The Scenario
A stockholder believes that the company’s officers or directors have engaged in conduct that breached their fiduciary duties and damaged the company, thus reducing the value of her stock. She tells an attorney that she wants to file a lawsuit. One of the first questions that the attorney must ponder is whether the potential claim constitutes a direct or derivative action. The distinction is often outcome-determinative, and yet, as one commentator put it, it is also “subjective, opaque and muddled.” See “The Distinction Between Directive and Derivative Claims,” Harvard Law School Forum on Corporate Governance (May 14, 2024).
The Difference
Stockholders who assert derivative claims face many hurdles. First, the plaintiff must have “contemporaneously” been a shareholder when the allegedly-wrongful transaction occurred. See 8 Del. C. § 327 (Delaware); Cal. Corp. Code § 800(b)(1) (California). There is a narrow exception to the contemporaneous ownership rule: the so-called “double derivative action,” in which a plaintiff brings an action against a parent corporation in order to enforce a claim allegedly held by a subsidiary. See Lambrecht v. O’Neal, 3 A.3d 277 (Del. 2010).)
Second, the courts in Delaware and California (and other states) require that the plaintiff continuously own the stock when the suit is filed through its resolution. See Lewis v. Anderson, 477 A.2d 1040 (Del. 1984); Grosset v. Wenaas, 42 Cal. 4th 1100 (2008). Thus, if the company is subject to an acquisition or merger, or dissolved, and the plaintiff is no longer a stockholder, then the derivative action would be dismissed. Again, Delaware makes a narrow exception: where the merger itself is the subject of fraud claims or is a sham intended to defeat the derivative action.
Plaintiffs in derivative actions must also plead either demand futility or wrongful refusal. Pleading demand futility generally requires pleading particularized facts showing that there is not a disinterested and independent board majority capable of objectively considering a demand on the board to file a lawsuit. Pleading wrongful refusal generally concedes that there was a disinterested and independent board majority, and requires a showing that such a litigation demand was in fact made, but that it was wrongfully refused.
These requirements may strangle a derivative action at the pleading stage. However, these conditions do not apply to a direct lawsuit.
Another difference between derivative and direct actions is that the former requires judicial approval for any settlement. That mandate became an issue in Norman v. Strateman, 112 Cal. App. 5th 92 (2025). In that matter, the Chief Executive Officer of a crypto company filed a derivative action against other founders for breach of fiduciary duty and other claims. One of the defendants filed a cross-complaint. The trial judge referred the matter to a settlement judge and the parties reached a binding settlement agreement. The plaintiff subsequently objected to the settlement because the trial judge did not approve it (apparently because the parties and trial judge forgot the need). The trial granted a motion to enforce the settlement, noting that derivative actions were designed to protect shareholders, and all three shareholders were covered by the settlement. On appeal, the defendants argued that judicial approval was not required because the lawsuit substantively proceeded as a direct action.
The Court of Appeal, however, held that the complaint’s allegations of self-dealing and misuse of assets were derivative and that a shareholder plaintiff must obtain court approval before settling and dismissing an action in order to ensure that the settlement is fair and reasonable to the corporation and shareholders. Because the trial court did not review and approve the settlement, the trial court’s order enforcing the settlement was vacated and the matter remanded.
The Distinction
In the simplest terms, a derivative lawsuit is brought on behalf of the corporation while a direct action is brought on the allegedly-injured stockholder’s own behalf. But this distinction is often more difficult to determine in reality than would appear in the abstract.
In the landmark decision in Tooley v. Donaldson, Lufkin, & Jenrette, Inc., 845 A.2d 1031 (Del. 2004), the Delaware Supreme Court sought to simplify the analytical distinction between direct and derivative actions. Under Tooley, courts must make a two-fold inquiry: who suffered the alleged harm, and who would receive the benefit of any recovery or other remedy? If the answer is that the corporation principally suffered the harm (and that shareholders were only indirectly injured as a result of being shareholders), and any recovery would go to the corporation, then the claim is derivative. If the stockholders were directly harmed and would receive the benefit of any recovery, then the claim is direct.
What about a claim that a controlling stockholder diluted the value of the minority shareholders? In Brookfield Asset Mgt., Inc. v. Rosson, 261 A.3d 1251 (Del. 2021), the Delaware Supreme Court overruled Gentile v. Rossette, 906 A.2d 91 (Del. 2006), which earlier case had held that such claims were permitted as direct actions. Brookfield held that Gentile created an unnecessary exception to Tooley. In Brookfield, plaintiffs alleged that a controlling stockholder had compelled the company to pursue a private placement of shares for inadequate value, which diluted the value of shares held by minority stockholders and their voting interest. But the court held that the company was principally injured by issuing shares at an unfairly low price and the injury to the stockholders flowed only indirectly to them in proportion to their holdings.
In California, however, courts still recognize the possibility that a shareholder claim against a majority or controlling stockholder, in which the latter allegedly took corporate value at the expense of the former—constitutes a valid direct claim. See, e.g., Jara v. Suprema Meats, Inc., 121 Cal. App. 4th 1238 (2004).
The Upshot
The direct-derivative distinction often drives the outcome of a given case. As a result, parties regularly engage in hard-fought pleading challenges over how the court should classify a given breach of fiduciary duty claim. The arguments generally are highly-technical legally, while also being driven largely by the particular facts of the case. When such issues are in play, it is wise to retain counsel with experience litigating such disputes.
For more information regarding Alto Litigation’s litigation practice, please contact one of Alto Litigation’s partners: Bahram Seyedin-Noor, Bryan Ketroser, or Joshua Korr.
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