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Derivative Litigation and Business Judgment

Corporate governance typically allows each shareholder to assert decision-making power proportional to his or her ownership stake in the company. However, under some circumstances a dissatisfied shareholder can cause significant problems for a company through a shareholder derivative suit. This is a process by which one or more shareholders initiate a lawsuit on behalf of the company when those in control of the company refuse to do so. This can potentially allow a minority of shareholders to compel a corporation to take action that is against the will of the directors.

Derivative suits often arise from allegations that the directors or officers of a corporation have breached their fiduciary duty by taking action that was not in the company’s best interests. However, there is a defense. To avoid being put in the position of vicariously managing companies, courts generally defer to the judgment of boards and officers according to the following standards:

  • Business judgment rule ‘ In most U.S. jurisdictions, courts defer to the judgment of corporate managers as long as their decisions appear to have been made in good faith and with reasonable skill and prudence. Essentially, this provides a defense if the decision was not fraudulent or grossly negligent.
  • Reasonableness rule ‘ Some jurisdictions, including Washington, DC, are willing to delve deeper and inquire into the reasonableness of managerial decisions. While courts in these jurisdictions may look at the fairness and rational purpose of managerial actions, it is still largely deferential.

Corporations faced with derivative action by one or more shareholders must take prompt steps to secure their managerial authority. Likewise, shareholders who suspect fraudulent, arbitrary or grossly negligent conduct by their managers should understand they do have legal recourse. An experienced DC metro area business litigation attorney can review your situation and determine what legal options are available.

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