What Is a Derivative Action?

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A shareholder owns pieces -- or shares -- of a corporation, but a board of directors elected by the shareholders conducts the corporation's business. A derivative action is a lawsuit brought by a shareholder on behalf of the corporation against a third party that has harmed the corporation. Typically, this third party is a director who has lost the corporation's money due to mismanagement. The derivative action allows a shareholder, as a partial owner of the corporation, to enforce the rights of the corporation and allows the corporation to recover funds lost by abuse or mismanagement.

State Law Governs Derivative Lawsuits

  • Derivative actions are governed by varying state laws, but many aspects of these lawsuits remain constant across the country. Generally, once a shareholder has filed a derivative action, he must provide notice of the lawsuit to all other shareholders of the corporation and give them the opportunity to join the lawsuit. Only a shareholder can file a derivative action and many states require that the shareholder must have been a shareholder at the time the alleged mismanagement took place.

Board of Directors Gets a Chance to Act First

  • Before filing a derivative action, a shareholder must present his demands to the corporation's board of directors in the form of a pre-suit demand. The pre-suit demand gives the board of directors the option to bring the lawsuit on behalf of the corporation. If the board of directors refuses to file the lawsuit, then the shareholder can proceed with the derivative action. Because the directors are the usual target of derivative actions, several states waive the demand requirement if the demand would be futile due to the directors' interest in protecting themselves from the lawsuit.

Lawsuit Follows When Board Fails to Act

  • In a typical derivative action, a shareholder first notices that the corporation is being mismanaged or abused in some way. For example, a shareholder may discover that directors of the corporation used the corporate jet for personal vacations without reporting the value of that trip as compensation. Because of the directors' abuse of the corporate jet, the corporation has incurred thousands of dollars in expenses. A shareholder can demand that the board of directors cease this activity. If the board of directors refuses to cease the improper use of the corporate jet, the shareholder can bring a derivative action on behalf of the corporation against the directors to recover the losses resulting from this abuse of company resources.

Corporation, Not Shareholder, Stands to Benefit

  • If the shareholder derivative action is not successful, everything at the corporation will remain as it was before the lawsuit. But if the shareholder wins the derivative action, the corporation may be awarded damages. The individual who initially filed the lawsuit does not recover damages because he filed on behalf of the corporation, not himself. However, if the shareholder is victorious, he will typically be compensated for the attorneys' fees and costs he incurred in bringing the lawsuit.

References

  • Photo Credit Patrick Ryan/Photodisc/Getty Images
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