The Distinction Between Direct and Derivative Shareholder Claims

One of the primary methods for shareholders to seek redress for corporate misconduct is the shareholder suit, in which shareholders may assert either “direct” or “derivative” claims. Under current legal doctrine, direct claims nominally seek to assert a right of the individual shareholder, while derivative claims seek to assert a right that formally belongs to the corporation and is asserted by the shareholder on the corporation’s behalf. Due to legitimate risks of shareholder and judicial overreach, courts have imposed numerous procedural hurdles upon derivative suits, making them much harder to bring than direct suits.

Although the distinction between direct and derivative claims is often outcome-determinative, the specific rules governing that distinction have long been flawed, with courts and commentators calling those rules “subjective,” “opaque,” and “muddled.” Moreover, the predominant Tooley test prevents courts from addressing numerous management misdeeds, thus harming shareholders and impairing justice. This Article explains how the Tooley test is fundamentally intractable and leads to gaming by transactional planners. Returning then to the underlying principles of corporate law, this Article proposes another test based on (1) the availability of alternative governance solutions, and (2) relative judicial competency.