Derivative actions permit a shareholder to bring suit on the corporation's behalf against officers, directors, and third parties for wrongful conduct which depletes the corporation's assets. The corporation (rather than the individual shareholder) is the direct beneficiary of any recovery; shareholders benefit only through the pro tanto increase in the value of their stock. Attorneys fees, however, are regularly awarded to plaintiffs who are successful either through settlement or on the merits after trial, giving the plaintiffs' bar a powerful incentive to pursue shareholder claims.
Derivative litigation is designed to enable shareholders to wrest corporate control from wrongdoing insiders. But abuse of the mechanism robs a diligent board of its fundamental right to manage the corporation. With the threat of increased shareholder reliance on the derivative suit and the attendant costs and disruption to orderly corporate management, corporate counsel would do well to consider some of the defensive strategies available to them.
Demand Requirement
Allowing a shareholder to pursue claims on the corporation's behalf is, by its very nature, an extraordinary remedy and a narrow exception to the rule vesting corporate boards with the power to manage the corporation and its affairs, including its litigation. In recognition of that rule, applicable law generally requires that directors be afforded the opportunity to initiate litigation on the corporation's behalf. Thus, a derivative suit plaintiff must either: (1) first make a demand on the company's Board of Directors to take the desired action and await the board's decision for a reasonable period or (2) serve a complaint including facts to demonstrate that the demand requirement should be excused as futile. In either circumstance, the demand requirement provides corporate managers with their first and most effective line of defense against spurious derivative litigation.
Where the shareholder picks the first option and makes a demand, the corporation's board may refuse the demand, concluding that the proposed litigation is not in the corporation's best interests. The shareholder may file suit anyway, but he will be required to show that the refusal itself was wrongful. And because courts apply the deferential "business judgement" standard of review to such refusals, plaintiffs rarely succeed in making that showing.
Where the shareholder chooses to file prior to making his demand, his complaint must include facts demonstrating that demand would have been "futile" - that either the role of the directors in the underlying transactions or the control and domination of the directors by the alleged wrongdoers renders the board incapable of giving meaningful consideration to the demand. If the complaint is lacking, the action must be dismissed.
Thus, no matter how plaintiff chooses to proceed, the demand requirement should, in most instances, give an independent and disinterested board of directors the power to terminate groundless derivative litigation.
Prematurity of Claims
In a race to the courthouse, many shareholders file premature claims for damages they allege the corporation is likely to suffer in the future. For example, where corporate employees have engaged in transactions which become the subject of non-derivative civil litigation, or criminal investigation, shareholders often bring derivative claims against non-participating corporate officers and directors for their failure to detect and prevent the challenged transactions. As damages, plaintiffs allege that the underlying transactions have spawned litigation, resulting in reputational damages and the possibility of economic damages to the corporation.
In these circumstances, courts have ruled that allegations of reputational injury and potential civil or criminal liability are too speculative; the corporation sustains no injury for which a derivative plaintiff may recover until such time as a judgement is rendered or a settlement reached in the non-derivative civil or criminal actions. To the extent that securities law reforms increase a defendant corporation's ability to prevail in these direct actions, the prematurity argument becomes even more compelling, and may provide additional weapons of defense.
Special Litigation Committees
Even where a shareholder is successful in arguing that his demand is futile and his claims ripe, the corporation may regain control of the litigation and, in proper circumstances, end it. By creating a Special Litigation Committee ("SLC"), the board may delegate to a group of its members the power to conduct an investigation of the plaintiff's claims and, if continued litigation is found to be contrary to the company's best interests, move to dismiss the litigation on that basis. A committee's success in moving for dismissal of a derivative action depends largely upon the independence and good faith of the committee's investigation and the bases supporting the committee's decision to terminate the litigation.
A committee maximizes it chances of success on a motion to dismiss by ensuring that the committee and its investigation possess the following characteristics:
- The SLC is comprised solely of board members (ideally numbering three or more) who were not on the board at the time of, and had no involvement in, the challenged transactions.
- The SLC retains independent counsel to assist in the investigation and advise the SLC of its rights and responsibilities.
- The SLC and its counsel review substantially all available information concerning the allegations and interview all relevant witnesses.
- The SLC hires independent accountants or other experts, where necessary, to assist in the investigation.
- The SLC prepares a detailed report of its findings and an explanation of the basis for it decision to continue or terminate the litigation.
- In reaching a decision to terminate the litigation, the SLC considers all relevant factors, including, but not limited to: (1) the merits of plaintiff's claim, (2) the existence and quantum of damages to the corporation, (3) the likelihood of recovery from defendants, (4) expense incurred by the corporation in pursuing the claim, (5) effect of suit on employee morale, (6) adverse reaction by the public, and (7) whether the company has taken measures to prevent a recurrence.
While the termination of a derivative suit by means of an SLC generally involves greater expense than some of the other avenues discussed above, it has nevertheless gained substantial popularity in recent years as an attractive alternative to protracted and expensive derivative litigation.
Conclusion
Derivative litigation can serve an important role in ensuring the integrity of corporate management, but such litigation must be limited to appropriate circumstances. In the new era of securities litigation, that end can be achieved where corporate management considers and deploys defensive strategies available to curb spurious suits.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
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