The Derivative Suit

AuthorJames D. Cox/Thomas Lee Hazen
ProfessionProfessor of Law at Duke University/Professor of Law at the University of North Carolina, Chapel Hill
§ 15.1 Nature and Basis of Derivative Action
An almost necessa ry 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 a re 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 direc tors or officers, normally
are not dealt with as wrongs to t he 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 t hat 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 fi nancial interest in
the corporation, the possible harmful economic ef fects 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 stock holders 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 initia l impact was on the corpora-
tion. These are the t ypes 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 ow n 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. Nevert heless, within t he narrow
band of factual settings in which t he corporate cause of action is today
allowed to proceed at the instance of the derivative suit plaintiff, t here
is a highly recognizable legitimacy to the right of the plaintiff and her
lawyer, under the watchful eye of the derivative su it court, to vindicate
the corporation’s injury.
A shareholder’s derivative suit should not be confused with a class
suit, in which shareholders havi ng 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 t he suit are common to
all members of the class. In ot her 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 act ion 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 d ifferences, which are explored in
succeeding sections. Because of these d ifferences, 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 individua l or derivative. For example, there has been a conflict
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