A shareholder derivative lawsuit is an action brought on behalf of a company by a shareholder or group of shareholders that seeks to hold the company's directors and officers personally liable for damage to the company as a result of their wrongdoing. Oftentimes, shareholder derivative lawsuits allege that directors and officers damaged the company by breaching their fiduciary duties of care and loyalty.
Generally, the action is internal to the company, and does not involve any outside parties bringing the lawsuit. In essence, a derivative action is brought by the shareholders of a corporation alleging misconduct on the part of corporate officers and directors, at the expense of the corporation itself and the owners of the corporation. The claim or claims brought under a derivative lawsuit are not personal claims to the shareholders, but claims brought on behalf of the corporation by the shareholders. This then begs the question that if directors, officers, or other third parties are found to have breached their duties owed to the shareholders and the corporation in a derivative lawsuit, how would that derivative liability be spread and how would it impact the shareholders and the corporation?
Directors and officers of corporations owe two fundamental duties to the corporation and its shareholders, namely a duty of care to ensure proper management of the corporation, and a duty of undivided loyalty to act in the best interest of the corporation and its shareholders. A derivative action is one belonging to the corporation, however it is commenced by a minority member against those in control in an effort to remedy an injury to the business itself usually as a result of a breach of the officers' and directors' fiduciary duties. Most frequently, derivative actions typically allege that the directors and/or officers have (1) failed to correct illegal or wrongful practices, (2) engaged in conduct resulting in corporate waste or engaged in conduct constituting mismanagement—which is a breach of the duty of care, and (3) breached the fundamental duty of undivided loyalty owed to the corporation–typically by engaging in conduct in which there is a conflict of interest.
Prior to commencing a derivative action, the shareholder must first bring the matter to the attention of the board of directors. This is known as making demand, and the board of directors then decide whether or not the derivative action would be in the best interest of the corporation. However, the decision whether or not to bring the action is subject to the business judgment rule which essentially shields the board from liability for business decisions that fall within the duty of care. Nevertheless, the business judgment rule would not protect the board of directors from making decisions that would otherwise violate the duty of loyalty. Furthermore, many states have recently adopted the notion that a shareholder may be able to go straight to court if the shareholder can prove that demand was "futile" in a demand futility state—that is—the board would be unable to make the decision because it is too self-interested in the outcome of the litigation to reach an unbiased conclusion. Demand Futility was pioneered in Aronson v. Lewis, 473 A.2d 805 (Del. 1984), where the court ruled that demand is not necessary to commence a derivative lawsuit as long as it can be shown that demand would have been futile and useless. Notably, as of January 1, 2020, Florida became the most recent state to adopt demand futility in its corporate code. See Fla. Stat. § 607.0742 (2020).
Although corporations may choose to protect its officers and directors from liability in a derivative action by placing such a protective provision in its articles of incorporation, or with director and officer liability insurance, there is only so much protection allowed by law. A corporation may choose to limit personal liability of its officers and directors for their negligence, however, they cannot limit personal liability based on a breach of a director or officer's undivided duty of loyalty to the corporation and its shareholders. This is apparent in the August 1, 2022 amendment to Delaware's General Corporation Law (DGCL) § 102(b)(7), which now permits corporations to eliminate or limit directors' personal liability to the corporation or its shareholders for monetary damages stemming from breaches of the duty of care, and companies typically include such provisions in their certificates of incorporation. However, the exculpation of directors under the DGCL is not unlimited as a corporation cannot exculpate directors for breaches of the duty of loyalty, acts or omissions not made in good faith or involving intentional misconduct or a knowing violation of law, illegal stock redemptions, stock repurchases, or dividends, or any transaction in which directors derive an improper personal benefit. See DGCL at § 102(b)(7).
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.