Shareholder Derivative Actions: From Cradle To Grave

1. DERIVATIVE ACTIONS BROUGHT IN STATE AND FEDERAL COURT Please click on the following link to read this article and its footnotes in full: Shareholder Derivative Actions: From Cradle To Grave

1. Defining Derivative Claims 1. What Is A Derivative Action? a. A derivative action is actually two causes of action: it is an action to compel the corporation to sue and it is an action brought by a shareholder on behalf of the corporation to redress harm to the corporation. See Aronson v. Lewis, 473 A.2d 805, 811 (Del. 1984) ("The nature of the action is two-fold. First, it is the equivalent of a suit by the shareholders to compel the corporation to sue. Second, it is a suit by the corporation, asserted by the shareholders on its behalf, against those liable to it."); Brown v. Tenney, 532 N.E.2d 230, 232 (Ill. 1988) (a derivative action is in effect two actions: "one against the directors for failing to sue; the second based upon the right belonging to the corporation.").

   2. A derivative action allows shareholders to monitor and redress harm to the corporation caused by management where it is unlikely that management will redress the harm itself. Meyer v. Fleming, 327 U.S. 161, 167 (1946) ("[T]he purpose of the derivative action [is] to place in the hands of the individual shareholder a means to protect the interest of the corporation from the misfeasance and malfeasance of 'faithless directors and mangers'" (quoting Cohen v. Beneficial Indus. Loan Corp., 337 U.S. 541, 548 (1949)); Kamen v. Kemper Fin. Servs., Inc., 500 U.S. 90, 95 (1991) (same); Jones v. H. F. Ahmanson & Co., 1 Cal. 3d 93 (1969) ("A shareholder's derivative suit seeks to recover for the benefit of the corporation and its whole body of shareholders when injury is caused to the corporation that may not otherwise be redressed because of failure of the corporation to act. Thus, 'the action is derivative, i.e., in the corporate right, if the gravamen of the complaint is injury to the corporation, or to the whole body of its stock or property without any severance or distribution among individual holders, or if it seeks to recover assets for the corporation or to prevent the dissipation of its assets.").

   3. An action is derivative when brought by a shareholder on behalf of the corporation for harm suffered by all shareholders in common. See Levine v. Smith, 591 A.2d 194, 200 (Del. 1991) ("A shareholder derivative suit is a uniquely equitable remedy in which a shareholder asserts on behalf of a corporation a claim belonging not to the shareholder, but to the corporation."); Lewis v. Knutson, 699 F. 2d 230, 237-38 (5th Cir. 1983) ("When an officer, director, or controlling shareholder breaches [a] fiduciary duty to the corporation, the shareholder has no 'standing to bring [a] civil action at law against faithless directors and managers,' because the corporation and not the shareholder suffers the injury[; e]quity, however, allow[s] him to step into the corporation's shoes and to seek in its right the restitution he could not demand on his own."); Avacus Partners, L.P. v. Brian, CCH Fed. Sec. L. Rep. ¶ 96,232 (Del. Ch. 1990) (action is derivative because it is brought by one or more shareholders on behalf of the corporation rather than by the corporation itself); see also, Katz v. Halperin, 1996 WL 66006, at *4 (Del. Ch. Feb. 5, 1996) ("A proven claim of mismanagement resulting in corporate waste is a direct wrong to the corporation, and all stockholders experience an indirect wrong. Corporate waste claims are derivative, not individual.").

      (1) "Although most derivative suits involve claims by a shareholder on behalf of a corporation, derivative suits also may be filed by members of an unincorporated association, such as a limited partnership." Draper Fisher Jurvetson Mgmt. Co. V, LLC v. I-Enterprise Co. LLC, 2004 WL 2944055, at *2 (N.D. Cal. Dec. 15, 2004) (plaintiff invested in venture capital funds, then alleged damages in the millions as a result of the defendants' fraudulent and negligent misrepresentation, breach of contract, breach of fiduciary duty, etc.; court held that most of the plaintiff's claims were derivative and had to be brought on behalf of the funds, of which plaintiff was a limited partner); see also Caparos v. Morton, 845 N.E.2d 773, 781 (Ill. App. 1 Dist. 2006) ("Limited partners seeking redress for the decreased value of their shares in the limited partnership must do so in a derivative action.").

      (2) "The same factors that caused the courts to fashion the derivative action procedure for shareholders and limited partners thus apply to condominium unit owners. All are owners of fractional interests in a common entity run by managers who owe them a fiduciary duty that requires protection. Condominium unit owners are, therefore, entitled to the same consideration by the courts as the litigants in those situations in which the courts have historically allowed derivative actions to proceed, independent of any statutory authority." Caprer v. Nussbaum, 825 N.Y.S.2d 55, 67 (2d Dep't 2006).

