Corporations as Litigants: What Businesses Need to Know About Direct and Derivative Lawsuits and Special Litigation Committees

Direct and Derivative Lawsuits

When Businesses are Involved in Lawsuits: Corporations as Litigants

Business enterprises (corporations for purposes of this article), just like people, can be sued and can sue other corporations or people.  In our legal system, a corporation is considered a person and therefore is subject to the same laws that govern a person.  Unlike a person, however, a corporation does not make its own decisions. Not to be too Star Trek-ish, but a corporation cannot think for itself; a corporation, while legally held to its actions, makes decisions on what it is or is not going to do through its board of directors.

Corporate Governance: How Boards of Directors Function

Corporations make decisions by way of a consistent process.  The shareholders of the corporation elect the board of directors.  When the shareholders elect the board of directors, they “delegate” to the board of directors the obligation or duty to oversee and manage the operations of the corporation.

A board of directors is generally referred to as a governing body.  While a board of directors is made up of individuals, a board of directors acts as a single body.  A board can take an action on behalf of a corporation; an individual member of a board of directors does not have the power to “act” by themselves on behalf of the corporation.  So, while each person on a board of directors generally votes yes or no on an action (or they abstain), approval of an action requires a majority of directors voting “yes” for an act of a corporation to be approved and authorized.  Regardless of “no” votes, if the requisite number of board members vote yes to approve an action, the board of directors is deemed to have approved an action for the corporation.  Basically, majority rules.

Once a board of directors decides on a course of action, the officers or managers of the corporation undertake the actions or authorize employees to take the action.  Officers and managers can make decisions on everyday or “ordinary” actions without board approval.  Major or important decisions that fall “outside the ordinary course of business” require the board of directors to act.  And extraordinary decisions – like the decision to shut down or dissolve a corporation, merge or sell all or substantially all of the assets – required the shareholders to have a meeting to vote yes or no on an action.

This process is called corporate governance; it is not a coincidence that it looks similar to how federal, state and local governments take actions and operate.  The important part of this process is that once the shareholders delegate the authority to the board of directors, the remedies available to shareholders when something goes wrong are limited.  Live with the consequences of a decision, vote out the members of the board of directors, or sue the corporation.

Why Special Litigation Committees are Formed During Lawsuits

When a corporation is involved in litigation – either it has been sued or it is suing someone – if the magnitude of the litigation is large (as measured by the amount of damages or fines or the negative impact on the business as a result of a lawsuit) then decisions regarding this sort of litigation generally resides with board of directors of the corporation.  Sometimes lawsuits of this magnitude are referred to as “bet the farm” litigation.  Another way of thinking about the magnitude of a lawsuit is if the amount of money that would be required to either a) take the lawsuit all the way to trial or b) be paid out if the corporation loses the lawsuit equals a substantial percentage of the annual revenues of a corporation, decisions about this sort of lawsuit are made by the board of directors (not the management of the corporation).  When a board of directors needs to make decisions about a lawsuit, it generally (but not always) puts in place a special litigation committee.

A special litigation committee (SLC) is a committee formed by a corporation’s board of directors to investigate and make recommendations regarding a particular legal claim or dispute that involves the business itself. The SLC is typically composed of independent directors who are not involved in the matter under review and who are appointed specifically to evaluate the matter objectively.

The Purpose of Special Litigation Committees

The job of the SLC is to decide if pursuing or defending a particular legal claim is in the best interests of the corporation and its shareholders. When a board of directors makes a decision for a corporation, the individuals on the board of directors cast votes based on what they think is in the best interest of the corporation and its shareholders.  An SLC does the legwork that leads up to that decision.  An SLC may investigate the claim, review relevant documents and evidence, interview witnesses and experts, and make recommendations to the board of directors regarding the appropriate course of action.

If an SLC recommends that a corporation pursue a claim, the board of directors may authorize the corporation to do so. If an SLC recommends that the corporation not pursue the claim, the board of directors may decide not to pursue the claim or may make a different decision based on other factors.

