Sometimes a CEO or other corporate insider puts the value of a company at risk by committing crimes such as wire fraud or embezzlement. When a shareholder believes that a director or officer has harmed the corporation by breaching a contract or breaching their duties, the shareholder can assert their rights and seek relief. One option is to file a derivative lawsuit. This article discusses shareholders rights and derivative actions, including information on the following:
- The shareholder’s role in the corporation
- The requirements for filing a derivative action
- Shareholder activism
The shareholders (also called stockholders) are investors who own shares in the corporation. The directors have obligations and duties to both the shareholders and the corporation itself. This role differs from that of the officers and executives who handle corporate governance by running the operations of the corporation, although the roles can overlap.
Derivative Actions and Shareholder Rights
Being a shareholder comes with certain duties, responsibilities, and rights. Shareholders have a general range of rights concerning the corporation, which include:
- ownership in a portion of the company;
- ownership transfer rights;
- voting rights; and
- an entitlement to dividends.
One of the most significant shareholder rights is the right to sue an officer or a director who has harmed the corporation. This type of litigation is referred to as a shareholder derivative action or lawsuit. Unlike a securities class action suit, where individual investors and shareholders are seeking relief, the derivative action includes the interests of all shareholders and permits them to file on behalf of the corporation.
Shareholders often bring derivative suits against their corporation to try to resolve conflicts between the shareholders and the officers, directors, or board members who have harmed the corporation through mismanagement or other wrongdoing. For instance, a shareholder of the fast food corporation Wendy’s filed a derivative action against its directors and officers for its security practices that ultimately led to a massive data breach.
Requirements for Shareholder Derivative Lawsuits
Many states require that a plaintiff must be a stockholder at the time of the alleged improper conduct in order to file a derivative action. Others require that the shareholder own stock at the time of the improper conduct and continuously throughout the resolution of the lawsuit; this is referred to as the “continuous ownership requirement.”
Prior to filing the suit, the affected shareholders must demonstrate that they informed the company’s management of the problems in writing and that the directors decided against pursuing any action. If management fails to comply, the shareholders must show that the management’s conduct adequately harmed their position and that they refused to resolve the issues.
The shareholder must give notice (on their own or at the expense of the corporation if ordered by the court) to the other shareholders that the action has been initiated, providing them the opportunity to join the lawsuit.
Damages for the Corporation
If a shareholder prevails, they won’t recover individually; any recovery obtained from a derivative action is for the corporation only. However, a shareholder will generally receive legal expenses from the corporation.
While a derivative suit is a very specific way to affect corporate governance, shareholder (or stockholder) activism is another more broader means to promote interests through shareholder rights, especially voting rights. Shareholder activism occurs when shareholders attempt to use their power to pressure management and affect a corporation’s behavior resulting in favorable results for the shareholder or to promote broader political or social causes, As an example, some Apple investors have sought to pressure the company to address smartphone addiction, especially among children. This can be achieved through various actions including litigation, proxy contests, publicity campaigns, and more.
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Purchasing securities “on margin” equates to investing with borrowed funds. The risks of trading on margin are unsuitable for many investors. If a financial adviser encourages margin trading without regard for a client’s investment profile, or without a client’s full understanding of the risks involved, the client can potentially seek to recover any money lost as a result of the margin transaction.
WHAT IS BUYING ON MARGIN?
An investor can buy securities using money borrowed from a brokerage firm (rather than paying for the securities in full). This is known as “buying on margin.”
Buying on margin requires opening a margin account and depositing an initial amount of purchased securities. The initial account equity (margin) is used as collateral to borrow money and purchase additional securities. Like other types of loans, interest is charged on the amount borrowed until it is repaid.
MARGIN TRADING RISKS
The risks involved with trading on margin include:
- Securities purchased on margin do not break even, or earn at least the amount of interest charged on the loan, resulting in the loss of funds.
