When shareholders believe that corporate directors or officers have acted improperly, two fundamentally different types of legal claims may result: derivative claims, which are brought on behalf of the corporation itself to remedy a harm done to the corporation, and direct claims, which are brought by shareholders in their own right to remedy a harm done to them individually or as a class. The distinction between these two forms of shareholder litigation determines who controls the claim, who benefits from any recovery, what procedural hurdles the plaintiff must clear, and what governance mechanisms the board can invoke in response. Every corporate director and officer should understand this distinction and its practical implications, because shareholder litigation is a persistent feature of the governance landscape for US corporations of every size.

The threshold question in any shareholder lawsuit is whether the plaintiff’s claimed injury is a direct harm to the shareholders themselves, or a harm to the corporation that affects shareholders only indirectly through the reduction in the value of their shares. The answer to this question determines the procedural architecture of the case. In a direct action, the plaintiff shareholder sues in their own name and any recovery flows directly to the shareholder plaintiffs. In a derivative action, the shareholder plaintiff sues in the name of the corporation, typically after the corporation has declined to pursue the claim itself, and any recovery flows to the corporation rather than to the individual plaintiff shareholders.

Direct Claims: Suing in Your Own Right

A shareholder may bring a direct claim when the alleged wrongdoing has caused a harm that is independent of any harm to the corporation, or when the duty allegedly breached runs directly to shareholders rather than to the corporation. The most common direct claims in the US corporate context include: federal securities fraud class actions alleging that the company and its directors and officers made materially false or misleading statements in public disclosures in violation of Section 10(b) of the Securities Exchange Act and Rule 10b-5; class action claims alleging breach of the duty of disclosure in connection with a merger or other fundamental corporate transaction; and state law class action claims alleging breach of the directors’ duty of loyalty in a going-private or other change-of-control transaction in which the shareholders allege that the board failed to secure adequate consideration.

Federal securities class actions under Section 10(b) and Rule 10b-5 are among the most significant litigation risks facing the directors and officers of US public companies. These cases typically allege that the company’s public statements — earnings releases, annual and quarterly reports, investor presentations, press releases — contained material misstatements or omissions that artificially inflated the company’s stock price during a class period, causing investors who purchased shares at inflated prices to suffer losses when the truth was eventually disclosed. Defendants typically include the company, the CEO, and the CFO, and sometimes other senior officers who signed SEC filings or made public statements during the class period.

The Private Securities Litigation Reform Act of 1995 (PSLRA) imposed heightened pleading requirements on securities class actions in an attempt to reduce frivolous strike suits. The PSLRA requires plaintiffs to plead with particularity the specific statements alleged to be false or misleading, the reasons why those statements were false or misleading, and facts giving rise to a strong inference of scienter — meaning fraudulent intent or severe recklessness. The ‘strong inference’ of scienter requirement has been interpreted by the Supreme Court in Tellabs, Inc. v. Makor Issues & Rights, Ltd. to mean that the inference of scienter must be more than merely plausible or reasonable: it must be cogent and at least as compelling as any opposing inference of innocence that can be drawn from the facts alleged. This is a demanding standard that has resulted in dismissal at the pleading stage in a significant percentage of securities class actions, but it does not prevent the filing of cases, and the cost of defending even a case that is ultimately dismissed is substantial.

Derivative Claims: Suing on Behalf of the Corporation

A derivative action is brought by a shareholder to enforce a right belonging to the corporation — most commonly a claim that the corporation has against its own directors or officers for breach of fiduciary duty, misappropriation of corporate assets, or related conduct. Because the right being enforced belongs to the corporation, derivative actions have a fundamental structure that distinguishes them from ordinary litigation: the shareholder plaintiff is not the real party in interest, the corporation is. This means that the shareholder plaintiff must overcome a set of procedural requirements designed to ensure that derivative litigation reflects a genuine corporate need, rather than a shareholder’s personal agenda or a strike suit motivated by the prospect of an attorneys’ fee award.

The cornerstone of derivative litigation procedure is the demand requirement. Under Delaware Court of Chancery Rule 23.1, a shareholder who wishes to bring a derivative suit must either make a demand on the board of directors to bring the claim on the corporation’s behalf, or plead with particularity the reasons why making such a demand would be futile. This requirement reflects the principle that the board of directors, not individual shareholders, is the appropriate decision-maker about whether to prosecute claims on the corporation’s behalf. If the board is capable of making an impartial decision about whether to pursue the claim, then the shareholder should allow the board to make that decision before filing suit. Only if the board is incapable of making an impartial decision — because a majority of the board is conflicted or lacks independence — is it appropriate to bypass the board entirely and file suit without demand.

