VocabuLaw

Derivative Action

What is it and what does it mean?

Description of the legal term Derivative Action:

Derivative action refers to a lawsuit brought by a shareholder on behalf of a corporation against a third party. In the UK, this type of action can be seen as an exception to the rule that a company is a distinct legal entity from its shareholders and normally, it is the company that must sue to redress any wrong done to it. However, there might be circumstances where the company’s management fails to take action to address a wrong, especially if those in control of the company are responsible for the alleged wrongdoing.

This is where derivative actions become relevant. They allow a minority shareholder to step into the shoes of the company and initiate legal proceedings. Such actions serve to protect the interests of the company where those in control have breached their duties or have otherwise acted against the interests of the company. The rationale behind this provision is to prevent a conflict of interest and address the imbalance that might occur when those charged with wrongdoing are in a position to prevent the company from taking action against them.

There are two types of derivative actions: common law and statutory. The common law derivative action is largely historical and has largely been replaced by the statutory derivative action introduced by the Companies Act 2006. According to this statute, a shareholder can apply for permission to continue a claim in the name of the company if they can show that the directors have committed an act of negligence, default, breach of duty, or breach of trust. The court must then determine if there is enough evidence to suggest that the company will not pursue the claim itself and whether the shareholder bringing the claim is acting in good faith.

The process of initiating a derivative action is stringent to prevent abuse of the system. The claimant must demonstrate to the court a prima facie case for the claim. If permission is granted, the action is conducted in the same way as any other claim on behalf of the company. Any damages awarded are for the benefit of the company, not the individual shareholder bringing the action.

Legal context in which the term Derivative Action may be used:

Consider a scenario where the directors of a major UK corporation engage in fraudulent transactions that benefit them personally but are detrimental to the company. For instance, the directors might secretly divert company funds to a firm they own. If the board of directors refuses to take action against those involved because they control the majority of the board, a minority shareholder could apply to initiate a derivative claim. The shareholder would need to show that the directors breached their duties to the company and that there is a necessity for the action to proceed, as the company will not do so on its own.

Another example would involve a technology company where the directors have failed to properly license technology from third parties, resulting in significant potential liability for the company. A concerned shareholder, upon discovering that the managerial body is reluctant to address this issue due to fear of personal liability or bad publicity, could be granted permission to proceed with a derivative claim. The shareholder would thus be acting in the best interests of the company and its shareholders to seek damages or an injunction against the directors for their failure to act within their legal obligations.

The concept of derivative action plays a crucial role within UK corporate law by providing an avenue for redress where those in control of a company are incapable or unwilling to take necessary legal steps to protect the company’s interests. It ensures that wrongdoers within the corporate structure can be held to account, thus safeguarding corporate governance and the interests of minority shareholders.

This website is for informational purposes only and may contain inaccuracies. It should not be used as a substitute for professional legal advice.