Today is Sunday, April 20, 2014

Derivative Suits: Nature and Function

by: J. Sixto C. Marella, Jr.

Derivative suits are actions filed in court by a stockholder or group of stockholders irrespective of number of shares held in cases where “directors are guilty of breach of trust, not of mere error of judgment or abuse of discretion and intra-corporate remedy is futile or useless, done for the benefit of the corporation, to bring about redress of the wrong inflicted directly upon the corporation and indirectly upon the stockholders.” There is no express provision in the Corporation Code on derivative suits but the right of a stockholder to initiate it has long been recognized by courts of common law, founded on equity. There are various theories to explain the grant of this right.

One theory is, the suit is an exceptional method of procedure to give a remedy for a corporate wrong affecting the shareholders indirectly which would otherwise escape redress, perhaps by the fraud of the wrongdoers themselves.

Another theory is that “the right of the stockholder to sue exists because of special injury to him for which he is otherwise without redress.” This idea that the plaintiff sues because of the special indirect damage to himself as a shareholder by the wrong to the corporation and its assets is not an adequate explanation of the basis of the shareholders' suit.

It has been held in Pascual vs. Del Saz Orozco, that it became gradually apparent that frequently the corporation was helpless to institute the suit. It was found that where the guilty parties themselves control the board of directors and also a majority of the stocks that the corporation was in their power, was unable to institute suit, and that the minority of the stockholders were being defrauded of their rights and were without remedy. The time came when the minority of the stockholders of the defrauded corporation – the corporation itself being controlled by guilty parties were given a standing in court for the purpose of taking up the cause of the corporation, and in its name and stead, of bringing the guilty parties to account.

For the action to prosper, it is necessary to show that the aggrieved party is the corporation and the cause is the willful act of the director or officer, resulting in damage or prejudice. Further, the following must be shown—

- the stockholder or member bringing the suit must have exhausted his remedies within the corporation; i.e., he has made a demand on the directors or trustees and the latter failed or refused to do so. This demand however is not necessary where it would be futile to make it, as where the majority of the directors or trustees are guilty of the wrong complained of.

- the stockholder or member must have been one at the time the transaction or act complained of took place, unless such transaction or act continues and is injurious to the stockholder. In one case, the Supreme Court has allowed a derivative suit brought by the heirs of the stockholder during whose lifetime the transaction took place.

- any benefit recovered by the stockholder or member as a result of the derivative suit, whether by final judgment, by judicial compromise or by extra-judicial settlement, must be accounted for to the corporation, who is the real party in interest.

- if the suit is successful, the stockholder prosecuting the suit is entitled to reimbursement from the corporation for the reasonable expenses of litigation, including attorney’s fees.

Derivative suit is to be distinguished from personal suit of a stockholder, available when, for example, the right to inspect corporate records is denied, and brings an action in his name. A class suit, is also different because it refers to suits involving a class of shareholders whose rights as such are violated, such as where holders of preferred shares are not given the preferential treatment they are entitled to.

The shareholder must, however, sue in good faith for the corporation and not as the representative or puppet of a rival company.

In one case derivative suit was held improper where plaintiffs who were minority stockholders sued the principal officer of the corporation for damages due to mismanagement and misuse of corporate assets and the relief prayed is for plaintiffs to be paid the value of their respective participation in the said assets.

On the matter of bringing in the corporation as a party plaintiff or defendant, the prevailing rule is, it should be made a party. It will bar future actions based on the same act because of res judicata.

In the prosecution of the derivative suit, the corporation is not allowed to be an active party. It should not have control over the suit against the real defendants. It is required to adopt a neutral or passive role with only a limited power to defend itself, while its volunteer representative conduct for its benefit the litigation which its management has failed or refused to bring. It need not answer or take any steps in the proceedings nor can it assume the status of co-plaintiff. The plaintiff has the right of control. It is improper to use corporate funds to give financial aid or to assist the defense of directors, officers or other defendants. The plaintiff shareholder is entitled to a fair opportunity to prosecute the lawsuit without having the resources of the corporation turned against him.

Worthy of note is Reyes vs. Tan where the appointment of a receiver in a derivative suit was allowed.

An interesting issue in derivative suits is whether it is proper in an action against a third person, where the board of directors, in the exercise of its judgment, decides not to sue. In the United States, this issue was disposed of in the manner as follows–

“A corporation's right to sue is correlative to its right not to sue. Unless an equitable basis for intervention be shown, an individual stockholder has no more right to challenge by a derivative suit a decision of the board not to sue a third person than to so challenge any other decision of the board. However, where the complaint alleges and it is proved that the directors acted in bad faith, dishonestly or in breach of trust, or were under the control of the wrongdoers, then a derivative suit against a third person may be given due course.”

If the suit is successful, any monetary award for the injury caused to the corporation shall inure to the corporation, not to the stockholder who brought the action. He is, however, entitled to recover costs of litigation including attorney’s fees.

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