Shareholder Actions: Direct Vs. Derivative Suits

When it comes to protecting their interests – or the interests of the corporation – shareholders have unique rights to take legal action. They can file suit either on behalf of the corporation itself, known as a derivative action, or on their own behalf, called a direct action.

On This Page

• What Are Direct Actions by Shareholders?
• Causes of Action
• What Is a Shareholder Derivative Lawsuit?
• Pursuing a Derivative Action
• Derivative Suits Against Closely Held Companies
• Preventing or Defending Against Derivative Action Lawsuits
• Applying Texas’ Business Judgment Rule to Derivative Claims

If you have more questions about your rights as a shareholder, call (713) 909-7323 today.

What Are Direct Actions by Shareholders?

Shareholders have a right to enforce the legal duties owed to them by corporate directors and officers through direct, or individual, lawsuits. These legal actions can address personal losses that result from a corporation’s breach of duty – especially so in small and closely held corporations where minority shareholders have been victimized by majority shareholder oppression.

Although Texas has infamously struck down the cause of action allowing individual shareholders to assert direct claims for shareholder oppression in the landmark Texas Supreme Court case Ritchie v. Rupe, there are many other legal claims.

Corporations owe duties to its shareholders, including its duty to recognize and not impair shareholder ownership rights, deal fairly and act impartially, and account and disclose. As such, there are legitimate avenues for individual shareholders to pursue legal remedies when those rights or duties are violated by a corporation.

Causes of Action

Causes of action (a.k.a. legal justification to bring a suit) to fight shareholder oppression and other forms of corporate misconduct may include:

• Breach of fiduciary duty. Shareholders do not have a formal fiduciary relationship with fellow shareholders or a corporation’s officers or directors but might be owed an informal fiduciary duty by fellow shareholders if they arise from a pre-existing relationship of trust. This is a common scenario in closely held corporations.
• Breach of contract or shareholder agreement violations. This cause of action may be used if a member of the corporation breaches a provision of the shareholder agreement. Breach of contract claims may result in financial damages or equitable remedies.
• Fraud or conspiracy. This can happen when majority shareholders and corporate insiders purchase minority shareholder interests in violation of duties of full disclosure and fairness, for example.
• Quantum meruit. Under this cause of action, the plaintiff seeks recovery for services provided under an implied contract, such as payment for serving on the board or a committee.
• Theft of trade secrets. If a corporate director or officer misappropriated trade secrets for their own private gain, you may have a claim for misappropriation under the Texas Uniform Trade Secrets Act (TUTSA).
• Force an examination of books and records. Shareholders have the right to examine basic documents such as company bylaws and minutes of board meetings. If the corporation refuses, you can file a lawsuit asking the courts to compel the corporation to fully comply with your request.
• Conversion of property. Because stock is considered personal property, individual shareholders may protect their property rights through the conversion cause of action which asserts that the defendant intentionally interfered with the plaintiff’s property causing it to lose value.
• Dividend actions. Individual stockholders have a legal right to corporate dividends and to a proportionate share of company profits and may seek redress for suppression or manipulation of dividends.
• Unjust enrichment. This cause of action is based on the doctrine that no one should be permitted to unjustly enrich themselves at the expense of another, without making compensation.
• Ultra vires. Any act that exceeds or abuses a corporation’s powers and purpose, which are generally laid out in its articles of incorporation or defined by state law.
• Breach of trust. An individual cause of action for breach of trust may arise from a corporation that violates the rights of shareholders or duties owed to shareholders.

What Is a Shareholder Derivative Lawsuit?

Because shareholders are owners of a company that, by law, cannot act for itself, there may be a need to enforce the legal duties corporate directors and officers owe the corporation and its shareholders. Shareholder derivative suits are claims brought on behalf of the corporation by shareholders who act as representatives.

Shareholder derivative suits can address a range of misconduct and fraudulent actions, including:

• Breach of fiduciary duty: Corporate officers and directors owe a fiduciary duty to the corporation that they serve, and they can be held liable if they failed to uphold their duty.
• Fraud and unlawful activity
• Self-dealing
• Unjust enrichment
• Insider trading
• False or misleading financial statements
• Corporate waste

In addition to claims brought against current or former officers and directors of a company, other third parties, such as accountants or lawyers, may also be named as defendants if their conduct caused harm to the corporation and an indirect loss to shareholders.

Pursuing a Derivative Action

In order to pursue a derivative action, Texas law enforces a number of procedural requirements:

1. Shareholders must have been owners at the time of alleged improper conduct;
2. Shareholders must prove they will fairly represent the interests of the company; and
3. Shareholders must formally demand, in writing, the company’s board take action on the basis of suspected misconduct. The board, through a group of officers as removed as possible from the underlying conflict (disinterested directors), has a specified amount of time (90 days) to determine an appropriate course of action. If the group of disinterested directors represents a majority of management, or is a court-appointed panel, and decides pursuing a claim is not in the company’s best interests, the court will be required to dismiss the derivative suit.

Derivative Suits Against Closely Held Companies

The procedural hurdles, and particularly the demand requirement, prove detrimental to the survival of many derivative claims. However, these safeguards are waived for closely held companies.

This means owners of companies or LLCs with fewer than 35 shareholders that are not publicly traded will not have to meet any of the requirements stated above. As such, minority shareholders of closely held companies have a much clearer field to pursue derivative suits on behalf of a corporation, to have those suits treated as direct claims “if justice requires,” and to prevail in recovering personally for damages that would have otherwise been provided and taxed through the corporation.

For these reasons, derivative claims have become a cornerstone in litigating minority and majority shareholder disputes.

Preventing or Defending Against Derivative Action Lawsuits

Directors and officers can mitigate the risk of derivative actions – and often defeat a derivative suit – by practicing good corporate governance, always acting in the best interests of the business, and dealing with shareholders in good faith.

You may be able to avoid shareholder derivative claims, or present a strong legal defense, by following these good governance practices:

• Promptly disclose material information to shareholders, such as notices of investigations or lawsuits.
• Take care with corporate assets. Improper or excessive executive compensation packages, for example, often lead to allegations of corporate waste.
• Take your oversight duties seriously. Failure to conduct due diligence over transactions or failure to act in the face of red flags may lead to allegations of failure of oversight. Be prepared to support board decisions with evidence and sound reasoning.
• Beware of conflicts of interest and remove yourself before participating in the decision-making process.

Applying Texas’ Business Judgment Rule to Derivative Claims

Texas has a business judgment rule, established by court precedent, that serves as a defense to breach of fiduciary duty claims in derivative lawsuits. The rule generally protects corporate officers and directors who use honest discretion and judgment when making decisions, even if those decisions turn out to be unwise, imprudent, or even negligent.

In other words, making bad decisions or mismanaging the business may not be sufficient grounds for a derivative action lawsuit. The rule will not protect directors or officers, however, from liability for fraudulent, criminal, or self-dealing acts.

Call Hendershot Cowart P.C. Today

At Hendershot Cowart P.C., our industry leading business law attorneys represent clients throughout the state of Texas when they wish to assert their rights as shareholders or defend against legal action. We also consult and work with clients who wish to create shareholder agreements and other governing documents or contracts to protect themselves against partnership and shareholder disputes.

If you wish to discuss your rights as a shareholder, or would like more information about pursuing or defending against a direct or derivative shareholder action, call (713) 909-7323 or contact us online to request an initial consultation.