Direct vs. Derivative Actions in California: A Shareholder’s Guide to Business Lawsuits
Direct vs. Derivative Actions in California: What Shareholders Need to Know
When you suspect wrongdoing or mismanagement in a company you own a stake in, your first step is crucial: determining whether your claim is a direct action or a derivative action. This distinction is more than just legal jargon-it shapes who can bring the lawsuit, what must be proven, and who ultimately benefits from any recovery. For California shareholders and LLC members, understanding the difference is essential to protecting your rights and your investment.
The Nature of a Direct Action
A direct action is brought by a shareholder or member to enforce a right that belongs to them individually, not to the company as a whole. The harm in a direct action is personal and specific. For instance, if you are denied your right to vote at a shareholder meeting, or if you are owed dividends that are not paid to you but are paid to others, you have suffered a direct injury. In these cases, California law allows you to sue for your own benefit, and any recovery goes directly to you. These actions proceed under standard litigation rules, without the extra procedural hurdles that derivative actions require.
The Nature of a Derivative Action
A derivative action, by contrast, is brought by a shareholder or member on behalf of the company itself. Here, the alleged harm is to the company as an entity-often involving breaches of fiduciary duty, self-dealing, or corporate waste by directors or officers. The shareholder acts as a representative for the company, and any recovery goes to the company, not directly to the individual who brought the suit. For example, if the board approves a transaction that unfairly benefits a director at the company’s expense, the injury is to the company, and a derivative action is the appropriate remedy.
The Demand Requirement and Procedural Safeguards
One of the defining features of a derivative action in California is the demand requirement, codified in California Corporations Code section 800. Before filing a derivative suit, a shareholder must first make a written demand on the board of directors, asking them to address the alleged wrongdoing. If making such a demand would be futile-such as when a majority of the board is implicated in the misconduct-the shareholder must clearly explain why in their complaint. Courts strictly enforce this requirement, and failure to comply can result in dismissal, regardless of the merits of the underlying claim.
Derivative actions also come with other procedural safeguards designed to prevent abuse and ensure that only legitimate claims proceed. Under California law:
The plaintiff must have been a shareholder at the time of the alleged wrongdoing and must remain a shareholder throughout the litigation.
The complaint must be verified (sworn to be true) and must detail the efforts made to obtain board action or explain why such efforts were not made.
Any settlement or dismissal of a derivative action generally requires court approval, with notice provided to other shareholders.
Similar requirements apply to derivative actions involving LLCs, as set forth in California Corporations Code section 17709.02.
Why the Distinction Matters
The difference between direct and derivative actions is not merely academic. If you bring the wrong type of lawsuit or fail to follow the statutory procedures-especially the demand requirement-your case may be dismissed before it is ever heard. California courts closely scrutinize whether a claim is direct or derivative and whether all procedural steps have been satisfied. Understanding these distinctions is essential for anyone seeking to protect their rights or address misconduct in a business setting.
Protect Your Rights-Contact Mr. Brooks
If you believe you have been wronged as a shareholder or company member, don’t risk losing your case on a technicality. Contact Mr. Brooks today to ensure your lawsuit is brought in the correct form and that all procedural requirements are met from the outset. With experienced legal guidance, you can safeguard your rights, your investment, and the future of your company.