The use of an SLC can help ensure that legal claims or disputes are evaluated objectively and in the best interests of the corporation and its shareholders, rather than being influenced by individual directors or officers.

Stockholder Lawsuits Against a Corporation

Sometimes the owners of a business enterprise (in a corporation: its shareholders) are compelled by circumstances or events to sue the corporation itself for harm the owner of stock of the corporation feels they are suffered in their capacity as a shareholder or stockholder.  With public companies whose stock is traded on the public stock exchanges, shareholders who bring lawsuits against a corporation may only hold a few shares of stock in these companies in order to bring lawsuits.  There are generally two different types of shareholder lawsuits.

Direct Shareholder Lawsuit

A direct shareholder lawsuit is a legal action brought by a shareholder or a group of shareholders on their own behalf, rather than on behalf of the corporation, against the corporation or its officers and directors for harm or damages that have been directly caused to the shareholder.

Direct shareholder lawsuits typically involve claims related to a breach of fiduciary duty, misrepresentation, or other alleged wrongdoing that has resulted in a direct financial loss to the shareholder. Unlike derivative lawsuits, direct shareholder lawsuits are brought by the individual shareholder seeking to recover damages for their own losses, rather than on behalf of the corporation.

Direct shareholder lawsuits can be complex and require careful analysis of the facts and legal issues involved. However, they can be an important tool for individual shareholders to hold corporations and their officers and directors accountable for wrongdoing that has directly harmed them.

Derivative Shareholder Lawsuit

A derivative lawsuit is a type of legal action brought by a shareholder or a group of shareholders on behalf of a corporation against a third party, usually the corporation’s officers or directors, for breach of fiduciary duty, fraud, or other wrongdoing that has caused harm to the corporation. The shareholder acts as a representative of the corporation, seeking to recover damages or obtain other relief for the corporation, rather than for the individual shareholder.

Generally, a shareholder does not have the authority to act on behalf of a corporation or cause a corporation to act.  That authority usually resides with the board of directors who makes the decisions and are then further delegated to the officers of a corporation who act to make those decisions happen.

Because of this, derivative lawsuits are typically brought when the corporation’s management or board of directors has failed to take action to address the wrongdoing or is itself implicated in the wrongdoing. The lawsuit is brought in the name of the corporation, but the shareholder who brings the suit (known as the “plaintiff”) must first obtain permission from a court to do so.  The court for a derivative lawsuit sits in the state of incorporation or formation of the corporation since that is the court that has “jurisdiction” over the corporation itself.

To succeed in a derivative lawsuit, the plaintiff shareholder must demonstrate that the defendants breached their fiduciary duties or engaged in other wrongful conduct that caused harm to the corporation, and that the corporation’s management or board of directors failed to take action to address the wrongdoing. Any damages recovered in the lawsuit are typically paid to the corporation, rather than to the individual shareholders who initiated the lawsuit.

Derivative lawsuits can be complex and time-consuming, and they require careful analysis of the facts and legal issues involved. However, they can be an important tool for holding corporate officers and directors accountable and recovering damages for harm caused to the corporation.

The Role of Attorneys in Corporate Lawsuits

Lawsuits involving corporations are complicated regardless of who is being sued or who is doing the suing.  Some lawyers do nothing but sue corporations on behalf of shareholders while other lawyers spend their days helping corporations and boards of directors navigate the decisions required to be made when lawsuits abound.  Regardless of sides, lawyers are necessary to guide shareholders, boards of directors and officers and managers during any sort of litigation.

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Kimberly Lowe

Kimberly Lowe

For over 20 years I have lawyered from the trenches with experience based on a comprehensive knowledge and understanding of how both for-profit and nonprofit enterprises operate. I guide entrepreneurs, executive management teams, boards of directors, multigenerational families, shareholders and investors through all aspects of the business life cycle from formation to operation to exit. Read Kim's Bio.

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