- Securities used as collateral drop in price and the firm issues a “margin call,” which requires the customer to repay all or part of the loan. The customer is not entitled to a time extension on a margin call.
- The client has limited control over their margin account. For example, the firm can force the sales of margin account securities without notice, sell securities without contacting the client, and increase margin requirements at any time.
MARGIN ACCOUNT ABUSE
Margin investing isn’t an appropriate strategy for most investors. Margin loans, however, can be highly profitable for brokerage firms (because of the interest paid on borrowed money) and for brokers, who might be paid a fee based on the size of the client’s loan.
Investment professionals must understand a client’s investment profile, including their willingness and ability to incur risk. Before a client opens a margin account, they should fully understand how margin transactions could affect their portfolio.
If your broker misrepresented the risks of a margin account, opened an unauthorized account in your name, or made excessive trades in your account, any lost money may be recoverable through a legal claim.
HEDGE FUND INVESTMENTS
Once reserved strictly for wealthy, financially sophisticated investors, hedge funds have become increasingly popular investment vehicles for traditional investors. Often, this is achieved through investment in “funds of hedge funds.” Because I’m a securities lawyer, I’ve seen both good and bad from this.
Both hedge funds and funds of hedge funds have risks that are inappropriate for most investors. Financial advisers may make exaggerated and misleading claims about these funds in order to lure potential investors. Hedge fund managers have also been known to defraud investors.
HOW HEDGE FUNDS WORK
Hedge funds are a type of investment fund. Like mutual funds, hedge funds pool the money of many investors and follow a specific investment strategy. But that is about as far as the similarities go.
Unlike mutual funds, hedge funds are not regulated by the Securities and Exchange Commission (SEC), and therefore do not offer many of the investor protections that mutual funds and other registered investment products do.
FUNDS OF HEDGE FUNDS
Hedge fund investment is usually limited to wealthy individuals and institutional investors. But funds of hedge funds—an indirect way of investing in hedge funds—typically require lower minimum investments that make them accessible to a broader investor class.
While funds of hedge funds may be registered SEC products, the underlying hedge funds are not. Funds of hedge funds thus carry the same investment risks that hedge funds do.
HEDGE FUND RISKS
The risks of investing in hedge funds and funds of hedge funds include:
- Not SEC Registered: Because hedge funds are not required to be SEC registered, they are not subject to mandatory reporting rules. As a result, it can be very difficult for investors to gauge a hedge fund’s performance. This can make it easier for a hedge fund manager to commit fraud.
- Speculative Investing: Hedge fund managers are paid based on the fund’s performance, which gives them an incentive to maximize positive performance. This can lead to sophisticated (read: risky) investment strategies such as short selling, derivatives investment, leveraging, and hedging.
- Illiquidity: Hedge fund investors may be unable to recoup their investment money if they want to opt out of the fund.
- Expensive: Hedge funds usually have numerous fee layers and impose higher investor costs than mutual funds.
- Tax Complexity: Hedge funds’ complex tax structure can present delays and difficulties during tax season.
WHEN YOU MAY HAVE A CLAIM FOR HEDGE FUND INVESTMENT LOSSES TALK TO A SECURITIES LAWYER
Hedge fund misconduct commonly occurs in the context of how the fund was sold.
Unless you are a wealthy, financially sophisticated investor, a hedge fund is mostly likely an unsuitable investment. And even if you are an accredited investor, an adviser must accurately present important information about the hedge fund. Any misrepresentations or omissions of material facts could constitute misconduct.
For non-accredited investors, funds of hedge funds may be suitable investments—however, their growth forecasts, risks, and drawbacks must be accurately presented.
Absent any misconduct in the sales stage, hedge fund managers and operators can commit investment fraud. Examples of fraudulent hedge fund conduct include providing phony account statements, not disclosing conflicts of interest, misappropriating investor funds, and operating Ponzi schemes.
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West Jordan, Utah
84088 United States
Telephone: (801) 676-5506