultation with an experienced San Diego corporate lawyer is best. 

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