   4. In contrast, an action brought by a shareholder for harm done to an individual shareholder or a group of shareholders is a direct action. See Kahn v. Kaskel, 367 F. Supp. 784 (S.D.N.Y. 1973) (a class action by shareholders is based upon individual rights belonging to each member of the class); Von Brimer v. Whirlpool Corp., 367 F. Supp. 740 (N.D. Cal. 1973) (if the injury is to one of the shareholders and not the corporation, it is direct), aff'd in part, rev'd on other grounds, 536 F.2d 838 (9th Cir. 1976); Behrens v. Aerial Comm., Inc. Del. Ch., No. 17436 (May 18, 2001) ("The distinction between a direct and derivative claim . . . turns on the existence of direct or 'special' injury to the plaintiff stockholder.").

      (1) A direct action can take many forms. See, e.g., In re Worldcom, Inc., 323 B.R. 844, 850 (Bankr. S.D.N.Y. 2005) ("Common examples of direct actions include suits to compel the payment of a dividend, to protest the issuance of shares impermissibly diluting a shareholder's interest, to protect voting rights or to obtain inspection of corporate books and records."); The Winer Family Trust v. Queen, 2004 WL 2203709, at *25 (E.D. Pa. Sept. 27, 2004) ("If the injury is one to the plaintiff as an individual shareholder, as where the action is based on a contract to which the shareholder is a party, or on a right belonging severally to the shareholder, or on a fraud affecting the shareholder directly, or if there is a duty owed to the individual independent of the person's status as a shareholder, the shareholder may assert a direct action on his own behalf."); Lefkowitz v. Wagner, 395 F.3d 773, 777 (7th Cir. 2005) (held that partners in a general partnership have a right to bring individual suits against fellow partners; analogizing the position of a general partner's suit "to a suit by a minority shareholder against the majority shareholder, claiming that the latter has violated the fiduciary duty that such a shareholder, especially in a closely held corporation, owes to minority shareholders.").

      2. How To Distinguish Between Direct And Derivative Actions? a. It is not always easy to tell whether an action is derivative or direct. See Abelow v. Symonds, 156 A.2d 416, 420 (Del. Ch. 1959) ("[T]he line of distinction between derivative suits and those brought for the enforcement of personal rights asserted on behalf of a class of stockholders is often a narrow one, the latter type of actions being designed to enforce common rights running against plaintiffs' own corporation or those dominating it, while the former are clearly for the purpose of remedying wrongs to the corporation itself"). Often, the same set of facts gives rise to both direct and derivative claims. See, e.g., Grimes v. Donald, 673 A.2d 1207, 1212 (Del. 1996); H. F. Ahmanson & Co., 1 Cal. 3d at 107 ("The individual wrong necessary to support a suit by a shareholder need not be unique to that plaintiff. The same injury may affect a substantial number of shareholders. If the injury is not incidental to an injury to the corporation, an individual cause of action exists."); Behrens, Del. Ch., No. 17436 ("The distinction between a direct and derivative claim, which is difficult to apply in specific circumstances, turns on the existence of direct or 'special' injury to the plaintiff stockholder."); Tuscano v. Tuscano, 403 F. Supp. 2d 214, 222 (E.D.N.Y. 2005) ("Obviously, any benefit derived by a corporation through derivative litigation will inure to an individual who owns half of that corporation. [But, that] standing alone, is not a reason to dismiss [a] plaintiff''s lawsuit. Under New York law, a shareholder derivative action is an appropriate method for one fifty-percent shareholder to obtain relief in the name of the corporation against the other fifty-percent shareholder."); In re J.P. Morgan Chase & Co. S''holders Litig., 2005 WL 1076069, at *6 (Del. Ch. Apr. 29, 2005) ("[When a] board of directors authorizes the issuance of stock for no or grossly inadequate consideration, the corporation is directly injured and shareholders are injured derivatively . . . [and] mere claims of dilution, without more, cannot convert a claim traditionally understood as derivative, into a direct one."); Gentile v. Rossette, 2005 WL 2810683, at *4-5 (Del. Ch. Oct. 20, 2005) (plaintiffs' claim for dilution for conversion of notes and stock was derivative; when board of directors authorizes the issuance of stock for no or grossly inadequate consideration the corporation itself is directly injured and the stockholders are injured derivatively); Rawoof v. Texor Petroleum Co., Inc., 521 F.3d 750, 757-58 (7th Cir. 2008) (plaintiff brought a direct action invoking the agency doctrine, claiming that he entered into an agreement with defendant corporation as an agent of his own company; court held that plaintiff was barred from bringing a direct claim because his status as a sole shareholder...