Corporate litigation breaks down into two broad categories, direct and derivative (see below). Because of the procedural and other requirements surrounding the derivative action such as the need to post bond or to make a demand on th directors, plaintiffs tend to view derivative actinos as something to be avoided.
Exceptions[]
If corporate litigation is derivative, the plaintiff has a more challenging time pursuing the case because of procedural requirements, etc (see derivative requirements below). However, there are exceptions that allow what would otherwise be a derivative suit to be brought as a direct suit.
A growing number of jurisdictions permit actions that should be derivative claims to be prosecuted in a direct action if the corporation is closely held. The reasons are varied. With its procedural complexity, a derivative action is overkill in a close corporation. A widely accepted view of the close corporation perceives the participants as owing not just duties ot the corporation but to each other, akin to partners in a partnership. Shareholders are able to proceed directly against the shareholder-directors for violation of those duties. Last of all, the risk of a multiplicity of actions is much less in a corporation with three or four shareholders.
Direct[]
The action is direct in two scenarios; if
- 1) the shareholder alleges the corporation has denied them a contract right associated with shareholding such as rights to dividends or disclosure. That is, there is a special duty such as a contractual duty between the wrongdoer and the shareholder.
- The shareholder's contract begins with articles of incorporation. Action to enforce its provisions are direct (for example, "action to enjoin an ultra vires act"). But the shareholder's contract is much broader, containing may implied terms as well. Those terms have their genesis in statutes and in common law of corporation. The ALI Proejct catalogues a long list of contactual rights: (1) actions to enforce a right to vote, to protect preemptive rights, to prevent the improper dilution of voting rights, or to enjoin the improper voting of shares; (2) actions to compel dividends or to protect accrued divident arrearages; (3) actions challenging the use of corporate machinery or the issuance of stock for a wrongful purpose (such as an attempt to perpetuate management in control).
- 2) the shareholder alleges a special and distinct injury over and above a dimunition in the value of shares. When the shareholder suffers injury seprate and distinct from that sufferd by other shareholders.
- However, in Tooley, the Supreme Court threw out the special rule altogether, and stated that the issue must turn solely on the following questions: "1) who suffered the alleged harm (the corporation or hthe suing stockholders; and 2) who woudl receive the benefit of any recovery (the corporation or the stockholders, individually)?"
In a direct action, damages recovered are paid to the shareholders and the shareholder may maintain the action in his or her own name.
Derivative[]
The action is derivative if - the shareholder sues to vindicate the violation of a duty owed to the corporation, either
- 1) fiduciary duties owed by the corporate directors or officers, or
- 2) obligations of a thid party pursuant to a contract with the corporation. That is, the shareholder steps into the corporation's so to vindicate wrongdoing to the corporation when the directors would not do so. For example, a supplier has allegedly breached a contract.
- In latter instance, the plaintiff may allege a cause of action against the third party, and may plead in the alternative against the directors. Plaintiff can allege mismanagement (duty of care) by the board, in that the board members were indifferent or inattentive to the breach by the third party of an imporatnt contract. Alternativley, plaintiff could allege self-dealing (duty of loyalty): that for some quid pro quo, the directors favored the interests of the supplier as a friend, associate, family member, or the like, over the best interests of the corporation.
In a derivative action the shareholder "derives" whatever rights she has from the corporation. Derivative actions are useful in cases in which the alleged wrongdoers are members of the group bestowed with the power to manage that is, some of the directors or officers themselves. In some cases, through sympathy or friendship, the remaining directors may choose not to pursue wrongdoing directors.
Any recovery goes to the corporate treasury. A central tenant of corporate law has long been that the board of directors manages the business and affairs of a corporation.
Those affairs influence litigation by the corporation or by shareholders in the corporate name, or rights of the corporation to commence litigation.
