How Shareholder Derivative Suits Fight Corporate Misconduct
Individual and institutional shareholders have the ability to take legal action on behalf of a corporation to protect it against harm. In a shareholder derivative action, these shareholders typically bring suits against insiders of the company, such as executives, officers, board members, or majority shareholders who are engaged in misconduct.
At Hendershot, Cannon & Hisey, P.C., our Houston business litigation attorneys protect the rights of shareholders by holding directors, officers, and majority shareholders accountable. By being part of the solution when fraud or misconduct occurs, especially when it is committed by management unlikely to bring suit against themselves, shareholders can take an active role in protecting their interests and the success of a company.
Because shareholders are owners of a company that, by law, cannot act for itself, there may be a need to enforce the legal duties corporate directors and officers owe their shareholders. Should a company suffer harm as a result of misconduct committed by directors, officers, or majority shareholders which would be unlikely to redress the harm itself, shareholders can take legal action by pursuing shareholder derivative lawsuits as representatives of the company. In addition to providing greater accountability for shareholders and protecting them and their companies from further harm, these actions can also recover lost value.
Shareholder derivative suits can address a range of misconduct and fraudulent actions, including:
- Breach of fiduciary duty
- Fraud and unlawful activity
- Unjust enrichment
- Insider trading
- False or misleading financial statements
- Corporate waste
In addition to claims brought against current or former officers and directors of a company, other third parties, such as accountants or lawyers, may also be named as defendants if their conduct caused harm.
Pursuing a Derivative Action
In order to pursue a derivative action, Texas law enforces a number of procedural requirements:
- Shareholders must have been owners at the time of alleged improper conduct;
- Shareholders must prove they will fairly represent the interests of the company; and
- Shareholders must formally demand, through a written demand, the company’s board take action on the basis of suspected misconduct. The board, through a group of officers as removed as possible from the underlying conflict (disinterested directors), has a specified amount of time (90 days) to determine an appropriate course of action. If the group of disinterested directors represents the majority of management, or is a court-appointed panel, and decides pursuing a claim is not in the company’s best interests, the court will be required to dismiss the derivative suit.
Closely Held Companies
The procedural hurdles, and particularly the demand requirement, prove detrimental to the survival of many derivative claims. However, these safeguards are waived for closely held companies. This means owners of companies or LLCs with fewer than 35 shareholders that are not publicly traded will not have to meet any of the requirements stated above. This waiver has significant implications for protecting shareholders’ rights in the legal landscape following the Texas Supreme Court case Ritchie v. Rupe.
By ruling that a separate shareholder doctrine was unnecessary in matters involving closely held corporations, the Texas Supreme Court emphasized the freedom from procedural hurdles required of derivative claims. Owners of closely held companies have the right to promptly pursue derivative claims on behalf of a company, and their derivative suits will be treated as direct claims of the shareholder “if justice requires.” As such, derivative plaintiffs pursuing claims on behalf of closely held companies have an easier time making personal recoveries of damages, which would have ordinarily gone to the business and been taxed at the corporate level and again when distributed to shareholders, as well as a recovery of attorney’s fees. For these reasons, derivative claims have also become a cornerstone in litigating minority and majority shareholder disputes.
If you have questions regarding shareholder derivative suits, or wish to discuss a potential case, contact our award-winning Houston business law attorneys at Hendershot, Cannon & Hisey, P.C. for an initial consultation.