What is a Derivative Lawsuit?
A derivative lawsuit occurs when one or more shareholders sue a company on behalf of the company itself. The shareholders file a lawsuit against the company’s board of directors or executives because they think the directors or executives did something wrong that hurt the company.
Why Shareholders File Derivative Lawsuits
Shareholders file derivative lawsuits when they think the company’s leaders broke the rules. This could mean the leaders:
- Did not do their jobs the right way
- Made bad choices that cost the company money
- Did not tell the truth about important things
- Took advantage of their power to help themselves instead of the company
The shareholders want the court to order the directors or executives to pay money to the company. They think this will compensate for the harm they caused. The money would go to the company, not directly to the shareholders.
Breach of Fiduciary Duty
One main reason for a derivative lawsuit is a “breach of fiduciary duty.” Fiduciary duty means the leaders must put the company’s interests first, be careful, and be honest. If they do not, they have breached their duty.
Some examples of breaching fiduciary duty are:
- Making deals that help the leaders but hurt the company
- Not paying attention and letting bad things happen to the company
- Lying about the company’s money or how well it is doing
- Taking company secrets or chances for themselves
Waste of Corporate Assets
Another reason is the “waste of corporate assets.” This is when the leaders spend the company’s money in a really bad way. It is more than just a mistake. The leaders have to be careless or do it to help themselves.
Some examples of wasting corporate assets are:
- Paying leaders way too much money
- Buying things the company does not need at high prices
- Giving away company secrets or property for no good reason
- Using company money for personal trips or gifts
How Derivative Lawsuits Work
Derivative lawsuits have a few special steps. They are different from other kinds of lawsuits.
Standing to Sue
First, the shareholders must show they have “standing to sue.” This means they have the right to sue the company. Usually, they must own stock in the company when the bad things happened.
They also usually have to own stock while the lawsuit is pending. This shows that they care about improving the company. However, if they sell their stock, they may lose their standing to sue.
Demand on the Board
In most cases, the shareholders have to make a “demand on the board” first. This means they have to ask the board of directors to sue the leaders themselves. The shareholders have to explain what they think the leaders did wrong.
The board then decides whether to sue the company. If it thinks it is not, it can refuse. If it refuses, the shareholders can ask the court for permission to file a derivative lawsuit anyway.
Proving the Case
If the derivative lawsuit goes to court, the shareholders have to prove their case. They have to show that:
- The leaders did something wrong
- What the leaders did hurt the company
- The company deserves money to make up for the harm
It can be hard to prove these things. The shareholders need a lot of evidence.
Special Legal Rules
There are some special legal rules for derivative lawsuits. These rules can make derivative lawsuits hard to win.
The “business judgment rule” is one example. This rule says courts should not second-guess leaders’ choices too much. The leaders do not have to be perfect. They just have to try their best and be careful. If they do this, the court will often take their side.
Examples of Derivative Lawsuits
There have been many big derivative lawsuits over the years. Here are a few examples:
Enron Scandal
After the Enron scandal in 2001, shareholders filed derivative lawsuits. Enron’s leaders lied about how much money the company was making. They also did not tell the truth in financial reports. This hurt the company and its shareholders.
The derivative lawsuits led to big changes at Enron. The leaders had to pay a lot of money. Some went to jail. The lawsuits helped the company get better.
Wells Fargo Fake Accounts
In 2016, Wells Fargo got in trouble for making fake bank accounts. Employees made accounts that customers did not ask for. They did this to meet big sales goals and get bonuses.
Shareholders filed derivative lawsuits against the board of directors. They said the board did not stop the fake accounts and let the ex-CEO keep too much pay after the scandal.
The lawsuits led to Wells Fargo making changes. They got rid of sales goals. They also took back a lot of the ex-CEO’s pay.
McDonald’s Ex-CEO
In 2021, a court said a derivative lawsuit against McDonald’s could proceed. The lawsuit concerned McDonald’s ex-CEO Steve Easterbrook, who was fired in 2019 for having relationships with employees, which was against company rules.
The lawsuit says McDonald’s board should have investigated Easterbrook more and that they let him keep too much money when he left. The board says it did the right thing based on what it knew. The court will decide whether the lawsuit can continue.
Importance of Derivative Lawsuits
Derivative lawsuits are an important way to hold company leaders responsible. They give shareholders a tool to help the company when leaders do wrong.
Some good things about derivative lawsuits are:
- They can get money back for the company if leaders waste it
- They can punish leaders who break the rules or hurt the company
- They can scare leaders and make them more careful
- They can lead to good changes that help the company in the long run
But there are also downsides to derivative lawsuits:
- They can cost the company a lot of money and time
- They can make leaders too scared to take any risks
- Some shareholders may use them to push for changes that only help themselves
- Courts may not want to get too involved in company business
Overall, derivative lawsuits are a balancing act. They can be a useful tool, but they can also cause problems. Companies and courts must be careful to use them properly.
Difference Between Direct and Derivative Lawsuits
Another kind of shareholder lawsuit is a “direct lawsuit.” It is important to distinguish direct lawsuits from derivative lawsuits.
In a direct lawsuit, the shareholders sue to help themselves. They say the company or its leaders hurt them directly. Maybe the company did not pay them the dividends it promised, or maybe the company lied to get the shareholders to buy stock.
If the shareholder wins a direct lawsuit, they get the money. The money does not go to the company.
But in a derivative lawsuit, the shareholder sues to help the company. They say the leaders hurt the company. Any money from the lawsuit goes to the company.
Sometimes, it is hard to tell if a lawsuit should be direct or derivative. It depends on where the harm happened first. If the company were hurt first, it would probably be a derivative lawsuit. If the shareholders were hurt first, it would probably be a direct lawsuit.
Final Thoughts
Derivative lawsuits are a tool for fixing companies. They happen when shareholders think leaders did something very wrong. The goal is to help the company, not the shareholders directly.
Derivative lawsuits are challenging. They are hard to prove, and special rules make it difficult for shareholders to win. Sometimes, they can cause new problems as they try to solve old ones.
Still, derivative lawsuits are important. They can lead to positive changes, punish leaders who break the rules, and help companies recover wasted money.
It takes balance to get derivative lawsuits right. Companies, shareholders, and courts all play a role. Together, they can work to keep companies fair and honest. This helps everyone in the long run.