What Is a Derivative Action for Corporations or LLCs?

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Directors and officers of a corporation, as well as managers and members of an LLC, must always act in the best interests of the company. A derivative lawsuit is a mechanism that can be used to protect shareholders from abuse by a corporation’s officers and directors by ensuring accountability when those in control fail to pursue legal action. Similarly, these types of actions can also be used when an LLC has been wronged by a manager or member. If you’re a corporate shareholder or LLC member, it’s important to understand what a derivative action is — and when it is necessary to bring one.

What Is a Derivative Action?

A derivative action allows a shareholder to bring a lawsuit on behalf of the corporation or LLC when the company itself has been harmed. Not to be confused with direct claims, these types of lawsuits are typically brought by a minority shareholder or LLC member to address the misconduct of a director, officer, or LLC manager who is not acting in the best interests of the company. They can also be brought by a minority shareholder, or a group of minority shareholders, against a majority shareholder.

A derivative action can be used to address a wide range of wrongdoing, including the following:

  • Breach of fiduciary duty
  • Allegations of fraudulent activity
  • Unjust enrichment
  • Corporate waste and abuse of company assets
  • Self-dealing and conflicts of interest
  • Insider trading

Derivative actions can be crucial for safeguarding the interests of shareholders and LLC members. These lawsuits help to ensure that the company enforces its rights and can recover the damages to which it is legally entitled. In addition to an award of monetary damages and equitable relief, a prevailing plaintiff in a derivative suit may also be awarded their attorneys’ fees.

Requirements for a Derivative Action

Derivative actions are complex, and it is essential to have a skilled business law attorney by your side to help you navigate the legal process. We welcome you to schedule a consultation to learn how our business lawyer can help.

When a company has suffered damages, the board of directors (or managers in an LLC that is manager-managed) typically make the decision regarding whether to file a lawsuit. A derivative suit can be brought when those who control the company fail to act. However, certain criteria must be satisfied before a legal action can be commenced.

One of the requirements that must be met before a derivative action can be filed is that a demand must first be made on the corporation’s board of directors, or managers/members of the LLC. This requirement may be waived if it can be shown that the demand would be futile — making a demand is usually not necessary in matters where the directors would be defendants in the case. In some instances, a lawsuit can be avoided if the board is able to resolve the issue after the demand has been made.

In addition, the shareholder bringing the suit must have been a shareholder of the company at the time the harm occurred, although there are specific exceptions to this rule. For example, a shareholder may have standing to bring a derivative suit if they acquired their shares by operation of law from a person who was a shareholder at the time the misconduct took place. A shareholder may also proceed with a derivative suit at the court’s discretion, if they acquired their shares prior to disclosure of the wrongdoing that is the basis of the action.

How Is It Determined Whether a Claim Is Direct or Derivative?

Sometimes, it can be difficult to determine whether a claim should be brought as a direct or derivative action. However, the legal processes and requirements for each type of lawsuit are different. If a shareholder is seeking a legal remedy which would benefit themselves, such as in cases involving a freeze-out, the suit would be brought as a direct action. If the company would benefit from the outcome of the action, the lawsuit would be a derivative action. Simply put, an action would be considered a derivative suit if the funds to be recovered belong to the company.

Some types of claims can only be brought as a derivative action. Others can be brought as either a direct claim or derivative claim, such as those involving conspiracy or a breach of confidential relationship, depending upon whether the injuries were suffered by the shareholder in their individual capacity or the corporation. Importantly, a demand to the board of directors must only be made in a derivative action — this requirement does not apply if the lawsuit is a direct action.

Contact an Experienced Illinois Business Litigation Attorney

Derivative actions are complex, and it is essential to have a skilled business law attorney by your side to help you navigate the legal process. Located in Rolling Meadows, Litico Law Group’s business litigation attorneys provide reliable representation and capable counsel for a wide array of business disputes in Illinois, including those involving derivative actions. We welcome you to contact us at (847) 307-5942 to schedule a consultation to learn how we can help.

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