Derivative actions: Overview, definition, and example
What are derivative actions?
Derivative actions are lawsuits brought by shareholders on behalf of a corporation against its directors, officers, or third parties for actions that have harmed the company. These lawsuits allow shareholders to seek remedies when the company itself fails to take action against wrongdoing.
For example, in a publicly traded company, if the board of directors engages in fraud or mismanagement and refuses to take corrective action, shareholders may file a derivative action to hold them accountable. Similarly, in a private corporation, minority shareholders may bring a derivative lawsuit if company executives misuse funds or engage in self-dealing.
Why are derivative actions important?
Derivative actions help protect shareholder interests, promote corporate accountability, and prevent management misconduct. Without this legal mechanism, executives could engage in fraud or negligence without consequences if the company refuses to take action internally.
For businesses, derivative action provisions in corporate agreements help clarify shareholder rights, set procedural requirements, and ensure that such lawsuits are pursued in the best interests of the company rather than for personal gain.
Understanding derivative actions through an example
Imagine a technology company where executives approve excessive bonuses for themselves while the company is struggling financially. Shareholders suspect misconduct but find that the board refuses to investigate. A group of shareholders files a derivative action, seeking to recover the funds and hold the executives accountable for breaching their fiduciary duties.
In another scenario, a real estate corporation enters a contract with a company owned by its CEO at inflated prices, causing financial harm to shareholders. If the company refuses to challenge the deal, shareholders can initiate a derivative lawsuit to unwind the transaction and recover damages.
Example of a derivative actions clause
Here's an example of how a derivative actions clause may appear in a contract:
“Any shareholder seeking to initiate a derivative action on behalf of the Company must first make a written demand to the Board of Directors requesting remedial action. If the Board fails to act within [X] days, the shareholder may proceed with legal action in accordance with applicable corporate laws and governance policies.”
Conclusion
Derivative actions serve as an important legal tool for shareholders to hold corporate executives accountable when a company fails to act on wrongdoing. These lawsuits help safeguard corporate integrity, protect shareholder investments, and ensure responsible management.
By including a derivative actions clause in corporate agreements, businesses can define shareholder rights, establish procedures for initiating lawsuits, and prevent misuse of derivative claims.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.