Managing Litigation Risk During the Business Lifecycle, Part 3: Derivative Actions

While litigation risk is an unavoidable aspect of running a business, business owners can limit such risks with early planning. In this third installment of PilieroMazza’s blog series, “Managing Litigation Risk During the Business Lifecycle,” we explore the impacts of derivative actions and the proactive steps that business owners can take to avoid them. Visit this link to access Part 1 in this blog series (Entity Formation and Organization) and this link to access Part 2 (Business Acquisition and Post-Closing Disputes).

What is a Derivative Action?

A derivative action is a lawsuit filed by one or more stakeholders (i.e., shareholders for a corporation or members for an LLC) on behalf of the company against officers, directors, or managers accused of misconduct. These lawsuits aim to correct wrongdoing that harms the company, such as financial mismanagement, self-dealing, or breaches of fiduciary duty. In the event leadership fails to act, stakeholders may take legal action to protect the company’s interests. Because derivative actions assert that the company’s leadership harmed the company itself, they present unique challenges implicating legal strategy, governance, and risk management throughout the business lifecycle.

Derivative actions can surface at any point, whether during early stages of fundraising and expansion or later phases marked by succession planning and exit strategies. High-profile cases, such as the derivative lawsuit against Tesla’s board over Elon Musk’s nearly $56 Billion compensation package, or the derivative action against Oracle’s directors for their alleged role in enabling discriminatory practices, illustrate how a company’s reputation and its leadership can be closely scrutinized through derivative actions.

As companies grow, managing litigation risk requires more than forceful responses to lawsuits. The best practice is to avoid derivative actions altogether, and this article explores how businesses can work to do so.

How Can Business Owners Avoid Derivative Actions?

1. Communicate Transparently with Stakeholders and Encourage Ethical Culture: Transparent and timely communication with stakeholders is a cornerstone of derivative action litigation risk management. Providing regular updates on financial performance, major strategic moves, and potential risks that the company faces can help maintain trust and preempt claims of mismanagement. Cultivating a strong ethical culture from the top down is equally important. A corporate environment where ethical decision-making is valued, rewarded, and widely understood can help deter risky conduct that might later spark stakeholder claims.
2. Avoid Conflicts of Interest: Conflicts of interest are among the most common triggers for a derivative action. When directors, officers, or managers of the company stand to benefit personally from decisions made on behalf of the company, the line between duty and self-interest is blurred. This opens the door to stakeholder suspicion. Best practices to avoid these conflicts of interest include ensuring that all transactions and business dealings are conducted fairly, with executives avoiding self-serving decisions that could be perceived as exploiting the company for personal gain. The adoption of a robust conflict of interest policy, board training on fiduciary obligations, and the use of independent committees to evaluate transactions involving insiders can go a long way towards avoiding derivative actions.
3. Strengthen Fiduciary Oversight and Maintain Strong Corporate Governance: Sound corporate governance is the bedrock of fiduciary compliance. Company directors, officers, and managers must act in good faith and in the best interests of the company. Boards and management should consist of independent and experienced members who actively monitor business practices and financial decisions. A well-functioning board and management structure helps ensure ethical leadership, while regular audits and external checks hold leadership accountable. Establishing clear policies, internal controls, and compliance mechanisms prevents misconduct before it starts. That said, governance practices should evolve with the company’s lifecycle. A startup might benefit from advisory boards and informal structures in its early stages, but more formal governance structures become critical as it matures. Companies like Apple and Microsoft have been lauded for their governance systems, which enable them to navigate complex stakeholder expectations and mitigate internal risk.
4. Promptly Address Stakeholder Concerns: Derivative actions often arise from patterns of unaddressed concerns rather than isolated misconduct. If stakeholders express dissatisfaction or bring issues to the surface, it is critical to acknowledge their concerns and take necessary corrective action. One method to do so is creating internal channels for stakeholders to raise concerns, such as hotlines or designated liaison officers who can flag potential issues early on. In contrast, ignoring warning signs can escalate tensions and lead to litigation. One recent example is Boeing’s experience following the 737 MAX crisis, wherein stakeholders filed a derivative suit alleging that its board failed to monitor safety risks, leading to catastrophic outcomes. A key lesson here is the need for proactive internal reporting mechanisms and clear documentation of board responses.
5. Proactively Engage Legal Counsel: One of the most effective ways to mitigate the risk of derivative actions is to proactively engage legal counsel. Consulting with experts helps owners anticipate potential stakeholder disputes and address concerns before they escalate into lawsuits. Lawyers can help companies interpret their fiduciary duties, structure transactions to minimize risk, and ensure best practices in corporate governance. Integrating legal risk analysis into daily operations positions businesses to anticipate risks before they materialize into stakeholder concerns and costly litigation.

