The Derivative Suit

• Author: James D. Cox/Thomas Lee Hazen
• Profession: Professor of Law at Duke University/Professor of Law at the University of North Carolina, Chapel Hill
• Pages: 370-400

§ 15.1 Nature and Basis of Derivative Action

An almost necessary consequence of a wrong to a corporation is some

impairment of the value of each shareholder’s stock interest. As a general

rule, however, shareholders are considered to have no direct individual

right of action for corporation wrongs that impair the value of their

investment. Injuries to t he corporation, such as those resulting f rom neg-

ligence, mismanagement, or fraud of its directors or officers, normally

are not dealt with as wrongs to the whole group of shareholders in their

corporate capacity but rather as a violation of the corporation itself, which

can be re dressed in a suit by or derivat ively on behalf of t he corporation.1

There are at least three sound reasons that continue to support the

continuing distinction between direct and derivative actions. To permit

shareholders to sue separately whenever the value of their shares is dim in-

ished by a wrong to the corporation would conf lict with (1) the separate-

corporate-entity concept, (2) the prior rights of c reditors, and (3) the duty

of management to sue for the protection of all concerned. A single act ion

by the corporation, or by a shareholder in a derivative suit on its behalf,

at least in theory obtai ns redress for all the shareholders and also protects

the priorities of creditors, who may be unable to collect their claims if

corporate assets are recovered by the shareholders indiv idually.

The derivative suit plaintiff is self-selected; without election or

appointment, he presents himself as spokesman for the corporate inter-

est. Because the plaintiff usually has no significant financial interest in

the corporation, the possible harmful economic effects of prosecuting

the suit cannot be expected to guide his decision to litigate. The deriva-

tive suit plaintif f has a fiduciary relationship to the other stockholders of

the corporation,2 yet such a person is not a worthy cand idate to decide by

himself whether the corp orate interest is served by suing on a contract the

corporation has entered, a tort allegedly committed to the corporation’s

property, or any other matter whose initial impact was on the corpora-

tion. These are the types of decisions for which the discretionary judg-

ment of the board of directors or its delegates are readily cal led into play.

As will be seen in succeeding sections, a faint aura of legitimacy

accrues to the plaintiff’s authority to represent the corporate interest

when the demand requirement is excused or otherwise satisfied because

the board of directors, due to its own failings or misconduct, is inca-

pacitated from carry ing out an independent assessment of the corporate

inte rest ser ved by t he suit . To be s ure, t hat aura is not nea rly as br ight as

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it would be had the corporation’s board of directors, after an assessment

from the corporation’s perspective of the costs and benefits, crisply

resolved to pursue the cause of action. Nevertheless, within the narrow

band of factual settings in which the corporate cause of action is today

allowed to proceed at the instance of the derivative suit plaintiff, there

is a highly recognizable legitimacy to the right of the plaintiff and her

lawyer, under the watchful eye of the derivative suit court, to vindicate

the corporation’s injury.

A shareholder’s derivative suit should not be confused with a class

suit, in which shareholders having individual rights and causes of action

against the corporation are represented by a member of the class of

shareholders having the rights and causes of action; the transactions

and the questions of law and fact involved in the suit are common to

all members of the class. In other words, a class action is used for direct

shareholder claims against the corporation.

§ 15.2 Distinguishing the Shareholder’s

Individual Suit from the Derivative Suit

As a rule, t he shareholder’s judicial remedy for mismanagement or other

wrongful acts of directors, officers, or third parties is by a derivative or

representative suit on behalf of the corporation. This result reflects not

only the practical assessment that the misconduct’s initial impact is on

the corporation itself, with any stockholder harm being consequential

to that impact, but also that the duty breached is one owed directly to

the corporation such that it is the corporation’s right that is violated by

the breaching conduct.3 In some instances, however, a personal right

of action is recognized even for corporate wrongs, if a separate duty is

owing to the individual or a collective proceeding on behalf of the cor-

poration does not give the shareholder redress.4 In some circumstances,

either a derivative suit or a direct action may be brought at the share-

holder’s election. The characterization of a particular cause of action as

derivative or direct (which in appropriate cases m ay be brought as a class

action) brings significant procedural differences, which are explored in

succeeding sections. Because of these differences, the initial character-

ization of a suit can be of critical significance.5

Courts frequently have great difficulty in classifying a plaintiff’s

claim as individual or derivative. For example, there has been a conflict

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