The Tooley test, adopted from Delaware law, helps New York courts determine whether a shareholder’s claim is direct or derivative. It asks two simple questions: Between the shareholders and the corporation, who suffered the alleged harm? Who would receive the benefit of any recovery or remedy? These questions might seem straightforward, but their answers can significantly impact how a case proceeds.
What counts as a direct suit?
A direct suit occurs when a shareholder sues for the harm they’ve experienced personally or for a violation of their rights, seeking a remedy that will benefit them directly. In New York, several issues may serve as grounds for a direct claim. This includes company officials, directors or leaders:
- Preventing shareholders from voting on important company decisions
- Denying shareholders access to financial statements or other important documents
- Failing to honor the terms of a contract, causing direct financial harm or limiting a shareholder’s rights within the company
- Making false statements about the company’s financial health, which can cause shareholders to lose money
- Offering some shareholders better terms than others during a merger or acquisition which can result in financial losses for the disadvantaged shareholders
These situations directly affect individual shareholders rather than the corporation as a whole.
What counts as a derivative suit?
A derivative suit is when a shareholder acts on behalf of the corporation to address the harm done to the corporation itself. In these cases, any recovery from the lawsuit goes to the company, not directly to individual shareholders.
Common grounds for derivative suits include directors or officials:
- Making poor financial decisions that reduce the company’s value and, indirectly, the value of shareholders’ investments
- Using their positions to benefit themselves at the company’s expense, such as awarding themselves with excessive salaries or approving contracts with their own businesses at inflated prices
- Spending company resources on unnecessary or overpriced goods or services
- Failing to act in the best interests of the company and its shareholders
- Insider trading, or using non-public information to trade company stock for personal gain
Derivative suits are a way for shareholders to protect the company’s interests when they believe the leadership isn’t doing so.
Protect your interests
Shareholder litigation extends beyond just direct and derivative suits, involving numerous legal hurdles and strategic decisions. An attorney can help you explore all potential courses of action.