Of course, proactive legal counsel is critical during transitional moments in the business lifecycle, too, including throughout fundraising, mergers, acquisitions, and leadership changes. Careful companies pay attention to events that could trigger stakeholder dissatisfaction. Those same companies treat legal counsel as a strategic partner, rather than a reactive necessity, and invest in creating structures that avoid derivative actions.

What Are the Consequences of Ignoring Stakeholder Rights?

Failing to quickly and consistently engage with stakeholder concerns can have serious consequences for a business and its leadership. Derivative litigation often signals issues beyond the courtroom, particularly surrounding accountability and the responsiveness of company leadership. Ignoring stakeholders’ rights leads to reputational damage, financial losses, internal turmoil, and the erosion of stakeholder loyalty and support. Understanding these risks drives home the point that stakeholder engagement is not just a compliance issue, but a core governance imperative.

1. Reputational Damage: In today’s era of rapid information sharing and heightened social media scrutiny, stakeholder grievances can quickly become public. Even before litigation is filed, media coverage, social media backlash, and activist campaigns can tarnish a company’s image. Consider the example of Wells Fargo, whose board faced stakeholder derivative suits following revelations about the creation of unauthorized customer accounts. Beyond the legal costs, these actions eroded the brand’s credibility, forcing the business to engage in a costly and prolonged public rehabilitation campaign. While a damaged reputation does not show up immediately on a balance sheet, it has long-term consequences for market value, investor confidence, and competitive standing.
2. Financial Strain: Derivative litigation—even if settled or dismissed—can result in significant financial costs. Legal fees and settlements drain resources, taking away from core business activities while limiting growth and innovation. In cases where liability is established, companies may be required to pay damages and fund compliance reforms, among other remedies, all of which strain a company’s bottom line. Moreover, ignoring stakeholder rights can trigger other financial consequences beyond the litigation itself, such as a drop in stakeholder confidence or falling stock prices. Therefore, the financial risks of inattention to stakeholder issues underscore again the importance of rigorous internal processes that prioritize engagement and accountability.
3. Leadership Disruptions: When derivative actions target officers, directors, or managers, the company often faces leadership instability. Courts may impose changes to corporate governance, including executive replacements. But even if executives are cleared of wrongdoing, the reputational fallout and potential for boardroom fracture can hinder business operations and goals. Leadership changes regularly have ripple effects throughout the organization, with employees questioning the company’s direction and competitors seizing the opportunity to gain market share. Companies that invest in a strong leadership team, with governance transparency and early conflict resolution, are better positioned to preserve management’s credibility.
4. Loss of Stakeholder Support: One of the most difficult consequences to quantify is the erosion of stakeholder trust. Ongoing disputes with investors can weaken business stability and strategic direction. Investors may be inclined to take their capital elsewhere, employees may leave, and customers may boycott. Companies that engage stakeholders transparently and with integrity are more likely to recover quickly from such setbacks.

Conclusion: Proactive and Ethical Leadership is the Best Defense

Derivative actions are more than just legal battles, as they often reflect deeper and unsettled issues within a company’s governance and culture. By proactively managing litigation risk through ethical leadership, transparent communication, and strong internal oversight, businesses can protect themselves from costly lawsuits while ensuring alignment among their stakeholders.

Early engagement with experienced counsel can make all the difference. If your company is facing a derivative action or if you would like to mitigate the risks of such actions, PilieroMazza attorneys are here to assist you. Please contact Todd Reinecker, Abby Baker, Mark Rosenow, Kaavya Ramesh, Cole Fox, or another member of the Firm’s Litigation & Dispute Resolution, Business & Transactions, or Corporate & Organizational Governance practice groups.

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If you’re seeking practical insights to gain a competitive edge by understanding the government’s compliance requirements, tune into PilieroMazza’s podcasts: GovCon Live!, Clocking in with PilieroMazza, and Ex Rel. Radio.