Derivative Suits vs. Direct Suits by Illinois Corporate Shareholders

Derivative Suits vs. Direct Suits by Illinois Corporate Shareholders

Video by Attorney Kevin O'Flaherty
Article written by Illinois Attorney Kevin O'Flaherty
Updated on
September 3, 2019

Shareholders of Illinois corporations have certain legal rights when it comes to governing those corporations. Because shareholders own a small portion, or “share” of the company, they have the power to affect vital aspects of the organization. If a shareholder is denied his or her right, that shareholder may take action against the corporation. If an individual causes damage to the corporation and the corporation does not sue, the shareholders may be allowed to bring a lawsuit against the corporation in order to make the company sue the wrongdoer. Depending on the shareholder’s loss, a shareholder has to decide what type of action to take against the corporation: a derivative lawsuits or a direct lawsuit.

In this article, we’ll answer the following questions:

·       What’s a derivative lawsuit?

·       What kinds of suits have to be brought derivatively?

·       What is a direct lawsuit?

·       What’s the difference between derivative and direct suits?

·       How do you decide whether a claim is derivative or direct?

·       Why does the distinction between derivative and direct lawsuits matter?

 

Derivative Lawsuits: What is a Derivative Lawsuit?

Initiated by a shareholder on behalf of a corporation, derivative lawsuits are claims that belong to the corporation, but are brought by a shareholder because the corporation’s management is either unwilling or unable to do so. Essentially, derivative lawsuits allow shareholders to force the corporation to sue those that are liable to the corporation. The legal duties in a derivative claim are duties that are owed to the corporation, not the shareholders; the legal remedy that the court awards is for the benefit of the corporation, not the shareholders. These suits are called “derivative,” because the shareholders’ loss is derivative to the corporation’s loss. If a shareholder sues a corporation and claims that the actions of the management harmed him or her individually, it is a direct lawsuit.

The filing shareholders act as a representative, or “ally,” of the corporation in derivative lawsuits. This method is often used to expose fraud and other breaches of fiduciary duty that occur within the corporation, like if perpetrators are actually the highest management positions (for more information regarding the specific responsibilities and roles of Illinois shareholders, see our other article, Duties of LLC Members). Minority shareholders can also file derivative lawsuits, but only in the event of a wrongful sale of corporate control by majority shareholders. While the shareholder is named the plaintiff and the corporation is named as a normal defendant in a derivative action, the corporation is the true plaintiff, and the shareholder, as the representative of the plaintiff, owes fiduciary duties to the corporation and to the other shareholders in conducting the lawsuit.

Examples of Derivative Suits: What Kinds of Suits Have to be Derivative?

  • Breach of Fiduciary Duty or Fraud: An action against directors and officers for breaching their fiduciary duties that belongs to the corporation and must be asserted derivatively by a shareholder. The directors’ duties of loyalty and care run to the corporation, not to the individual shareholders. If the corporation is unwilling to join the suit as a plaintiff due to being controlled by the defendants, it may be named as a nominal defendant.
  • Breach of Statutory Duties: The liability of an officer or director for breach of his or her statutory duties also belongs to the corporation and may properly be asserted in a derivative action.
  • Sale of Control: An action to recover the premium obtained by certain shareholders through the wrongful sale of corporate control may be asserted derivatively. However, unlike a typical derivative action, the benefit of any recovery will accrue only to the minority shareholders who were harmed by the wrongful sale and not to the selling shareholders or their successors in interest.
  • Other Rights Belonging to the Corporation: A cause of action for fraud, breach of confidential relationship and conspiracy must be brought derivatively, if the corporation (not the shareholder) suffered the injuries alleged in his or her individual capacity. A cause of action for failure to assert a legal malpractice claim by the officers and directors of the corporation is also a derivative action.

Direct Lawsuits: What is a Direct Lawsuit?

Based on legal rights that belong to the individual shareholder, direct claims are oftentimes used by shareholders in small corporations, particularly with minority shareholders who are alleging unfair treatment at the hands of majority shareholders. In a direct lawsuit, a shareholder brings forth a claim based on the shareholder’s ownership of shares, so the plaintiff shareholder brings his own claim in his own name to vindicate the violation of legal duties to him or herself and seeking a legal remedy for his or her own benefit. Examples of direct lawsuits include contract rights related to shares, rights related to the recovery of dividends, and rights to review the records of the corporation. In these suits, the individual shareholder is seeking redress of wrongs committed by the corporation’s board or other shareholders that directly affect the individual shareholder.

How Do You Know if Corporate Claim is Derivative or Direct?

If an Illinois court is determining if a claim is direct or derivative, the main focus is on whether the injury associated was either to the shareholder directly or the corporation. If any funds sought to be recovered belong to the corporation, the action is considered derivative. In order to determine if a claim is derivative or direct, answer these two questions:

1.) Who was harmed: a corporation or a shareholder?

2.) Who would receive the benefits of recovery: a corporation or a shareholder?

If the answer to either of these questions is “the shareholder,” the claim will likely be considered direct. If the answer to either of these questions is “the corporation,” the claim will likely be considered derivative.

Why Does the Distinction Matter?

The distinction between derivative lawsuits and direct lawsuits is important, because the law imposes different requirements on the process and the ability of the parties to sue. If a shareholder is planning on asserting a derivative lawsuit, that shareholder is subject to specific requirements that may differ from if the same shareholder were to assert a direct lawsuit. For example, if the lawsuit is a derivative one, shareholders are required to make a demand on the directors to bring a lawsuit from the corporation before they can file a complaint themselves. On the other hand, demand is not required if the suit is a direct one. Directors represent a corporation in all decisions, including litigation matters; therefore, a demand to sue is required. If a board says no, the shareholder cannot bring the same claim on behalf of the corporation unless he or she can prove a wrongful refusal.

If shareholders made a demand and the board of the corporation refused to file a lawsuit, the shareholders have to state that the demand was futile beforehand. Demand requirement may be excused under the demand futility exception if 1) majority of the board is interested or not independent, or 2) if the original decision will not receive a business judgment rule protection. Even if the demand is excused as futile, the boards can still take action to stop the litigation by establishing a committee of disinterested directors to take a fresh look: a Special Litigation Committee. When it comes to deciding whether to uphold the decision of the Special Litigation Committee, Illinois court applies a two-prong test:

1.) Inquiries into dependence and good faith of the committee, and

2.) A balance between legitimate corporate claim and corporation’s best interests in not to due applying court’s own judgment.


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