SLG Helps Stockholders to Bring and Win Delaware Derivative Lawsuits
Much of business law revolves around what happens when those who run a company disagree with those who own it. Sometimes, the stockholders believe that the board of directors or the company’s executive officers are actively harming the business. When that happens, the law provides a specific mechanism for the stockholders to act: the derivative lawsuit.
Derivative lawsuits create a bit of a paradox. These suits involve a stockholder stepping into the corporation’s shoes to sue the company’s own leadership. Essentially, the stockholders are fighting for the company’s rights when the board of directors refuses to do so.
At Shlansky Law Group, we have many years of experience helping stockholders with Delaware derivative lawsuits. We regularly step in to protect the rights of directors and investors when the stakes are at their highest. Our team leverages its knowledge of business strategy and Delaware law to win cases when it matters most. Call SLG today at 347.378.6990 for a confidential consultation.
Direct vs. Derivative Claims: Knowing the Difference
Before reviewing how derivative suits operate, you have to know what they are not. There are two types of litigation that courts commonly see.
A direct lawsuit occurs when one stockholder suffers a distinct harm that the others do not. One of the most common examples is when the company refuses to accept that particular stockholder’s votes when electing the board.
In a derivative lawsuit, a stockholder brings a suit against the directors or officers, alleging that they took action that harmed the company. A common example is when board members engage in self-dealing, such as buying inventory from a director’s other company at inflated prices. Because the money wasted belongs to the corporation, the corporation suffers the primary injury. Any harm to the stockholders (e.g., a drop in the share price) is merely a byproduct of the financial damage done to the business entity itself.
Who Can Bring a Derivative Lawsuit?
You cannot just buy a single share of stock on Monday and file a massive lawsuit against the board of directors on Tuesday. Delaware law imposes strict standing requirements to prevent opportunistic individuals from buying their way into litigation.
To file a derivative claim, the plaintiff must meet the “contemporaneous ownership” requirement. This means they must have owned stock in the company at the exact time the alleged wrongdoing occurred. They also have to maintain continuous ownership of that stock throughout the entire litigation process. If a stockholder sells her stock halfway through the case, she loses her standing, and the court will generally dismiss the suit.
Common Types of Derivative Lawsuits
stockholders generally file these suits when they believe that leadership has breached its fiduciary duties. Traditional corporations are bound by the rigid framework of the DGCL. This framework imposes strict rules on how boards operate and outlines specific, unyielding fiduciary duties that directors owe to the corporation and its stockholders.
- Breaches of the Duty of Loyalty. This happens when directors or officers put their own financial interests ahead of the company’s. A conflict transaction occurs when a director or controlling stockholder stands on both sides of a deal or expects to receive a personal financial benefit that the other minority stockholders will not receive. If a CEO directs the corporation to buy real estate from a shell company he personally owns at an inflated price, he violates his duty of loyalty. Delaware courts view these transactions with suspicion, as there is a clear conflict of interest.
- Corporate Waste. Plaintiffs might argue that the board threw away corporate assets on deals that no reasonable businessperson would ever approve. These claims are hard to prove, but they often appear when executive compensation packages look entirely divorced from a company’s actual performance.
- Caremark Claims and Oversight Failures. Caremark claims are especially dangerous because they expose directors to personal liability. They occur when stockholders allege that the directors either ignored signs of criminal activity or failed to implement proper reporting systems to prevent it. Caremark cases are difficult for stockholders to win. A successful case requires showing the directors intentionally neglected their duties, which is a very high bar under Delaware law.
Derivative Suits in Alternative Entities (LLCs and LPs)
It is worth noting that derivative lawsuits are not exclusive to traditional corporations. In Delaware, many businesses are not traditional corporations but are instead incorporated as “alternative entities,” such as Limited Liability Companies (LLCs) and Limited Partnerships (LPs).
If the harm was suffered by the LLC or LP itself (e.g., a manager stealing company funds), a member can file a derivative lawsuit on behalf of the entity to recover damages for the business. However, these cases operate differently. Delaware allows alternative entities to expand, restrict, or eliminate traditional fiduciary duties, replacing them with a purely contractual standard of conduct. Disputes frequently arise over whether a specific action taken by a manager breached the “implied covenant of good faith and fair dealing” (which cannot be eliminated) or whether the governing agreement successfully shielded the manager’s self-interested actions from liability.
