Shareholder Derivative Suits

When a company is harmed by the actions or inaction of a controlling shareholder, director, or officer, the other shareholders may file suit to stop the harm. Illinois law permits shareholders (or members of a limited liability company) to maintain a “derivative action” on behalf of the company. Unlike a typical lawsuit filed by an individual, a derivative action is brought on behalf of the company itself and not in the name of the shareholder who filed the suit. Damages in derivative actions are paid to the company and not the shareholder.

In Brown v. Tenney, 125 Ill.2d 348 (1988), the Illinois Supreme Court described the purpose of derivative actions as follows:

The derivative suit is a device to protect shareholders against abuses by the corporation, its officers and directors, and is a vehicle to insure corporate accountability. The derivative action really consists of two causes of action: one against the directors for failing to sue; the second based upon the right belonging to the corporation. The action is typically brought by a minority shareholder, because a majority or controlling shareholder can usually persuade the corporation to sue in its own name.

As the court explained, the shareholder filing a derivative action acts as the representative of the company in the suit. When a company has been harmed, the decision whether or not to initiate a lawsuit is typically made by the board of directors (or managers in a manger-managed LLC). The mechanism of shareholder derivative suits was created to address situations where those in control of a company’s normal business operations, namely its officers and directors, fail to bring suit on behalf of the company.

Shareholders filing a derivative action must generally fulfill certain procedural requirements before filing suit. One of the most important prerequisites is to make a demand on the board of directors to file the lawsuit. The failure to make such a demand may be excused where the shareholder demonstrates such a demand would have been futile—such as where the directors themselves would be defendants. Another requirement is that the shareholder must have been a shareholder at the time the alleged injury to the company took place, though Illinois law recognizes several exceptions to this contemporaneous shareholder requirement.

Direct Actions vs Derivative Suits

A shareholder may suffer injury in either of two ways: (i) directly through an injury which affects the shareholder individually, or (ii) indirectly through an injury to the corporation which has the consequential effect of reducing the value of the shares which the shareholder owns. Under Illinois law, a shareholder may not file a direct action unless he or she can demonstrate a direct injury unique from that that suffered by fellow shareholders. In the absence of such an injury, the cause of action belongs to the company itself.

Situations where a shareholder is the target of a freeze-out or squeeze-out are common examples of a direct, unique injury that may be brought directly by the shareholder. Where an officer, director, or controlling shareholder breaches his or her fiduciary duties to the company, a shareholder must bring a claim derivatively because the company, and not the shareholder, suffered the injury. While it is true that a shareholder in such a situation has been injured, namely, the loss of value to the shareholder’s shares resulting from the loss of corporate funds, the injury is not unique to that shareholder but rather is shared by all shareholders alike.

In determining whether a claim is direct or derivative, Illinois courts have explained that it is useful to examine what must be proven to succeed on the claims asserted. As one court explained:

An action in which the holder [i.e., the investor] can prevail only by showing an injury or breach of duty to the corporation should be treated as a derivative action…An action in which the holder can prevail without showing an injury or breach to the corporation should be treated as a direct action that may be maintained by the holder in an individual capacity.

Attorney’s fees in derivative actions

Illinois courts have generally recognized that a successful shareholder in a derivative suit is entitled to an award of attorney’s fees. This applies even when there are only two shareholders. Such courts have reasoned that a party who has conferred a benefit upon another through litigation may obtain a share of the attorney’s fees from those who benefit. This is often referred to as the “common fund” doctrine, which is a recognized exception to the so-called “American Rule” which requires each party to bear its own cost of litigation, including attorney’s fees. The Illinois Limited Liability Company Act authorizes awards of attorney’s fees to the prevailing party in derivative actions.

Normally attorney fee awards are paid from the common fund. However, in certain circumstances, a defendant may be required to pay all or part of the award personally. It is in the discretion of the court whether to require such an attorney fee award to be paid from the common fund or by the defendant personally.

Lubin Austermuehle’s Chicago, Wheaton, and Naperville commercial litigation attorneys have more than thirty-five years of experience helping business clients unravel the complexities of Illinois and out-of-state business laws. Our Chicago business dispute litigation lawyers represent individuals, family businesses and enterprises of all sizes in a variety of complex legal disputes, including disputes among partners and shareholders as well as lawsuits between businesses. We serve clients throughout Illinois and the Midwest. If you’re facing or considering filing a business or class-action lawsuit, the experienced Illinois breach of fiduciary duty attorneys at Lubin Austermuehle can help. To set up a consultation with one of our Chicago shareholder dispute attorneys and Chicago business trial lawyers, please call us toll-free at 630-333-0333 or contact us online.