In this article, we explain minority shareholder derivative actions in Illinois. A minority shareholder is a shareholder who owns less than 50% of the total shares of a corporation’s stock. For more on the definition of a minority shareholder, check out our article, What Are Minority Shareholders?
A shareholder derivative suit is a lawsuit brought by a shareholder on behalf of a corporation against a third party. This third party could be an employee of the corporation, including an executive officer or director. Typically, a shareholder can only sue on behalf of a corporation when the corporation has a valid cause of action, but has refused or failed to use it. Under traditional corporate law, management is responsible for bringing and defending the corporation against suit. If the suit is successful, the proceeds go to the corporation, not to the shareholder who initiated the suit.
Because the claims are not based on the legal rights of the individual shareholder, but the corporation, the action is “derivative.” However, if the minority shareholder were to bring a claim in his or her own name to seek legal remedy for his or her own benefit, the action would be “direct.” When it comes to derivative actions, even though the minority shareholder is named as the plaintiff and the corporation is named as a nominal defendant, the corporation is truly benefiting from the success of the lawsuit.
For example, a claim for breach of fiduciary duty can only be brought as a derivative suit, while other claims such as breach of statutory duties, breach of confidential relationships, and conspiracy can be brought by either an individual shareholder as a direct claim or a minority shareholder as a derivative action on behalf of the corporation.
In order to file a derivative suit against a corporation, the plaintiff must be a shareholder of the corporation. They must have also been a shareholder at the time of the inciting incident. So, if someone recently became a shareholder, they will not be able to file a derivative suit over an incident that occurred prior to them becoming a shareholder.
Prior to filing the suit, the shareholder must first propose a request or make a demand to the board of the corporation they are in conflict with and ask for the change that they are looking for and believe will be for the betterment of the corporation. The board will be given time to consider the request, often calling on outside or impartial console to determine of the request is worth submitting to. The decision to agree with the shareholder and file the suit or to deny the request falls in the hands of the board.
If the board agrees to the request made by the shareholder and decides to go forward with the lawsuit, the original shareholder and the corporation will begin the derivative suit process against the third party they believe is wronging them. At this time, the shareholder will notify all other shareholders that the suit is going forward and invite them to join if they so choose. Once the process begins, it will develop as a class action lawsuit and the shareholder or shareholders must present the case on behalf of the corporation.
However the board may decide that the claim is not worth pursuing. This may happen if they believe the original claim is without merit or that pursuing the suit would do more harm than good for the corporation. If the board decides the claim is not worth pursuing, but the original shareholder still believes the claim is valid, they could decide to file suit individually, without the backing of the corporation. Continuing the suit individually without the backing of the corporation would be a significant risk for the original shareholder. If they are successful, the shareholder will likely be entitled to compensation for the cost. However, if the individual shareholder’s suit is not successful, they will possibly be held responsible for paying the entire financial cost of the proceedings.
For more on the legal rights of minority shareholders, see our article “What Is Minority Shareholder Oppression?”