How Derivative Suits Are Brought: The Pre-Suit Demand
Because a derivative lawsuit is technically done for the benefit of the corporation, the board of directors theoretically gets to decide whether or not to file it. Before a stockholder can sue on the company’s behalf, she usually has to make a “pre-suit demand” on the board. She writes a letter detailing the allegations and asking the board to take legal action. The board then investigates and decides whether suing is in the company’s best interest.
Unsurprisingly, boards rarely decide to sue themselves. To get around this roadblock, stockholders try to prove “demand futility.” They argue that asking the board to sue is pointless because the board members are too conflicted or implicated in the wrongdoing to make an objective decision.
Rights and Responsibilities During Delaware Derivative Lawsuits
The Company Itself
When a company gets hit with a derivative suit, it does not just sit on the sidelines. The corporation itself is named as a nominal defendant. The company has an interest in the outcome of the litigation, even if the primary fight is between the stockholders and the board.
SLG regularly represents the stockholder, but occasionally represents the corporate entity itself to ensure its operations are protected and its assets are not wasted during litigation.
Special Litigation Committees
Sometimes a board is accused of wrongdoing, and the company has to decide whether to sue its own directors. Because the board cannot make that decision objectively, they form a special litigation committee. This committee consists of independent directors who had no part in the challenged transaction.
When we represent these committees, SLG sometimes conducts independent investigations into the alleged wrongdoing. We may review thousands of documents, interview witnesses, and ultimately advise the committee on whether to pursue the lawsuit in the corporation’s best interests. This requires absolute objectivity and a deep understanding of how the Delaware courts evaluate committee independence.
Individual Directors
During the process, the directors accused of malfeasance have strong legal defenses. This is because Delaware law gives the board, not the stockholders, the power to run the corporation.
When representing directors, the standard rule is the business judgment rule. Corporate directors and officers are protected from liability when they make business decisions, so long as they acted in the company’s best interest with reasonable care in good faith. In cases where the business judgment rule applies, Delaware courts do not question the legality or wisdom of the board’s business decisions.
Why You Need Experienced Legal Counsel
In most states, a judge can preside over a criminal jury trial one day, rule on a lawsuit the next day, and then hear a series of small claims cases the day after. Even the simplest business disputes can take months or years of litigation before anything substantial happens.
Delaware is the exact opposite. Its courts are highly specialized. For example, the Delaware Court of Chancery hears most business disputes in the state. It is a court of equity, which means it has no juries. The Court is run by Chancellors and Vice Chancellors who are highly experienced corporate law experts. Practically every aspect of the Court is designed to move with speed and expertise.
The presiding judges have zero patience for lawyers who are unfamiliar with Delaware law or who seek continuance after continuance to stall for a settlement. The Court knows the law inside and out, and it expects the same of legal counsel. SLG provides the representation needed to thrive in this environment, where deep knowledge of case law and experience with the court’s procedures are more vital than anywhere else.
Frequently Asked Questions (FAQs) About Derivative Lawsuits
Can a stockholder sue us in our “home” state rather than in Delaware?
Usually, no. Under the “Internal Affairs Doctrine,” the laws of the state of incorporation govern disputes between a company’s leadership and its stockholders. Because a corporation’s internal affairs are governed by the law of the state where it is incorporated, disputes involving those companies naturally flow to Delaware. Furthermore, most modern Delaware corporations include forum-selection clauses in their bylaws that mandate derivative claims be filed in the Delaware Court of Chancery. Delaware courts enforce these clauses aggressively.
What is “Pre-Suit Demand,” and why is it so important?
Although the dispute is really between the stockholders and the directors, a derivative lawsuit is technically brought by a stockholder, acting on behalf of the company, against the directors. However, the board of directors still has the legal authority to run the company. A pre-suit demand is a formal request by the stockholder asking the board to file the lawsuit.
It might seem ridiculous for a stockholder to ask the directors to file a lawsuit against themselves. However, this is an important procedural step. The stockholder must either file the demand or show that making such a demand would have been futile. This prevents weak or retaliatory claims from moving forward.
Protect Your Investment and Your Rights with SLG Today
Do not let a battle between stockholders and leadership hurt your business or your investment. If you or your business are dealing with boardroom deadlock or a stockholder lawsuit, contact the highly experienced SLG team today at 347.378.6990.
