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Is Shareholder Derivative Action Right For You?

What if the corporation is defrauded by one or more insiders who can control the board of directors and effectively prevent the corporation from seeking damages against the wrongdoing insiders? As an example, suppose the CEO has set up a competing business to capitalize on an opportunity that rightfully belonged to the corporation and the board of directors knows about it but does nothing to stop the CEO? Where the corporation has been ripped off by insiders and the board fails to take action to protect the corporation’s interests, the law provides a remedy to the shareholders: any shareholder who owned their shares at the time of the fraud can bring suit in right of the corporation to pursue the legal claim that the corporation’s board failed to pursue. This type of shareholder derivative action is particularly useful when the corporation’s claim for damages is against insiders who control the corporation and who would not authorize the corporation to bring a lawsuit against themselves. A shareholder derivative lawsuit is a very strong weapon for remedying frauds perpetrated on the corporation by insiders.

Some of the types of frauds on the corporation which can be remedied by a shareholder derivative lawsuit include:

Diversion of corporate opportunities

Occasionally a director, CEO or other executive officer of a closely held corporation will decide to benefit himself at the expense of the corporation and its shareholders by stealing away a business opportunity that properly belongs to the corporation. As an example, an officer might learn that a customer is looking for a product that it has not previously ordered from the corporation but which the corporation could easily supply to the customer at a nice profit by getting it from another vendor. Suppose in that scenario the officer decides to set up his own sideline business and sell the product to the customer through the officer’s sideline business, which he feels is justified because his corporate employer has not historically dealt in the product the customer is now seeking and, anyway, he feels it is justified because he feels his corporate employer has not been compensating him enough lately for all the work he does. So, the corporate officer proceeds to discretely supply the new product line to the customer through his own corporation set up for this purpose.

This is a very simple example of a diversion of a corporate opportunity by a corporate officer who had a fiduciary duty to present the opportunity to the corporation and not to divert it to himself. Even without a written agreement every director and officer of the corporation is held to a high standard of fiduciary duty to the corporation. They are not allowed to profit at the expense of the corporation. Before an officer may profit from a business opportunity that properly belonged to the corporation there must be full disclosure of all relevant facts of the opportunity to the board of directors and an affirmative election not to pursue it by the board without participation in the deliberations or the vote by the interested officer or director. Officers and directors are simply not free to pick and choose the business opportunities they will consider their own.

Such opportunities are presumed to be opportunities of the corporation and there must be a proper record demonstrating presentation of the opportunity to the corporation and an affirmative decline to pursue the opportunity by the corporation’s board of directors. Profits made by an officer or director who diverts a corporate opportunity to himself or to another party are deemed held in trust by the officer or director and can be recovered in a suit by the corporation for breach of fiduciary duty, for constructive trust and for an accounting. If the board of directors declines to pursue such a claim any shareholder can seek to recover the diverted profits for the corporation through a shareholder derivative suit brought in the right of the corporation.

Fraudulent transfers of corporate assets

Sometimes an officer of the corporation or a corporate employee steals money or property from the company. We all know that embezzlement and theft happens in the real world but we are reluctant to consider that someone we know and work with on a regular basis might actually be stealing. We give people the benefit of the doubt. This can be hazardous for directors on corporate boards. Directors have a duty to investigate suspicious activities and transactions, and there is almost always some kind of suspicious circumstance where there has been a theft of money or property of the corporation by an insider. Directors must be vigilant and insist that accounting and control procedures put in place to prevent theft and fraud are adhered to, and any deviation from those procedures should be investigated.  When serious theft of money or property of the corporation occurs the directors have a duty to pursue it.

In the real world, sometimes corporate boards just want to cover it up to avoid public scandal and keep investors and other stakeholders from learning about it. Theft of money or property from the company creates a claim for recovery of the assets or their value by the corporation and it is a situation that puts the corporation at risk of further loss from fraud if the wrongdoing is covered up and the culpable parties, often insiders, are not exposed through investigation and pursuit of the loss. If the board of directors fails to pursue such a fraudulent transfer of corporate assets any shareholder may take up the cause by bringing a shareholder derivative action in the right of the corporation. Before bringing a derivative lawsuit a shareholder is required to inform the corporation’s board in writing of the facts underlying the proposed case and give the board an opportunity to pursue the claim.

Failure to pursue claims of the corporation

Claims of the corporation against wrongdoers who are not directly connected to the company as employees, officers or directors can also be pursued by a shareholder derivative action when the corporation’s board of directors negligently fails to pursue such claims to the injury of the company. Such wrongdoing by outsiders may take many forms such as unfair competition, raiding of the corporation’s staff, or theft of intellectual property or trade secrets, among many other forms in which such unlawful conduct by outsiders can manifest.

Occasionally the perpetrators of such assaults on the corporation’s business and property are assisted by one or more persons inside the corporation who will benefit from the unlawful taking of the corporation’s business or property. Ultimately, it is the shareholders who lose when such claims of the corporation are not pursued since it affects the value of the corporation and the failure to pursue such claims is likely to make the wrongdoers feel they can get away with further wrongdoing with impunity.

If you have been defrauded by corporate insiders and you would like to know if shareholder derivative action is the best course of action, call me for a free consultation to discuss your case.