Derivative Lawsuits: What Directors, Officers and Shareholders Need to Know

by: Carl J. Calnero and Martin N. Jensen

These are challenging economic times for many businesses.  A climate such as this one can result in actions against individuals who manage and/or direct corporations, limited liability companies or other types of business associations. Whether we are talking about a moderately sized real estate investment venture, a large multi-national corporation, or a family venture, many such associations have been involved in litigation in the past few years.

Lawsuits take on particular significance when a corporation is involved. Shareholder derivative lawsuits provide legal insurance for minority interests to safeguard against abuse and/or incompetence – but such lawsuits are not without their quirks.  Whether you are considering filing a shareholder derivative lawsuit or you are defending against one, the following are a number of worthy considerations.

Is the Claim Truly Derivative?
There are two broad types of lawsuits that shareholders can file when there has been an injury: a direct lawsuit or a derivative lawsuit.  Whether a claim is truly derivative or is instead an individual claim may impact a variety of litigation components.

A direct or individual lawsuit is one that has been brought to remedy harm done to an individual shareholder.  Any damages recovered are given to the individual shareholder who filed the lawsuit, not to the company or the shareholders in general.  By contrast, a derivative lawsuit is brought on behalf of the corporation for injuries to the entire entity, usually by shareholders or by directors acting at the behest of the general shareholders.  This type of lawsuit usually arises out of a breach of a fiduciary duty.  In effect, the party filing the suit claims to be acting on behalf of the corporation because the directors and management failed to exercise their authority for the benefit of the company and all of its shareholders.  We see this type of suit most often in situations where there is fraud, mismanagement, self-dealing and/or dishonesty which are engaged in or ignored by officers or directors.

A key case in California is Nelson v. Anderson (1999) 72 Cal.App.4th 111.  In that case, the plaintiff was a minority shareholder who sued for individual recovery, as opposed to corporate recovery.  The court was asked to determine whether Nelson had standing to assert an individual claim.  The test developed by the court is to look to the type of harm allegedly suffered.  In other words, it is the nature of the “wrong,” not the resulting injury that determines the nature of the lawsuit. The claimant must establish the right to recover independent of his status as a shareholder; otherwise the claim is usually deemed to be a corporate or a derivative action.

Is a Bond Needed?
Bonds are not required to be posted in individual actions.  However, when a court has deemed a lawsuit to be truly derivative, the corporation may ask the court to order the plaintiff to post a bond.  The purpose of posting a bond is to ensure that corporate resources are not unnecessarily wasted by having to defend a lawsuit, including hiring attorneys to represent its executives. The requirement for posting a bond protects against “litigation terrorism,” where corporations are threatened with having to defend meritless cases rather than capitulate to the demands of minority shareholders with contrary views regarding management.  In many cases, the requirement of posting a bond may deter the filing of suit at the outset.

Can One Attorney Represent Both the Corporation and its Executives?
Attorneys are required to comply with ethical obligations relating to representation of clients.  While the California Rules of Professional Conduct permit an attorney representing a corporation to “also represent any of the corporation’s directors, officers, employees, etc.,” there are certain limitations.  An attorney cannot jointly represent clients whose interests may, or do, conflict. When an executive is accused of fraud or theft, it would be virtually impossible for one attorney to jointly represent that person and the corporation.  There are strict requirements pertaining to joint representation, including having the attorney obtain informed written consent of the subject parties.

What Other Requirements Apply to Derivative Lawsuits?
The law imposes specific requirements for derivative suits that are not present in other types of litigation.   For example, before minority shareholders can file suit, they typically must make a demand on the board of directors to take on their claim in litigation. The law also requires that the complaint in a derivative suit be verified, which means it must be signed under oath by the suing party or its representative.  This may deter frivolous claims.

Derivative lawsuits pose different and unique requirements than other types of business litigation.  Porter Scott attorneys are well versed in corporate and partnership litigation. The firm can provide exceptional counsel in prosecuting or defending these types of claims.