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Shareholder Rights and Derivative Actions

Shareholder rights play an essential role in shaping the operation of a company.

One of the ways that shareholders exercise their rights is through derivative actions. This article explores shareholder rights and derivative actions for small businesses. It shows how this cause of action empowers shareholders to protect their interests.

Corporate Roles

The corporate shareholders are investors who own parts of the corporation. The directors have obligations and duties to the shareholders and the corporation. This role differs from the officers and executives who handle corporate governance. But, the roles can overlap.

A company trusts the board of directors to make critical decisions in the best interests of the corporation and its shareholders. Fiduciary duties, including the duty of care and loyalty, legally bind them. The duty of care entails making informed decisions and diligently overseeing company matters. The duty of loyalty means putting the corporation's best interests before personal gain. It also requires the board to avoid conflicts of interest.

When board decisions deviate from these duties, shareholders can file a derivative action. This holds the wrongdoers accountable and seeks to repair the harm caused to the corporation.

Direct Actions vs. Derivative Actions

A shareholder brings a direct action to address the harm to their rights as a shareholder. For example, violations of their ownership rights or dividend entitlements. Direct actions focus on protecting the individual shareholder's interests.

Derivative actions concern the corporation's overall well-being and governance. A shareholder initiates a derivative action on behalf of the corporation when there has been an alleged breach of fiduciary duty. Generally, this concerns actions by corporate directors or officers. This type of case aims to remedy harm to the company, with any resulting damages benefiting the corporation.

Derivative Actions and Shareholder Rights

Shareholders hold ownership in a corporation. Shareholders exist whether it's a closely held corporation, LLC, or another business entity. Their collective ownership implies certain rights and privileges to include:

  • Participation in major business decisions
  • Access to corporate information
  • A share of corporate assets

Being a shareholder comes with specific duties, responsibilities, and rights. Shareholders have a range of rights, which include:

  • Ownership in a portion of the company
  • Ownership transfer rights
  • Voting rights
  • Entitlement to dividends

One of the most significant shareholder rights is the right to sue an officer or a director who has harmed the corporation. This type of business litigation is a shareholder derivative action or lawsuit.

A shareholder derivative lawsuit allows individual shareholders to take legal action on behalf of the company. It is also known as a "derivative claim." Minority shareholders often file these claims. This legal action is typically used when a breach of duty, self-dealing, or other actions harm the company.

Shareholders often file derivative suits to resolve conflicts with officers, directors, or board members who harm the corporation. For example, a Wendy's shareholder sued its directors and officers in 2016 over security practices that led to a data breach.

Requirements for Shareholder Derivative Lawsuits

Many states require a plaintiff to be a stockholder during the improper conduct to file a derivative action. Others require that the shareholder own stock at the time and throughout the lawsuit's resolution.

Notice Requirements

Before filing the suit, the affected shareholders must state:

  • They informed the company's management of the problems in writing
  • The directors decided against pursuing any action

What if management doesn't comply? Then, the shareholders must show that the management's conduct harmed them and that they refused to resolve the issues.

The filing shareholders must notify the other shareholders about the action to allow them to join the lawsuit. The notice may be on their own or at the corporation's expense if ordered by the court.

Damages for the Corporation

If shareholders prevail, they won't recover individually. Any recovery from a derivative action is only for the corporation. However, a shareholder will generally receive legal expenses from the corporation. These legal expenses could include attorney fees incurred during the lawsuit.

In corporate governance, the business judgment rule often comes into play. This rule presumes that corporate directors act in good faith. So, shareholders must show that the directors' actions breached their duties.

Jurisdiction and Shareholder Agreements

Where a small business operates can impact the possibility of shareholder derivative action. State laws vary, and the legal rules for pursuing these claims may be better in certain places. For instance, New York is a common jurisdiction for shareholder derivative suits. This is because of the state's well-established business laws and corporate governance practices.

Shareholder agreements outline the rights and responsibilities of shareholders. Shareholder agreements can also play a role in derivative actions. These agreements may include provisions related to:

  • Dispute resolution
  • Demand requirements
  • Limitations on legal action

Small businesses should carefully review and understand these agreements before considering a derivative suit.

Need More Information on Shareholder Derivative Suits? Contact an Attorney

An attorney familiar with business litigation and business organizations can help provide answers. They can help you determine whether it's appropriate to file suit and help you understand shareholder rights. They can also explain the legal remedies available to majority shareholders and minority stakeholders.

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