Derivative Actions

By Stuart Cappus

Many people operate businesses through corporations. The law considers corporations to be persons separate and apart from the individuals who create, own and operate them. The individuals involved in the ownership and management of a corporation can be broken down into three categories: shareholders, directors and officers. Shareholders own the corporation by virtue of owning shares in the corporation. A shareholder can own anywhere from 1 share to 100% of the shares of a corporation. Directors are elected by shareholders to oversee the activities and general management of the corporation. Finally, officers are appointed by the directors to manage the day-to-day operations of the corporation.

Given their status as persons under the law, corporations can sue and be sued by others. However, for a variety of reasons, the directors of a corporation may refuse or neglect to sue someone who has wronged the corporation. Because the value of the corporation and, by extension, its shares can be negatively impacted by management failing to prosecute a legal action, shareholders should be rightfully concerned if and when this happens. And because the alleged wrong was committed against the corporation and not the shareholder, the shareholder cannot simply sue the alleged wrongdoer in his own name.

Fortunately, the Business Corporations Act provides an avenue of recourse to shareholders who find themselves in such a situation. Section 232 allows shareholders and directors of a corporation to apply to court for permission to prosecute a lawsuit in the name of the corporation. This is called a derivative action. Before a court will grant such permission, the shareholder or director must establish that (a) they have used reasonable efforts to cause the corporation’s directors to prosecute the lawsuit; (b) they have given the corporation notice of their application; (c) they are acting in good faith; and (d) it is in the best interests of the corporation to prosecute the lawsuit.

From a practical standpoint, derivative actions will almost always be pursued by a minority shareholder. That is because a majority shareholder can simply elect new directors who will do what he tells them to if the former directors refuse or neglect to comply with his request.