Direct and Derivative Suits | Brian JM Quinn | November 15, 2013

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Direct and Derivative Suits

Original Creator: Brian JM Quinn Current Version: Brian JM Quinn Show/Hide

Officers and directors of Delaware corporations are subject to the jurisdiction of Delaware courts under Delaware's long-arm statute for lawsuits related to the corporation and their duties as directors and officers of the corporation. By virtue of incorporating in Delaware and maintaining an agent in Delaware for service of process, directors of a Delaware corporation, no matter where they are, can be served by making service on the corporation's agent as listed in the corporation's certificate of incorporation.

Stockholders may bring different kinds of litigation against the corporation. Direct suits are brought on behalf of the stockholder in the stockholder's capacity as a stockholder and seek to vindicate the rights of the stockholder. Derivative suits are brought by stockholders on behalf of the corporation and seek to vindicate the rights of the corporation. Stockholders seeking to bring a derivative action on behalf of the corporation must comply with  the requirements of Chancery Rule 23.1.

Many times the most important question in stockholder litigation turns on the type of litigation that is at issue. Stockholders may attempt to characterize the litigation as direct in order to maintain control, while boards may attempt to characterize the question before the court as derivative in order to assert control over the litigation and end it. Understanding the distinction between direct and derivative suits can be confusing. However, there is a coherent test (Tooley) for determining which is which.

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  1. 2 Show/Hide More Delaware long arm statute
    Original Creator: Brian JM Quinn
    You might wonder how it is the case that a corporate director sitting in New York or Massachusetts could be subject to the jurisdiction of the courts of Delaware. The short answer is that all persons who agree to become corporate directors also consent to jurisdiction of the Delaware courts under Delaware's “long arm statute.”
  2. 3 Show/Hide More DGCL § 321 - Service of process
    Original Creator: Brian JM Quinn
    You may have wondered why the corporate law statute requires that the corporation name a registered agent, along with an address in the state of Delaware, in its certificate of incorporation.  The registered agent plays an important role in ensuring corporate officers and directors are subject to the jurisdiction of the Delaware courts for the purpose of stockholder litigation and other litigation related to the corporation.
  3. 4 Show/Hide More DGCL Sec. 327 - Derivative actions
    Original Creator: Brian JM Quinn Current Version: Brian JM Quinn
    In order to have standing in derivative litigation, a stockholder must have already been a stockholder at the time of the bad act that gave rise to the litigation. This requirement prevents people from observing some bad act and then buying into a lawsuit. 
  4. 5 Show/Hide More Delaware Rules, Rule 23.1
    Original Creator: Brian JM Quinn Current Version: Brian JM Quinn

    The Delaware Rules of Civil Procedure lay out rules for bringing and maintaining a stockholder derivative action. Compliance with these rules is necessary in order for a claim to stay in court. Often times, defendants will move to dismiss a plaintiff's claim for failure to comply with the requirements of Rule 23.1.  

    The Rule 23.1 Motion to Dismiss often revolves around the characterization of the claim (direct v. derivative) and the independence of the directors (demand required/demand futility).

  5. 6 Show/Hide More Tooley v. Donaldson Lufkin, & Jenrette, Inc.
    Original Creator: Brian JM Quinn Current Version: Brian JM Quinn

    In Tooley, the court was asked to determine whether shareholder litigation is direct or derivative. Rather than rely on a more traditional, and cumbersome, “special injury” test, the court in Tooley announced a new, simpler test for determining whether a stockholder action is direct or derivative.

    Since Tooley other jurisdictions, like New York, have abandoned their own versions of the special injury in favor of specifically adopting Delaware's Tooley standard.

  6. 7 Show/Hide More Gentile v. Rossette
    Original Creator: Brian JM Quinn Current Version: Brian JM Quinn

    Because there are important procedural hurdles to bringing a derivative suit, it oftentimes becomes an important point of contention between the parties whether the particular litigation is direct or derivative. This case is an example of that problem in action. Note how the court applies the Tooley test to assist it in answering the question whether the claims are direct (and thus properly brought by the stockholder) or are derivative in nature (requiring the stockholder to make a demand on the board and thus lose control over the litigation).

    This opinion is a decision on a Rule 23.1 Motion to Dismiss (“MTD”). Much shareholder litigation lives or dies at this stage. The 23.1 MTD battle is typically fought on two grounds: 1) character of the litigation; and 2) demand futility.

    With respect to the character of the litigation, the defendant board will typically attempt characterize the litigation as derivative and then will argue since the plaintiff failed to make a demand on the board as required under Rule 23.1 for derivative litigation, and for that reason the court should dismiss the litigation in favor of the defendant board.  For its part, plaintiff will attempt to characterize the litigation as direct, thus ensuring that the case cannot be dismissed on procedural grounds. 

    We will take up demand futility later in this chapter.

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June 10, 2016

litigation corporate

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