Derivative suit

A shareholder derivative suit is a lawsuit brought by a shareholder on behalf of a corporation against a third party. Often, the third party is an insider of the corporation, such as an executive officer or director. Shareholder derivative suits are unique because under traditional corporate law, management is responsible for bringing and defending the corporation against suit. Shareholder derivative suits permit a shareholder to initiate a suit when management has failed to do so. Because derivative suits vary the traditional roles of management and shareholders, many jurisdictions have implemented various procedural requirements to derivative suits.

Purpose and difficulties

Under traditional corporate business law, shareholders are the owners of a corporation. However, they are not empowered to control the day-to-day operations of the corporation. Instead, shareholders appoint directors, and the directors in turn appoint officers or executives to manage day-to-day operations.

Derivative suits permit a shareholder to bring an action in the name of the corporation against parties allegedly causing harm to the corporation. If the directors, officers, or employees of the corporation are not willing to file an action, a shareholder may first petition them to proceed. If such petition fails, the shareholder may take it upon himself to bring an action on behalf of the corporation. Any proceeds of a successful action are awarded to the corporation and not to the individual shareholders that initiate the action.

In recent years, “appraisal arbitrage” has developed as a form of shareholder litigation. Popular among hedge funds seeking to take advantage of favorable case law on valuation, such arbitrageurs buy shares in the target company of a transaction about to close and file suit claiming that the fair value of the company is higher than the ultimate price paid by the acquirer in the acquisition. The financial incentive is cashing in on a higher court-determined price plus default interest at 5% above the Federal Reserve discount rate, compounded quarterly.^[1]

Procedure

In most jurisdictions, a shareholder must satisfy various requirements to prove that he has a valid standing before being allowed to proceed. The law may require the shareholder to meet qualifications such as the minimum value of the shares and the duration of the holding by the shareholder; to first make a demand on the corporate board to take action; or to post bond, or other fees in the event that he does not prevail.

Derivative suits in the United States

In the United States, corporate law is based on state law. Although the laws of each state differ, the laws of the states such as Delaware, New York, and California, Nevada where corporations often incorporate, institute a number of barriers to derivative suits.

Generally in these states, and under the American Bar Association guidelines, the procedure of a derivative suit is as follows. First, eligible shareholders must file a demand on the board.^[2] The board may either reject, accept, or not act upon the demand. If after a period of time, days the demand has been rejected or has not been acted upon, shareholders may file suit.^[3] If the board accepts the demand, the corporation itself will file the suit. If rejected, or not acted upon, the shareholder must meet additional pleading requirements.^[4] On the requirements being met by the shareholder, the board may appoint a “special litigation committee” which may move to dismiss.^[4] If the special litigation committee makes a required showing, the case will be dismissed. If the committee fails to make a showing, the shareholder suit may proceed.^[5]

This model approach is followed to a greater or lessor degree among various states. In New York, for example, derivative suits must be brought to secure a judgment "in [the corporation's] favor."^[6] Delaware has different rules in regards to demand and bond requirements too.

The famous case of Shaffer v. Heitner, which ultimately reached the United States Supreme Court, originated with a shareholder derivative suit against Greyhound Lines.

Derivative suits in the United Kingdom

In the United Kingdom, an action brought by a minority shareholder may not be upheld under the doctrine set out in Foss v Harbottle in 1843. Exceptions to the doctrine involve ultra vires and the "fraud on minority". According to Blair and Stout's "Team Production Theory of Corporate Law", the purpose of the suit is not to protect the shareholders, but to protect the corporation itself. Creditors, rather than shareholders, may bring an action, if a corporation faces insolvency.

The Companies Act 2006 provided a new procedure, but it did not reformulate the rule in Foss v Harbottle.^[7] In England and Wales, the procedure slightly modified the pre-existing rules, and provided for a new preliminary stage at which a prima facie’’ case must be shown. In Scotland where there had been no clear rules on shareholder actions on behalf of the company, the Act sought to achieve a result similar to that in England and Wales.

• Roberts v Gill & Co Solicitors [2010] UKSC 22

Derivative suits in continental Europe

Derivative shareholder suits are extremely rare in continental Europe. The reasons probably lie within laws that prevent small shareholders from bringing lawsuits in the first place. Many European countries have company acts that legally require a minimum share in order to bring a derivative suit. Larger shareholders could bring lawsuits, however, their incentives are rather to settle the claims with the management, sometimes to the detriment of the small shareholders.^[8][9]

Derivative suits in New Zealand

In New Zealand these can be brought under the Companies Act 1993 section 165 only with the leave of the court. It must be in the best interest of the company to have this action brought so benefits to company must outweigh the costs of taking action.

Derivative suits in India

In India, derivative suits are brought under the clauses of oppression and mismanagement.

See also

• Business judgment rule

References