Legal Definitions - derivative action

A derivative action is a type of lawsuit initiated by a shareholder on behalf of a corporation, rather than for the shareholder's personal benefit. This legal action is typically brought when the corporation itself has suffered a wrong or harm, but its board of directors or management has failed or refused to take appropriate legal steps to address it. Essentially, the shareholder steps in to compel the corporation to enforce a right or claim that belongs to the corporation, often against its own directors, officers, or a third party who has caused the company harm. If the lawsuit is successful, any damages or recovery awarded go directly to the corporation, thereby benefiting all shareholders indirectly by increasing the company's value.

• Example 1: Mismanagement and Self-Dealing by Directors

  Imagine a publicly traded technology company, "InnovateTech Inc." Its board of directors approves a deal to sell a valuable patent to a new startup, "FutureSolutions LLC," for a price significantly below market value. It is later discovered that several InnovateTech directors secretly own substantial shares in FutureSolutions LLC, creating a clear conflict of interest. The board, naturally, refuses to sue FutureSolutions LLC or its own directors for this potentially fraudulent transaction that cost InnovateTech millions. A group of concerned InnovateTech shareholders could then initiate a derivative action on behalf of InnovateTech Inc. to challenge the patent sale and seek damages from the directors involved or FutureSolutions LLC. The goal would be to recover the lost value for InnovateTech, not for the individual shareholders directly.

• Example 2: Failure to Pursue a Breach of Contract Claim

  Consider "Global Logistics Corp.," a shipping company that entered into a major contract with a software vendor, "RouteFinder Inc.," to develop a new logistics management system. RouteFinder Inc. failed to deliver the software on time and according to specifications, causing Global Logistics Corp. significant financial losses and reputational damage. Despite clear evidence of breach of contract, Global Logistics's CEO, who has a close personal friendship with RouteFinder's CEO, convinces the board not to sue RouteFinder Inc. A minority shareholder of Global Logistics Corp., seeing the company suffer, could file a derivative action against RouteFinder Inc. (and potentially against Global Logistics's board for failing in their duty) to recover the damages Global Logistics Corp. incurred. Any compensation won would go into Global Logistics Corp.'s coffers.

• Example 3: Negligence Leading to Environmental Fines

  Suppose "CleanEnergy Corp.," a renewable energy company, operates a processing plant that, due to years of neglected maintenance and ignored safety warnings by its management, causes a significant environmental spill. This spill results in millions of dollars in fines from regulatory bodies and substantial cleanup costs for CleanEnergy Corp. The board of directors, wanting to avoid negative publicity and protect the executives responsible, decides not to pursue legal action against the negligent executives or the third-party contractor whose faulty equipment contributed to the spill. A shareholder, concerned about the company's financial health and reputation, could file a derivative action on behalf of CleanEnergy Corp. to hold the responsible executives accountable and recover the costs of the fines and cleanup for the company.