Derivative actions permit a shareholder to sue on behalf of the corporation or LLC where the corporation or LLC has been damaged. It is sometimes difficult to distinguish between damages to the business and damages to individual shareholders or LLC members in the context of closely-held corporations or LLCs where shareholder interests and individual interests are often intertwined.
If the corporation or LLC suffered the injury, then the claim belongs to the corporation or LLC and the shareholder must sue derivatively on its behalf. This remains true even though the shareholder may have personally suffered, such as by a decrease in the value of stock or LLC interests owned, because such injuries are common to all shareholders. A shareholder or LLC member may bring a direct action if he or she suffered a distinct injury separate from other shareholders or LLC members.
In determining whether a claim is direct or derivative, it is helpful to look at what the shareholder will have to prove to succeed on the claim. If the shareholder can only prevail by showing an injury or breach of duty to the corporation, then the claim should be treated as a derivative action. If he or she can prevail without any such showing, then the action may be direct and maintained by the shareholder in an individual capacity. Typical breach of duties forming the basis of a derivative suit include fraud, breach of fiduciary duties, waste, mismanagement of corporate assets, or failure to pursue claims against a third party.
This begs the question: why doesn’t the corporation or LLC just initiate a lawsuit on behalf of itself? This is usually because those in control of the corporation or LLC are themselves the wrongdoer: the president has stolen corporate money, an officer has engaged in self-dealing, a director has taken some action to the detriment of the corporation, or a managing member has violated the LLC operating agreement.
A prerequisite to a derivative suit is a demand by the shareholder or LLC member upon the corporation or LLC that the entity file the suit. In the context of smaller corporations and LLCs, this will be upon the board of directors or managers. Generally, publicly held corporations will have appointed a disinterested committee of directors to decide whether to sue. Often the courts will uphold the decision of a disinterested committee to decline a shareholder’s demand that the corporation file suit against one of its directors or officers. In small corporations or LLCs, after the corporation or LLC declines to sue, the shareholder or LLC member can sue on its behalf.
In the context of smaller entities, a shareholder or LLC member will be excused from making a demand for the entity to sue if he or she can show that a demand would have been futile (e.g., if the demand would have to be made upon those individuals who would be named defendants in such a lawsuit).
In shareholder or LLC member derivative suits, any money recovered by the plaintiff belongs to the entity. There are some legal doctrines that allow a shareholder to recover attorney fees from the award recouped for the entity.
To speak to one of our lawyers, get in touch with us at (312) 223-1699 or email Thomas E. Patterson at firstname.lastname@example.org for more advice and information.