James R. Balmforth: Shareholder Rights and Derivative Actions

Sometimes a CEO or other corporate insider puts the value of a company at risk by committing crimes such as wire fraud or embezzlement. When a shareholder believes that a director or officer has harmed the corporation by breaching a contract or breaching their duties, the shareholder can assert their rights and seek relief. One option is to file a derivative lawsuit. This article discusses shareholders rights and derivative actions, including information on the following:

The shareholder’s role in the corporation
The requirements for filing a derivative action
Shareholder activism

Corporate Roles

The shareholders (also called stockholders) are investors who own shares in the corporation. The directors have obligations and duties to both the shareholders and the corporation itself. This role differs from that of the officers and executives who handle corporate governance by running the operations of the corporation, although the roles can overlap.

Derivative Actions and Shareholder Rights

Being a shareholder comes with certain duties, responsibilities, and rights. Shareholders have a general range of rights concerning the corporation, which include:

ownership in a portion of the company;
ownership transfer rights;
voting rights; and
an entitlement to dividends.

One of the most significant shareholder rights is the right to sue an officer or a director who has harmed the corporation. This type of litigation is referred to as a shareholder derivative action or lawsuit. Unlike a securities class action suit, where individual investors and shareholders are seeking relief, the derivative action includes the interests of all shareholders and permits them to file on behalf of the corporation.

Shareholders often bring derivative suits against their corporation to try to resolve conflicts between the shareholders and the officers, directors, or board members who have harmed the corporation through mismanagement or other wrongdoing. For instance, a shareholder of the fast food corporation Wendy’s filed a derivative action against its directors and officers for its security practices that ultimately led to a massive data breach.

Requirements for Shareholder Derivative Lawsuits

Many states require that a plaintiff must be a stockholder at the time of the alleged improper conduct in order to file a derivative action. Others require that the shareholder own stock at the time of the improper conduct and continuously throughout the resolution of the lawsuit; this is referred to as the “continuous ownership requirement.”

Notice Requirements

Prior to filing the suit, the affected shareholders must demonstrate that they informed the company’s management of the problems in writing and that the directors decided against pursuing any action. If management fails to comply, the shareholders must show that the management’s conduct adequately harmed their position and that they refused to resolve the issues.

The shareholder must give notice (on their own or at the expense of the corporation if ordered by the court) to the other shareholders that the action has been initiated, providing them the opportunity to join the lawsuit.

Damages for the Corporation

If a shareholder prevails, they won’t recover individually; any recovery obtained from a derivative action is for the corporation only. However, a shareholder will generally receive legal expenses from the corporation.

Shareholder Activism

While a derivative suit is a very specific way to affect corporate governance, shareholder (or stockholder) activism is another more broader means to promote interests through shareholder rights, especially voting rights. Shareholder activism occurs when shareholders attempt to use their power to pressure management and affect a corporation’s behavior resulting in favorable results for the shareholder or to promote broader political or social causes, As an example, some Apple investors have sought to pressure the company to address smartphone addiction, especially among children. This can be achieved through various actions including litigation, proxy contests, publicity campaigns, and more.

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