Derivative Lawsuit

Derivative Lawsuit (also known as a 'Shareholder Derivative Suit' or 'Stockholder Derivative Action') is a special type of lawsuit brought by a shareholder on behalf of the corporation, rather than for themselves directly. Think of it as a shareholder stepping into the company's shoes to sue wrongdoers when the company's own management refuses to do so. The most common targets of these suits are the company's own executives or board of directors, who may be accused of breaching their duties through actions like fraud, insider trading, or gross mismanagement. The core idea is that these actions harmed the corporation as a whole, thereby damaging the value of its shares. If the lawsuit is successful, any financial compensation recovered goes directly into the company's treasury, not into the pocket of the shareholder who filed the suit. This mechanism serves as a powerful tool for holding management accountable and protecting the long-term value of the enterprise.

For a value investing practitioner, a derivative lawsuit is more than just legal drama; it's a critical aspect of corporate governance. Strong governance protects a company's assets and ensures that management acts in the best interest of the shareholders. When this breaks down, shareholder value is destroyed. Derivative lawsuits act as a crucial check on corporate power. The mere threat of one can deter executives from engaging in self-serving behavior that harms the company. For an investor, the filing of a derivative suit can be a major red flag, signaling deep-seated problems with a company's leadership and internal controls. However, it can also be a sign of a healthy, engaged shareholder base willing to fight for their rights. A successful suit that ousts corrupt management or recovers misappropriated funds can unlock significant value for the company, benefiting all shareholders in the long run. By understanding this tool, investors can better interpret boardroom conflicts and assess the quality of a company's governance.

Bringing a derivative lawsuit isn't as simple as filing a complaint. Courts have put procedures in place to prevent frivolous lawsuits that could distract and harm the very company they are meant to protect.

Typically, before filing suit, a shareholder must first make a formal 'demand' on the corporation's board of directors. This demand is essentially a letter that lays out the alleged wrongdoing and requests that the board take legal action against the responsible parties. The board's independent members must then investigate the claim.

• If the board agrees, the corporation itself will file the lawsuit, and the shareholder's involvement ends.
• If the board refuses, they must justify their decision, often by stating that a lawsuit is not in the company's best interest. This decision is often protected by the business judgment rule.

What happens if the board is packed with the very people who committed the wrongdoing? In that case, making a demand would be a pointless exercise. This is where the concept of 'demand futility' comes in. A shareholder can ask the court to skip the demand requirement by arguing that the board is too conflicted or biased to make an impartial decision. For example, if a majority of the board members are accused in the lawsuit, making a demand on them to sue themselves would be futile. Proving demand futility is often the first major battle in a derivative lawsuit.

It’s crucial to remember: the shareholder who brings the suit is acting as a champion for the company. Any money won in the lawsuit goes to the corporation. This replenishes the corporate treasury and benefits all shareholders by increasing the company's overall value. To encourage these lawsuits when they are necessary, courts will often award the successful shareholder plaintiff their legal fees, paid from the funds recovered for the corporation.

A famous derivative lawsuit involved Tesla's 2016 acquisition of SolarCity. Shareholders sued CEO Elon Musk and the board, alleging that the deal was essentially a bailout for the struggling solar panel company, which was founded and run by Musk's cousins. The lawsuit claimed that Musk, who was a major shareholder and chairman of both companies, pushed the deal through a conflicted board to benefit himself and his family at the expense of Tesla shareholders. While the court ultimately ruled in Musk's favor, the case is a textbook example of a situation ripe for a derivative suit: a major corporate action tainted by allegations of self-dealing and conflicts of interest among leadership.

As an investor, you can watch for warning signs that might indicate poor governance and a higher risk of value-destroying behavior.

• Conflicts of Interest: Scrutinize transactions with 'related parties'. Is the company doing business with firms owned by the CEO's family members?
• A Weak Board: Does the board of directors consist mainly of the CEO's friends, family, and close business associates, or is it composed of strong, independent outsiders?
• Excessive Pay: Is executive compensation outrageously high and disconnected from the company's actual performance? This can suggest a board that is too cozy with management.
• A History of Scandals: Have the company or its executives repeatedly been investigated or fined by regulators? A pattern of misconduct is a significant red flag.