Requirements to bring a derivative suit[]
- 1) Contemporanous ownership
- exceptions include - 1) undisclosed wrongdoing, 2) continuing wrong, 3) double derivative actions
- 2) Continuous ownership
- 3) Clean Hands Requirement
- 4) Adequate Representation Requirement
- 5) Verification Requirement - the plaintiff must "verify" the complaint. Verification requries that a plaintiff read teh allegations and attest that, in good faith and based upon personal knowledge, she believes them to be true. A vertified compalint must be signed by the plaintiff. In contrast, most modern pleading is stated to be based on "information and belief." In most non-derivative actions, the attorney signs the pleading on the client's behalf. Under the law establisehd by the Surowitz case, the verifying plaintiff need only demosntrate that somoen whom she has confidence has investigated the allegations and believes them to be true. Surowitz is a land mark case that has diffused the verification requriement as a viable weapon for derivative action defendants.
- 6) Security for Expenses Requirement - the shareholder-plaintiff, or at least a party plaintiff with a small stake in the corporation, udnertake to pay defendants' costs shoudl the plaintiff lose or abandon the litigation. Such an undertaking normally consist of a promsie to pay (a bond) that may be required to be collateralized in whole or in part. Undertaking may be collateralized by placing cash or neotiable securities in the registry of the court.
- 7) Demand
Remedies in Derivative Actions[]
The norm in an action based upon violation of a fiduciary or other duty owed to the corporation is that the recovery goes to the corporate treasury. In close corporations, a growing number of courts permit plaintiff-shareholders to proceed directly, resulitng in direct payment of damages. Plaintiff-shareholders recover damages in proportino to the shares they hold (pro rata).
In other cases involving closely held or other corporations, courts continue to style the action as derivative but permit any reocvery to go directly to shareholders. The theory of these "pro rata recovery" case is taht, if the wrongdoers own a substantial amount of shares, and if the damages are paid to the corporate treasury, the reocver flow in part to the wrondoers.
The Special Litigation Committee Device[]
The method corporations used to speak out about whether or not a derivative action should continue is the Special Litigation Committee (SLC).
To form an SLC, the board of directors delegates to the committee of two or three directors all the board's power with resepct to the litigation. Often, the board amends the bylaw dealing with board size, adds two or three new director positions, and appoints to those position person who had no conceivable connection with the alleged wrongdoing. These "expansion" directors then staff the SLC.
- When a demand has been made, the board creates the SLC after an initial determination that the plaintiff's claims are colorable.
- When demand is alleged to be excused on futility grounds the board creates the SLC soon after the plaintiff files suit to try to have the SLC deal with the merits of the litigation.
In Auerbach v. Bennett, the New York Court of Appeals held that "[t]he susbtantive aspects of a decision to terminate a shareholder's derviative suit ... are beyond judicial inquiry," if the decision has been made by a committee of disinterested directors, based upon a reasonable investigation. In other words, the New York court bestowed a high degree of business judgment rule protection to shield the board recommendation to dismiss the judicial rewview as to the merits of the decision itself. However, in order to be afforded this protection, the protection, the
- the directors on the SLC have the burden of proving their disinterestedness, and
- the diligence of their investigation.
Therefore, under the Auerbach approach, the cout examines the SLC's proof as to the disinterestedness of the paritcipating directors and the diligence they have exercised. The court must then dismiss the action if it finds:
- a decision,
- a degree of diligence in making it,
- disinterestednes on the committee members' parts, and
- a rational basis ofr the decision made, . The court may not linger, delving into the pluses and minuses of the decision itself.
However, as determined in Zapata, a Delaware court may in its discretion, even after a review of SLC compliance with the business judgment rule based upon the SLC's proof on those issues, proceed to a review of the merits of the SLC's recommendation. Therefore, after a review of the SLC's good faith, independence, and diligence (adequacy of investigation), based upon the proof offered by the directors. The court should "determine, applying it own independent business judgment, whether the [SLC] motion should be granted.
The second step is intended to thwart instances where corporate actions meet the criteria of step one, but the result does not appear to satisfy its spirit, or where corporation actions would simply prematurely terminate a stockholder grievance deserving of further consideration in the corporation's interest.