Shareholders in corporations play a powerful role in governing those corporations. Shareholders, by virtue, own a portion or “share” of the company, and by owning these shares, they hold the power to bring claims against the company. The two main types of claims shareholders can bring against a company are direct claims and derivative claims.
Direct Actions by Shareholders
The central inquiry in determining whether a claim is direct or derivative is whether the complained-of injury was an injury to the individual shareholder directly, or to the entity as a whole.[1] A direct claim seeks redress for harm to that particular individual and not as a consequence of damage to the entity that the individual holds an ownership interest in.[2] Further, direct claims are based on legal rights that belong to the individual shareholder. A shareholder may directly sue the corporation, an officer, or director if one of these individuals takes actions that result in direct harm to the shareholder. While seemingly straightforward, direct claims are rarer than derivative action because it is often difficult for a shareholder to demonstrate that she has suffered a specific harm as a result of actions by the officers or directors.[3]
Thus, direct claims are more often used by shareholders in small corporations, particularly with minority shareholders who are alleging unfair treatment at the hands of the majority shareholders.[4] In those situations, the individual shareholder is seeking redress of wrongs committed by the corporation’s board or other shareholders that directly affect the individual shareholder.[5] Other typical causes of action that can be brought through direct action are fraud, conspiracy, and breach of statutory duties.
Shareholder Derivative Suits
In comparison to a direct claim, a derivative action belongs to the corporation, not the shareholder. However, because an entity cannot by law act for itself, a shareholder essentially steps into the shoes of the corporation and seeks redress on behalf of the company.[6] Generally, the plaintiff must be a legal or beneficial owner of stock security, or other equity. Furthermore, options, warrants, or other rights to purchase or receive stock typically do not confer standing to bring a derivative action.
As a representative of the company, derivative actions allow the individual shareholder to bring suit against wrongdoers on behalf of the entity and to force liable parties to compensate the entity for injuries so caused.[7] Thus, while the shareholder is the named plaintiff in a derivative action and the corporation is named as a nominal defendant, the corporation is the true plaintiff, and the shareholder as the representative of the plaintiff owes fiduciary duties to the corporation and to the shareholders collectively in conducting the lawsuit.
As such, derivative actions provide shareholders an opportunity to prevent abuses of power by those in charge of the entity. Typical derivative suits allege improper actions by those in charge of the entity including, self-dealing, breach of fiduciary duties, unjust enrichment, insider training, false or misleading financial statements, corporate waste, and fraud. Moreover, it is important to note that derivative suits proceed differently depending on the state of incorporation and whether suit is brought in state or federal court.[8] For example, the jurisdiction of incorporation sets the requirements for how long the shareholder bringing suit must have owned shares and the minimum value of those shares.
It is important to be aware of the types of actions available for shareholders to redress harms done by a corporation. For more information on the topics covered here today, or for services related to your specific situation, contact our knowledgeable corporate governance attorneys at (646) 766-8308 or email info@kilegal.com to get the help you need.
[1] https://bc-llp.com/shareholder-derivative-action/
[2] https://tremblylaw.com/difference-shareholder-derivative-suit-vs-direct-claim/
[3] Id.
[4] Id.
[5] https://thebusinessprofessor.com/en_US/business-governance/shareholder-direct-and-derivative-actions
[6] Id.
[7] https://www.law.cornell.edu/wex/shareholder_derivative_suit
[8] Id.
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