What is a Derivative Action Filed on Behalf of a Business Entity?

A derivative action, also known as a derivative lawsuit, is a legal claim filed on behalf of a business entity by one or more of its shareholders or members against a third party who has caused harm to the entity. This type of lawsuit is unique in that it seeks to recover damages or other relief on behalf of the entity itself, rather than on behalf of the individual shareholders or members.

Business entities, such as corporations and limited liability companies (LLCs), are separate legal entities from their shareholders or members. As such, any harm done to the entity is typically borne by the entity itself, rather than by its individual shareholders or members. However, there are instances where a third party, such as an officer, director, or controlling shareholder, may cause harm to the entity through their actions or inactions. In these cases, shareholders or members may file a derivative action on behalf of the entity to recover damages or other relief.

Derivative actions are designed to allow shareholders or members to hold third parties accountable for their actions and to ensure that the entity is properly compensated for any harm suffered. This can be especially important in cases where the management of the entity is implicated in the wrongdoing, or where the management is otherwise unwilling or unable to pursue legal action.

To bring a derivative action, the shareholder or member must first demonstrate that they have standing to sue on behalf of the entity. This typically requires showing that they own shares or membership interests in the entity, and that they have made a good faith effort to obtain the support of the entity’s management to pursue legal action. Marchand v. Barnhill, 212 A.3d 805, 2019 Del. LEXIS 310, 2019 WL 2509617 (holding that two directors who both worked at Blue Bell for most, if not all, of their entire careers were beholden to the Kruse family and therefore not independent for demand futility) (case attached).  If the shareholder or member can demonstrate standing, they may then file a complaint alleging the wrongful conduct of the third party and seeking damages or other relief on behalf of the entity.

What is before us is whether a majority of Duke Energy directors face a substantial likelihood that they will be found personally liable [**27] for intentionally causing Duke Energy to violate the law or consciously disregarding the law. We find, as the Court of Chancery did, that the plaintiffs failed to meet this pleading requirement.106 Thus, the plaintiffs were required to first demand that the board of directors address the claims they wished to pursue on behalf of the Company. We therefore affirm the Court of Chancery’s December 14, 2016 judgment dismissing the plaintiffs’ derivative complaint.

City of Birmingham Ret. & Relief Sys. v. Good, 177 A.3d 47, 2017 Del. LEXIS 522 at **27, 48 ELR 20002, 85 ERC (BNA) 2248, 2017 WL 6397490] (case attached).

If the court determines that the complaint has merit, it may allow the derivative action to proceed. The third party in question will then be required to defend themselves against the allegations of wrongdoing, and the court will ultimately decide whether damages or other relief should be awarded to the entity. Any damages or other relief awarded by the court typically go to the entity, rather than to the individual shareholder or member who brought the suit.

Derivative actions can take many forms and can be brought for a variety of reasons. Some common examples of derivative actions include:

1. Breach of Fiduciary Duty

One of the most common reasons for a derivative action is a breach of fiduciary duty by a director, officer, or controlling shareholder of the entity. Fiduciary duties are obligations of trust and loyalty owed by these individuals to the entity and its shareholders or members. When these individuals breach their fiduciary duties, they may cause harm to the entity, and shareholders or members may file a derivative action to recover damages or other relief on behalf of the entity.

For example, if a director of a corporation uses their position to benefit themselves at the expense of the corporation, such as by taking a personal loan from the corporation or awarding a contract to their own company, this may be a breach of their fiduciary duty. Shareholders of the corporation may file a derivative action to recover damages or other relief on behalf of the corporation.

2. Fraud

Derivative actions may also be brought for fraud committed against the entity. Fraud is a deliberate misrepresentation or omission of material facts, made with the intent to deceive or manipulate another party. When a third party commits fraud against an entity, shareholders or members may file a derivative action to recover damages or other relief on behalf of the entity.

For example, if an officer of an LLC misrepresents the financial condition of the entity to potential investors, causing the entity to suffer financial harm, shareholders or members of the LLC may file a derivative action to recover damages or other relief on behalf of the LLC.

3. Corporate Waste

Derivative actions may also be brought for corporate waste, which refers to the unnecessary or excessive use of corporate assets or resources. When directors or officers of an entity engage in corporate waste, shareholders or members may file a derivative action to recover damages or other relief on behalf of the entity.

For example, if the board of directors of a corporation approves an extravagant and unnecessary executive compensation package, shareholders of the corporation may file a derivative action to recover the excessive compensation paid to the executives.

4. Insider Trading

Derivative actions may also be brought for insider trading, which refers to the purchase or sale of securities based on material nonpublic information. When insiders, such as directors or officers of an entity, engage in insider trading, shareholders or members may file a derivative action to recover damages or other relief on behalf of the entity.

For example, if an officer of a corporation purchases shares of the corporation’s stock based on material nonpublic information, shareholders of the corporation may file a derivative action to recover the profits made by the officer through the insider trading.

Bottom Line:  derivative actions are an important tool for shareholders or members of business entities to hold third parties accountable for their actions and to ensure that the entity is properly compensated for any harm suffered. While derivative actions can be complex and time-consuming, they can also be effective in recovering damages or other relief on behalf of the entity. If you believe that a third party has caused harm to a business entity of which you are a shareholder or member, you may wish to consider filing a derivative action. However, it is important to consult with an experienced attorney before taking any legal action.