Shareholder Derivative Suit
A derivative suit is a lawsuit brought by a shareholder on behalf of the corporation against a third party — usually directors or officers — for harm done to the corporation. The recovery goes to the corporation, not the suing shareholder. Derivative suits are the primary mechanism for enforcing fiduciary duties against insiders.
Elements (Procedural Prerequisites)
- Stock ownership: plaintiff must have been a shareholder at the time of the alleged wrong (contemporaneous ownership rule, FRCP 23.1) and must maintain ownership throughout the litigation
- Demand or demand excuse: plaintiff must either make a written demand on the board to bring suit and have the demand refused, OR show that demand is excused as futile
Demand Futility (Aronson / Rales Tests)
Aronson test (Del.) — demand excused if plaintiff pleads particularized facts creating reasonable doubt that:
- A majority of the board is disinterested and independent, AND
- The challenged transaction was otherwise the product of a valid exercise of business judgment
Rales test — applies when the board did not approve the challenged transaction (oversight claims, Caremark); demand excused if a majority of the current board faces a substantial likelihood of personal liability.
If demand is made and the board refuses, the refusal is reviewed under the business judgment rule (was it made in good faith, on an informed basis, by disinterested directors?).
Special Litigation Committee (SLC)
If the board forms a Special Litigation Committee of independent directors to evaluate the derivative suit:
Delaware (Zapata two-step):
- Court evaluates the independence of the SLC members and the good faith/reasonableness of their investigation
- Court applies its own independent business judgment to decide whether the suit should proceed
MBCA approach: court applies business judgment deference to the SLC’s decision if the SLC is disinterested and acts in good faith.
Settlement and Attorney’s Fees
Derivative suits require court approval for settlement. Attorney’s fees are paid by the corporation if the suit results in a substantial benefit to the corporation (corporate benefit doctrine). This creates incentive for both meritorious and strike suits.
Policy
- Shareholders must overcome the board’s right to control corporate litigation; demand requirement filters nuisance strike suits while preserving access for meritorious claims
- SLC mechanism allows the corporation (through independent directors) to terminate frivolous suits with judicial oversight
- Contemporaneous ownership rule prevents “buying into” a lawsuit
Key Cases
| Case | Rule |
|---|---|
| Aronson v. Lewis (Del. 1984) | Articulates the demand futility test for interested transactions |
| Rales v. Blasband (Del. 1993) | Alternative demand futility test for claims not involving board approval |
| Zapata Corp. v. Maldonado (Del. 1981) | SLC may move to terminate derivative suit; court uses two-step independent review |
| Beam v. Stewart (Del. 2004) | Independence requires more than mere social friendships; inquiry is director-specific |
| In re Oracle Corp. Derivative Litigation (Del. Ch. 2003) | SLC members with ties to Stanford (where defendant professors worked) lacked independence |