When corporate executives breach their duties and harm the company, shareholders may be unable to sue directly—but they can file derivative suits on the company's behalf. Shareholder derivative actions allow investors to hold directors and officers accountable when the company itself won't pursue claims against its own leadership.
What Is a Shareholder Derivative Suit?
A shareholder derivative suit is a lawsuit brought by shareholders on behalf of the corporation against parties who have harmed the company—typically directors, officers, or controlling shareholders. The claim belongs to the corporation, not the shareholders personally—any recovery goes to the company, benefiting shareholders only indirectly through improved corporate value.
Derivative suits differ from direct shareholder suits, where shareholders sue for harms done to them individually (such as securities fraud claims for misrepresentation in stock purchases).
When Derivative Suits Are Appropriate
Derivative suits address harm to the corporation itself, including:
Breach of fiduciary duty: Directors and officers who violate their duties of care and loyalty—self-dealing, corporate waste, failure to oversee risk—harm the corporation.
Corporate waste: Approving transactions so one-sided that no reasonable businessperson would agree to them.
Executive compensation abuses: Excessive pay packages that lack proper approval or aren't tied to performance.
Insider trading by executives: When insiders profit illegally using corporate information, the company may have claims against them.
Fraud or misconduct: Actions by insiders that expose the company to regulatory penalties, litigation, or reputational harm.
Demand Requirement
Before filing a derivative suit, shareholders must typically "demand" that the board of directors pursue the claim. This demand letter asks the board to investigate and, if appropriate, sue the wrongdoers on the company's behalf.
The board then has a reasonable time to investigate and respond. If the board refuses to sue ("demand refused"), shareholders can proceed only if they prove the refusal was wrongful—that the board failed to conduct a reasonable investigation or acted in bad faith.
Demand Futility
Shareholders may be excused from the demand requirement if demand would be "futile"—when the board cannot be expected to fairly evaluate whether to sue. Demand futility typically exists when a majority of directors face personal liability for the alleged wrongdoing, directors are beholden to or controlled by the alleged wrongdoers, or the challenged transaction was not a valid exercise of business judgment.
Pleading demand futility requires particularized facts about each director's situation—conclusory allegations that the board is "interested" are insufficient.
Standing Requirements
To bring a derivative suit, shareholders must meet standing requirements:
Stock ownership: You must have owned stock at the time of the alleged wrongdoing (the "contemporaneous ownership" requirement).
Continuous ownership: You must maintain ownership throughout the litigation.
Fair and adequate representation: You must be able to fairly represent the interests of shareholders similarly situated.
Special Litigation Committees
Boards often respond to derivative suits by forming Special Litigation Committees (SLCs)—independent directors tasked with investigating whether the suit serves the corporation's interests. If the SLC recommends dismissal, courts apply varying standards of review depending on jurisdiction.
Challenging SLC recommendations requires showing the committee lacked independence, didn't conduct a reasonable investigation, or reached conclusions unsupported by the investigation.
Settlement and Recovery
Derivative suit settlements require court approval. Courts ensure settlements are fair to the corporation and shareholders. Settlements typically involve monetary payments to the corporation, corporate governance reforms, and attorney fee awards for plaintiff's counsel.
Because recovery goes to the corporation rather than individual shareholders, plaintiff shareholders' primary compensation comes from the increase in share value—though named plaintiffs sometimes receive modest incentive awards.
Attorney Fees
Derivative suits are typically brought on a contingency basis—attorneys are paid from any recovery or the "corporate benefit" produced by the litigation. Courts award fees based on the value of the recovery and, in cases producing non-monetary benefits (governance reforms), the value of those reforms to the corporation.
Potential Outcomes
Successful derivative suits can result in monetary judgments or settlements paid to the corporation, removal of wrongdoing directors or officers, corporate governance improvements, disgorgement of ill-gotten gains by executives, and deterrent effects on future misconduct.
Getting Legal Help
Derivative litigation is complex and expensive. Specialized securities litigation firms handle these cases on contingency, bearing the cost and risk of litigation. If you believe corporate insiders have harmed your company through breach of duty, consult an experienced securities litigation attorney about whether a derivative suit is appropriate.