Legal Definitions - shareholder's derivative action

A shareholder's derivative action is a specific type of lawsuit brought by one or more shareholders on behalf of the corporation itself. This action is typically initiated when the corporation's directors, officers, or sometimes third parties have allegedly harmed the company through a breach of their legal duties, and the corporation's leadership has failed or refused to take action to address the harm.

The crucial aspect of a derivative action is that the injury suffered is by the corporation, not directly by the individual shareholder. Therefore, any financial recovery or judgment from the lawsuit goes directly to the corporation, not to the shareholders who brought the suit. The shareholders are essentially stepping in to protect the company's interests when those entrusted with that responsibility (like the board of directors) have failed to do so.

Before filing a derivative action, shareholders generally must first formally demand that the corporation's board of directors take appropriate action. If the board refuses, fails to respond, or if making such a demand would clearly be pointless (known as "futility"), then the shareholders may proceed with the lawsuit.

Examples:

• Mismanagement of Corporate Funds:

  Imagine a publicly traded technology company, "InnovateTech Inc.," whose CEO and CFO are discovered to have used company funds to purchase luxury personal items and make questionable investments in shell companies they secretly own. This misuse of funds causes significant financial losses for InnovateTech Inc. The board of directors, some of whom are close allies of the CEO, decides not to pursue legal action against the CEO and CFO to recover the stolen money, fearing negative publicity or internal conflict.

  How it illustrates the term: A group of InnovateTech shareholders, seeing the corporation's assets being depleted and the board failing to act, could initiate a shareholder's derivative action. They would sue the CEO and CFO on behalf of InnovateTech Inc. The lawsuit's goal would be to recover the misused funds and return them to the corporation, not to the individual shareholders. The shareholders are acting as fiduciaries for the company's well-being because the company's official leadership has neglected its duty.

• Breach of Fiduciary Duty in a Merger:

  "Global Energy Corp." is considering a merger with a smaller competitor, "Renewable Solutions." The board of directors of Global Energy, influenced by personal relationships and potential future board positions at Renewable Solutions, approves a merger agreement that significantly overvalues Renewable Solutions, effectively paying far more than it's worth and causing a substantial financial detriment to Global Energy. Several independent financial analysts confirm that the deal is highly unfavorable for Global Energy. Despite this, the board pushes the merger through and refuses to reconsider or challenge the terms.

  How it illustrates the term: Here, the board members of Global Energy are accused of breaching their fiduciary duty to act in the best interest of Global Energy. Shareholders of Global Energy could file a derivative action against these board members. The lawsuit would seek to prevent the damaging merger or recover the financial losses incurred by Global Energy due to the board's poor decision-making. The shareholders are stepping in to protect the corporation from its own board's actions, and any successful outcome would benefit Global Energy as a whole.

• Failure to Address Systemic Compliance Issues:

  "SecureBank Inc.," a large financial institution, faces repeated fines and regulatory scrutiny due to persistent failures in its anti-money laundering (AML) compliance systems. Despite warnings from regulators and internal auditors, the board of directors consistently defers significant investments in upgrading these systems, prioritizing short-term profit targets over robust compliance. This inaction exposes SecureBank Inc. to massive future penalties, operational restrictions, and severe reputational damage, which could significantly impact its long-term viability.

  How it illustrates the term: Concerned shareholders of SecureBank Inc. could bring a derivative action against the board of directors. They would argue that the board's deliberate failure to address critical compliance issues constitutes a breach of their duty to manage the company responsibly, putting the corporation at significant risk. The lawsuit would aim to compel the board to implement necessary compliance upgrades and potentially recover any losses already suffered by the corporation due to the board's inaction, with all recovered funds benefiting SecureBank Inc.