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7 Nov 2019

Derivative Suits: They’re Not Just for Public Companies Anymore

Shareholder derivative lawsuits have traditionally been the domain of public company shareholders seeking to rein in the potentially detrimental actions of large public companies. There is however, a far less heralded but particularly inventive application of derivative suits: to address disputes within small law firm partnerships.

Derivative Lawsuits

If it’s been a minute since your business organizations class in law school, your memory of derivative suits may have dulled a little. No worries.

Generally speaking, derivative suits give shareholders a method of protecting the interests of the companies they own when there is reason to believe that management is not doing so. Shareholders often have little control over decisions made by companies they are invested in, which presents a dilemma when a board of directors is taking action (or failing to take action) in a way that harms the company—like failing to pursue a valuable legal claim, for instance.

Each state has its own laws relating to how a derivative suit can be initiated, but the bottom line is that they allow shareholders to sue boards in the name of the company.

The Derivative Approach to a Law Firm Dispute

So, how could derivative suits apply to law firms as opposed to public companies? At least three conditions have to be present.

  1. The law firm in question has to be structured as a corporation. Only then would the legal protections allowing shareholders to file derivative claims apply to attorneys in a law firm.
  1. The lawyers that effectively control the law firm’s decision making (that could be a managing partner, a chairman, an executive committee or some combination of the three) must be taking some action that arguably cuts against the interests of the firm.
  1. The lawyers bringing the action against them must have an equity interest in the firm, such that they qualify as corporate shareholders.

 Of course, all other statutory and common law requirements must be followed as well. For instance, state law often requires that, before a shareholder can file a derivative suit, they must first ask the company to file the suit on its own behalf. Only after the company declines can the shareholder go forward.

It’s not every day that all of those conditions will be met in partnership disputes. In many (if not most) firms that are corporations, any partner(s) acting against the interest of the firm will have a minority ownership stake. When that’s the case, the corporation itself could take action against them.

But in firms with highly concentrated ownership and management (like some large personal injury firms dominated by a single personality) or small firms with fewer than five or ten shareholders, it’s quite possible that one or more partners could prevent the firm from acting in its own self-interest.

How the Derivative Approach Could Work

Take a well-established firm structured as a corporation with just two shareholders, each owning exactly half of the firm. The firm has run successfully for many years and built a recognizable brand. But at some point, the partners begin to disagree over business strategy, working styles, personalities or some other factor—as they do in so many business marriages.

At that point, the partners may begin to put their own interests above the partnership’s, or even intentionally harm the firm just to spite the other.

One partner might appropriate the law firm’s computer equipment, for instance. The other, meanwhile, might give his son’s law firm the right to a jingle long associated with the warring partners.

Any law partner that has been involved in a situation like this knows it can be highly distressing. It would not however, be the first time such destructive behavior happened in a partnership. And in addition to other legal claims that the above hypothetical would give rise to, it could become the basis of a shareholder derivative suit by either of them.

In this situation, neither partner would agree to file a lawsuit on behalf of the firm based on their own misconduct. While the aggrieved partner may have other claims to pursue, its possible that a court would allow them to step into the shoes of the corporation in order to recover its intellectual property (phone number and jingle) or actual property (computer equipment).

A similar situation could play out at a firm in which a small group of partners that manage the firm begin making choices that benefit them, to the detriment of other partners.

An Unorthodox, yet Happy Ending?

Certainly, the idea of filing a shareholder derivative suit is a rare one that is likely to arise only in extreme situations. It’s just those situations however, in which parties need to consider every legal tool at their disposal. The shareholder derivative suit is an overlooked tool that may, in the right case, bring a troubling partnership dispute to a satisfying resolution.