Should You File a Derivative
or Direct Shareholder Lawsuit?

Shareholders in corporations can bring lawsuits against the company if they feel they have been personally harmed, or if they feel the corporation as a whole has been harmed. In either case, they must show that the harm resulted from decisions or actions by the board of directors or company officers.

These two different types of lawsuits are called direct action and derivative action. Direct action is available when an individual shareholder can show personal harm. Derivative action, which will often be brought by an individual shareholder, is reserved for cases in which harm to the company and its shareholders as a whole is suspected.

If you’re a shareholder in a company and suspect wrongdoing, poor decision-making, fraud, or other harmful actions, which approach do you take? If you’re considering action against a corporation in or around the greater San Francisco area, contact the Law Offices of David H. Schwartz, INC. Attorney David Schwartz is a business litigation attorney with a 45-year track record of achieving solid results for his clients. He will listen to your grievance and guide you in the proper direction.

Derivative Lawsuits

A derivative action can be undertaken by a shareholder acting on behalf of the entire corporation — not himself personally — when he suspects the shareholders’ investment in the company is being jeopardized. Generally, the action must be based on the suspicion or observation of one of the following by the board, officers, or a third party affiliated with the company:

  • Fraud or breach of fiduciary duty
  • Breach of statutory duty
  • Conspiracy
  • Self-dealing
  • Wrongful sale
  • Malpractice
  • Abuse
  • Illegality
  • Irrational or biased decision-making
  • Gross mismanagement

Before filing a lawsuit, the shareholder must first make a demand on the board to right the wrong. If the board refuses to do so, legal action can ensue. Alternately, the shareholder will need to show that making such a demand would be futile. Choosing whether to make a demand or skip it because it would be futile is a complex issue and should be referred to an experienced attorney like David H. Schwartz.

In a nutshell, corporate boards and company officers have both a duty of care obligation to manage prudently and a duty of loyalty obligation to act in the best interests of the corporation and its shareholders. Courts are generally reluctant to second-guess officers and directors on their decision-making under a legal doctrine known as the business judgment rule. They are not generally as reluctant when it comes to violations of their duty of loyalty.

In California, the plaintiff — the shareholder bringing the derivative action — must post a $50,000 bond to cover the legal expenses of the corporation should the lawsuit fail. Once in court, the success of the lawsuit will largely hinge on how well the plaintiff’s side can raise doubts about the good faith or independence of the decision-makers. If the lawsuit prevails, the court may order the corporation to rectify the situation through a number of means.

The individual shareholder whose name appears as the defendant on the lawsuit will not receive personal gain, except in that share value may rise for every shareholder as a result of the action. The individual shareholder can, however, petition to have their legal expenses paid by the corporation since they were acting on the company’s behalf to correct a wrong.

Direct Action Lawsuits

A direct-action lawsuit involves direct harm to an individual shareholder — such as having their voting rights abused, or a promised dividend not paid. In situations like these, the individual shareholder can sue the company directly with no demand requirement. However, if the alleged harm extends to more than just one individual and potentially impacts all shareholders, then a derivative action might be more relevant.

Deciding between direct or derivative action can sometimes be tricky, so consulting and working with a trusted corporate litigation attorney is always advised.

Experienced Corporation Litigation Counsel

Generally speaking, more opportunities arise for derivative actions than for direct actions, but the legal road to either can be strewn with challenges and obstacles and prove difficult to navigate. In his more than four decades of experience, attorney David H. Schwartz has handled numerous direct and derivative shareholder actions.

If you’re a shareholder who suspects fraud, abuse, or other harmful corporate actions, contact the Law Offices of David H. Schwartz, INC., to start the consultation process. David Schwartz is an experienced and effective advocate for shareholder rights.

The Law Offices of David H. Schwartz, INC. serves individuals and businesses in the San Francisco Bay area, as well as San Jose, San Mateo, Santa Clara, Oakland, and Alameda County.


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