Derivative suit

A shareholder derivative suit is a lawsuit brought by a shareholder on behalf of a corporation against a third party. Often, the third party is an insider of the corporation, such as an executive officer or director. Shareholder derivative suits are unique because under traditional corporate law, management is responsible for bringing and defending the corporation against suit. Shareholder derivative suits permit a shareholder to initiate a suit when management has failed to do so. Because derivative suits vary the traditional roles of management and shareholders, many jurisdictions have implemented various procedural requirements to derivative suits.

Under traditional corporate business law, shareholders are the owners of a corporation. However, they are not empowered to control the day-to-day operations of the corporation. Instead, shareholders appoint directors, and the directors in turn appoint officers or executives to manage day-to-day operations.

Derivative suits permit a shareholder to bring an action in the name of the corporation against parties allegedly causing harm to the corporation. If the directors, officers, or employees of the corporation are not willing to file an action, a shareholder may first petition them to proceed. If such petition fails, the shareholder may take it upon himself to bring an action on behalf of the corporation. Any proceeds of a successful action are awarded to the corporation and not to the individual shareholders that initiate the action.

In recent years, “appraisal arbitrage” has developed as a form of shareholder litigation. Popular among hedge funds seeking to take advantage of favorable case law on valuation, such arbitrageurs buy shares in the target company of a transaction about to close and file suit claiming that the fair value of the company is higher than the ultimate price paid by the acquirer in the acquisition. The financial incentive is cashing in on a higher court-determined price plus default interest at 5% above the Federal Reserve discount rate, compounded quarterly.

In most jurisdictions, a shareholder must satisfy various requirements to prove that he has a valid standing before being allowed to proceed. The law may require the shareholder to meet qualifications such as the minimum value of the shares and the duration of the holding by the shareholder; to first make a demand on the corporate board to take action; or to post bond, or other fees in the event that he does not prevail.

In the United States, corporate law is based on state law. Although the laws of each state differ, the laws of the states such as Delaware, New York, and California, Nevada where corporations often incorporate, institute a number of barriers to derivative suits.

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