The Demand Futility Standard: Zuckerberg and Its Aftermath

The Delaware Supreme Court substantially revised the demand futility analysis in United Food and Commercial Workers Union and Participating Food Industry Employers Tri-State Pension Fund v. Zuckerberg, decided in 2021. The Zuckerberg decision unified the previously bifurcated demand futility standards of Aronson v. Lewis (for business decision cases) and Rales v. Blasband (for non-business-decision cases) into a single three-part test that asks the following questions with respect to each director on the board at the time the complaint is filed: (1) whether the director received a material personal benefit from the alleged misconduct; (2) whether the director faces a substantial likelihood of liability on any of the claims that would be asserted in the derivative suit; and (3) whether the director lacks independence from someone who received a material personal benefit or who faces a substantial likelihood of liability. If more than half of the board fails at least one of these tests, demand is excused and the plaintiff may proceed without making a demand.

The Zuckerberg standard is shareholder-friendly in some respects and board-friendly in others. It is shareholder-friendly in that it provides a clear, unified framework for assessing demand futility that does not require plaintiffs to satisfy both of Aronson’s separate requirements. It is board-friendly in that it focuses the analysis on the specific directors serving at the time of the complaint, not at the time of the challenged transaction, which means that a board refresh — replacing conflicted directors with independent ones between the time of the alleged misconduct and the filing of the complaint — can potentially defeat a demand futility argument even for conduct that clearly benefited the previous board.

Where a shareholder makes demand on the board (rather than alleging demand futility), the board has the authority to investigate the claim and decide whether to pursue it. If the board decides not to pursue the claim — which is the typical outcome — that decision is reviewed under the business judgment rule, and the derivative suit is dismissed unless the plaintiff can show that the board’s refusal was wrongful (i.e., not made in good faith by a disinterested and adequately informed board). The demand-made derivative plaintiff faces a very high bar in challenging the board’s refusal. The appropriate board response to a derivative demand is to convene a disinterested committee or a special litigation committee to conduct a thorough investigation, make a determination, and document the process carefully.

The Continuous Ownership Requirement and Standing

Derivative plaintiff standing is restricted to shareholders who owned shares at the time of the alleged wrongful act and who maintain that ownership throughout the litigation. This is the ‘continuous ownership’ requirement under Rule 23.1 and its state law equivalents. The purpose of the rule is to ensure that derivative plaintiffs have a genuine stake in the corporation’s recovery and to prevent shareholders from purchasing shares after the fact solely for the purpose of bringing litigation. The continuous ownership requirement means that a shareholder who sells all their shares after filing a derivative suit loses standing and the suit must be dismissed, unless another eligible shareholder is substituted as plaintiff. It also means that in a cash-out merger — a transaction that converts shareholders’ equity interests into cash — all derivative suits pending at the time of the merger are typically extinguished, because the former shareholders no longer hold stock in the corporation whose claims are being asserted.

Class Certification and Settlement

Direct shareholder claims seeking relief on behalf of a class of shareholders must satisfy the class certification requirements of Federal Rule of Civil Procedure 23 (for federal cases) or the applicable state class action rules. These requirements include numerosity (the class is so large that joinder of all members is impractical), commonality (there are questions of law or fact common to the class), typicality (the representative plaintiff’s claims are typical of the class), and adequacy (the representative plaintiff and class counsel will fairly and adequately protect the interests of the class). In securities class actions, plaintiffs must also satisfy the additional requirements of Rule 23(b)(3): that common questions predominate over individual questions, and that a class action is superior to other available methods of adjudication.

The settlement of both derivative and direct class action claims is subject to judicial approval. For class actions, Rule 23(e) requires court approval of any settlement and provides class members with an opportunity to object. For derivative suits, Delaware Court of Chancery Rule 23.1 requires court approval of settlements and discontinuances of derivative actions. The court’s role in approving settlements is intended to protect absent class members and the corporation from collusive settlements that benefit plaintiff’s counsel at the expense of the class or the corporation. In practice, most securities class action settlements are approved after a fairness hearing, but the scrutiny applied has increased in recent years as courts have become more attentive to the proportion of the settlement allocated to attorneys’ fees versus the compensation actually delivered to class members.

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