The Distinction Between Direct and Derivative Shareholder Claims

Jim An is a Teaching Fellow and Lecturer in Law at Stanford Law School. This post is based on his recent article forthcoming in the George Washington Law Review.

One of the first legal questions that courts ask when reviewing a shareholder suit is whether the pleaded claims are “direct” or “derivative.” However, although the distinction between direct and derivative claims is often outcome-determinative, the specific legal rules governing that distinction have long been flawed, with courts and commentators calling those rules “subjective,” “opaque,” and “muddled.”

Furthermore, as I argue in a forthcoming article, The Distinction Between Direct and Derivative Shareholder Claims, the predominant legal tests for distinguishing between direct and derivative claims are internally inconsistent, logically indeterminate, and readily manipulable. That said, an improved test is possible by clearly articulating the underlying policy concerns that motivate existing doctrine.

Direct versus Derivative Suits and the Tooley Test

As mentioned, whether a claim is considered direct or derivative is tremendously influential on its viability and likelihood of success. Among other things, derivative claims are disadvantaged because they (1) must generally please demand futility, an onerous standard; (2) may be taken over by a special litigation committee; and (3) can only be prosecuted by current shareholders. Direct claims, on the other hand, are subject to none of these constraints.

Under the predominant Tooley test, so named for the Delaware Supreme Court case from which it originated, courts make the following inquiry: (1) who suffered the alleged harm and (2) who would receive the benefit of any recovery or other remedy? If the answer to the foregoing questions is that the corporation suffered the alleged harm and would receive the benefit of a recovery, then the claim is considered derivative, and if individual shareholders suffered the alleged harm and would receive the benefit of a recovery, then the claim is considered direct. (Also, while some states nominally have a test other than Tooley, they all essentially work the same way.)

Tooley’s Internal Inconsistencies

To corporate litigators, perhaps the most obvious flaw with Tooley is how it analyzes alleged injuries arising out of financing deals, as exemplified by the 2021 Delaware decision Brookfield Asset Management v. Rosson. In Brookfield and similar deals, an insider engages in an unfair dilution by injecting additional capital into the corporation in exchange for an excessive number of shares. Under Tooley and the cases that interpret it, the corporation as an entity is considered to have suffered an injury in the first instance from the unfair deal, with any harm to non-participating shareholders arising out of the injury to the corporation. But in fact, these deals result in the corporation receiving capital and giving up only paper shares, and the corporation’s balance sheet shows more net assets and shareholder equity afterwards. So, it is more than a bit incongruous to say that the corporation suffered a harm from such deals. Instead, the real reason that non-participating shareholders suffered a harm is because their stake in the firm was diluted, not because the firm lost value, which it did not.

Now, it might seem like the easy solution to this weird legal result is simply to treat claims arising out of stock issuances and similar transactions as direct claims, but there are good reasons not to do that! If any stock issuance gives rise to a direct claim, then every stock compensation case would be treated as a direct claim. Vexatious plaintiffs might even be able to directly bring claims against employees for, say, breach of an employment contract where stock was received as compensation. This would not only be total chaos but would also unreasonably burden the use of stock as compensation in comparison to cash. (Likewise, it would make little sense for an M&A buyer’s stockholders to be able to bring direct suits in a stock-for-stock deal, but only derivative suits in a cash deal. What would be the policy basis for effectively favoring cash over stock?)

Tooley’s Indeterminacies

Less obviously but still importantly, Tooley is also faulty because identical economic results can be reached via different formalities with different resulting treatment under Tooley’s prongs.

As for Tooley’s harm prong, consider, for instance, a Corporation X which has an equity value of $10 million, half of which is held by a controller and the other half of which is held by minority shareholders.[1] Now, consider three potential transactions:

  1. The controller causes Corporation X to pay $2 million for a worthless asset that he owns, and then, using the $2 million in proceeds, purchases another $2 million of shares at fair market value.
  2. The controller causes Corporation X to issue sufficient additional shares to the controller themselves for zero consideration such that the controller holds 60% of Corporation X’s equity afterward.
  3. The controller causes Corporation X to cancel a sufficient number of minority shares such that the controller holds 60% of Corporation X’s equity afterward.

Each of these transactions results in the same economic outcome: the post-transaction Corporation X has $10 million in equity value, 60% of which is held by the controller and 40% of which is held by minority shareholders. And because each of these three transactions are economically identical, it would make little sense if claims arising out of one of these transactions were considered derivative while claims arising out of another were considered direct. Yet Tooley would treat claims arising out of these transactions differently, with the first two transactions giving rise to derivative claims and the third transaction giving rise to direct claims.

Similarly, the remedy prong of Tooley is also essentially a dealer’s choice. As Delaware Court of Chancery Vice Chancellor Laster has noted, “a court of equity can award a stockholder-level remedy for a derivative claim.” Not only is Vice Chancellor Laster correct, but the reverse is also true—courts can award corporation-level remedies for direct claims. For example, as a remedy for any of the three above-mentioned transactions, a court could order the controller to (1) repay the corporation the amount of the overpayment, (2) cancel some of the controller’s stock, or (2) order the controller to pay the minority shareholders directly. Any of the three remedies could equitably resolve the harm, but under Tooley, the first remedy would suggest that the claim is direct, either of the latter two remedies would suggest that the claim is derivative.

Tooley’s Manipulability

The manipulability of Tooley readily follows from the preceding. Tooley creates incentives for corporate managers to rearrange transactions that would give rise to direct claims into forms that instead give rise only to derivative claims. Expecting such shenanigans, investors reduce their willingness to pay and spend time and energy trying to contract protections for themselves. We all end up burdened with higher transaction and agency costs and lower investment.

A Revised Test and Thoughts on the Way Forward

As I hint at above with my discussion of stock compensation, Tooley is not fixable simply by letting a bunch more derivative claims proceed instead as direct claims. There are good reasons why we want to keep certain claims—even those involving stock issuance and dilution—derivative.

Instead, I propose that the distinction between direct and derivative claims be governed by two factors: first and foremost, the availability of and relationship to other governance mechanisms to redress the substantive concern of the shareholder; and second, the relative competence of the judicial system to resolve the matter.

When applied, these two factors not only more clearly divide claims between direct and derivative groupings, but also rationally explain courts’ existing inclinations to treat some shareholder claims as derivative and others as direct. For instance, courts’ general aversion to garden-variety claims of mismanagement are explained by both of these factors. Shareholders asserting such claims (including vanilla stock compensation claims) can resort to multiple other remedies provided for by corporate law, not the least being the shareholder franchise. And as courts and commentators have noted, judges—through no fault of their own—are necessarily ill-prepared to second-guess the good-faith business decisions of duly elected managers. Disputes involving those decisions are best subject to the heightened burdens accompanying derivative claims.

By contrast, when it comes to claims involving things such as shareholder voting, non-ratable injuries to minorities, and inadequate merger sale prices, shareholders often have trouble asserting their rights anywhere other than via litigation. After all, shareholders whose vote is threatened cannot very well use that same vote to fix the matter. Likewise, when a controller inflicts a non-ratable injury on the minority, the shareholder franchise can offer but cold comfort. And of course, the closing of a merger also closes the ballot box for the selling shareholders. Accordingly, in each of these cases, the courts should (and they generally, though not always, already do) treat claims arising out of these facts as direct.

I welcome any comments/questions/suggestions for improvement.

Endnotes

1To the extent it simplifies a reader’s thinking, the minority’s shares may be considered to be non-voting shares.(go back)

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