Derivative lawsuits can pose a serious challenge to mid-sized companies. These actions are not brought by a corporation itself but by one or more shareholders on the corporation’s behalf. Typically, they arise when shareholders believe that the company in question has been harmed by the actions—or inaction—of its officers, directors or other key decision-makers.
At the heart of a shareholder derivative lawsuit is a claim that those in control of the company breached their fiduciary duties. These duties include the duty of care—acting prudently and responsibly—and the duty of loyalty—placing the company’s interests above personal gain. A derivative claim might allege self-dealing, waste of corporate assets, fraudulent practices or a failure to act on clear misconduct.
How the process tends to unfold
For shareholders, a derivative suit is a tool to hold insiders accountable when the board fails to act. Plaintiffs must prove that the misconduct at issue harmed the company and that the board’s failure to address it directly contributed to that harm. Because any recovery goes to the corporation—not to the shareholders personally—these cases are often driven by a desire to improve corporate governance rather than seek direct financial gain.
For corporate boards, the first sign of a potential derivative action is, usually, a shareholder demand. This is a formal request asking the board to investigate and pursue a claim against an insider. In many jurisdictions, including in federal and state courts, courts expect shareholders to issue this demand before filing a suit—unless doing so would be futile because the board is too conflicted to act impartially.
When a demand is received, the board must take it seriously. Forming a special litigation committee (SLC) composed of independent directors to investigate the allegations is often a prudent move. If the SLC determines that litigation is not in the company’s best interest, it must be able to show the court that the decision was well-reasoned and made in good faith. Otherwise, the lawsuit may proceed.
Mid-sized companies are particularly vulnerable to internal disputes that lead to derivative litigation. These businesses are often large enough to have complex management structures but small enough that relationships among insiders and shareholders are more personal and less formal. That dynamic can increase the risk of conflicts of interest and poor recordkeeping, both of which become problematic during litigation.
If your company is facing a potential derivative suit or you are a shareholder considering one, seeking legal counsel can help you understand your rights and options so that you can make informed decisions accordingly.