Law of the Game on Joystiq: Shareholder Deriva-what?
Each week Mark Methenitis contributes Law of the Game on Joystiq, a column on legal issues as they relate to video games:
What the hell is a shareholder derivative suit? Ever since the Take-Two shareholder derivative lawsuit was announced, I've been deluged by various forms of that question. So this week I've decided to outline some of the basics of the law of corporations and explain the 'shareholder derivative suit' a little better.
So, really, what is a corporation? Put simply, it is an entity (i.e., an 'artificial person') that is created pursuant to the laws of a state. It is a separate legal entity from the people who make up the officers and directors of that corporation. Of course, the corporation is not the only business entity, but for this discussion, I'll limit the discussion to a standard corporation, or a 'c-corp' to those of you familiar with the terminology. While the specifics of corporations vary from state to state, there are a number of commonalities among all US corporations. (Corporations in other countries may vary more substantially from this description.) Those common features are:
Corporations are like people: they can enter into contracts, hold bank accounts, pay taxes and be sued
Corporations can live on indefinitely; they can also be terminated at any time (given that the procedures set out by law are followed)
Corporations can only act through their officers, directors or agents. (Obviously, since it isn't a physical entity, someone has to operate on its behalf)
Corporations have stock, that is, shares of ownership, which can either be kept private or traded publicly
Corporations have bylaws, which are the rules by which the corporation operates (in addition to the laws in the state of incorporation)
So, how is a corporation formed? Simply, first you file with the state. Then you draft by-laws. After that, you have an initial meeting whereby the bylaws are ratified and the initial officers and directors are set out. That meeting is recorded in the minutes. The corporation can issue stock to the shareholders in exchange for capital (the order of events can get a little complex with a startup; largely depending on whether the initial directors are also the shareholders). That's more or less all there is to it.
We're getting closer to the shareholder derivative concept, but in order to understand that, you have to understand the interplay between the three groups of people who are involved in the corporation: the directors, the officers and the shareholders. The officers, such as a president or CEO, are the ones who run the company on a day-to-day basis. They are put in this position by the board of directors, who set the general direction for the company and make major decisions in their meetings, which generally occur either quarterly, semi-annually or annually. The directors, however, don't actually own the company. The company is owned by the shareholders, and the shareholders appoint the directors. The shareholders are in a unique position, as they receive dividends from the company but also will almost never be held accountable for the company's actions. Conversely, it is more likely that officers and directors can be held accountable, but generally the circumstances are pretty limited.
So, then where does this 'derivative action' concept arise? The basic theory of a corporation is that the officers and directors are fiduciaries of the company, that is, they owe certain duties to the company above all else. Specifically, they are to act in the company's best interest, without using confidential information to either personally profit or otherwise injure the company. So, what happens when the officers or the board starts acting in a way that the shareholders feels is deliberately hurting the company? The shareholder derivative action is one answer. However, it's slightly more peculiar than it sounds.
A derivative action is actually where the shareholder sues on behalf of the corporation itself, not the shareholders. So, in theory, the corporation is suing its own management. Derivative actions, though, are relatively uncommon and even more rarely successful. Why? There is a doctrine called the 'business judgment rule' that gives broad discretion to officers and directors in their business decisions. More specifically, unless a deliberate breach of the fiduciary duty is shown, it's likely considered within the 'business judgment' spectrum. Basically, even if management is making poor business decisions, that isn't necessarily grounds for a suit.
There's actually a procedure the shareholder has to follow, which involves issuing a complaint to the board of directors before initiating suit, but it does vary some from state to state. The idea is that there needs to be a minimum threshold for a derivative action, and so these structural restrictions exist to limit the availability of the action to when all of the formalities have been followed. Otherwise there might be a suit anytime any shareholder is dissatisfied with a management decision. Generally, I would assume that the lawyers in the Take-Two case have made sure these formalities have been followed.
So, what about the Take-Two action? I'm might be limited to the reports that are appearing online, but according to the reports about the lawsuit and past developments, Take-Two has been having corporate issues for quite some time. It would not be unreasonable to see a chance of success in the derivative action based on management's refusal to entertain EA's acquisition bid as well as the increased compensation, but given the general lack of success in derivative actions, some significant evidence of breach of the fiduciary duty would need to be present. However, if I were a Take-Two shareholder, I would be pretty bitter right now based on descriptions of the EA buyout 'talks' and the recent increased compensation for the company's executives. It's easy to see why the shareholders likely felt they had few other options available.
Mark Methenitis is the Editor in Chief of the Law of the Game blog, which discusses legal issues in video games. Mr. Methenitis is also a licensed attorney in the state of Texas with The Vernon Law Group, PLLC and a member of the Texas Bar Assoc., American Bar Assoc., and the International Game Developers Assoc. Opinions expressed in this column are his own. Reach him at: lawofthegame [AAT] gmail [DAWT] com.
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