When Shareholders Sue: Understanding Legal Actions Against Companies Like Theranos

The recent Theranos scandal brought to light corporate governance issues and the potential legal actions shareholders can take when such malfeasance occurs. In many jurisdictions, shareholders have the right to sue on behalf of a company against an external entity or its officers and directors. This article explores these mechanisms under the context of U.S. law.

Derivative Lawsuits: Filling the Breach

Derivative lawsuits enable a class of shareholders to sue on behalf of the company against a third party, such as a director or officer, when the company itself fails to act due to conflicts of interest. The rationale behind derivative lawsuits is straightforward: if the company’s management decides not to pursue claims against third parties that have harmed the company, the shareholders, who are the ultimate owners, assert corporate rights on behalf of the company. These lawsuits are common in cases where there is a credible third-party damage to the company, despite the company’s internal governance failing to take appropriate action.

Securities Class Actions: Allegations of Misleading Information

Another major category of lawsuits involves securities class action filings, which are brought under U.S. federal securities law. These lawsuits are brought by shareholders alleging that company officers or other insiders knowingly made false or misleading statements to investors about the company’s financial health, operations, or prospects. The suits define a specific time period during which the alleged fraud occurred and a group of investors (either buyers or sellers of securities) who were impacted by these misleading statements. Such cases frequently result in large settlements, in which not only do the affected shareholders receive compensation, but there are often significant governance reforms aimed at preventing future misconduct.

Who Defends the Company?

A key aspect of these suits is the financial impact on the company. Directors and officers of most firms are typically indemnified by the company itself, as dictated by Directors Officers (DO) insurance. This insurance covers legal expenses and potential judgments against the company due to the actions of its leadership. Most companies pay premiums into these policies over time, meaning that when a lawsuit is brought, it is essentially the shareholders’ money supporting the legal defense. The indemnification and insurance coverage are structured to shield the personnel from financial hardship.

Settlements: A Common Outcome

Settlements are a common outcome in these lawsuits. Firms understand that taking a case to court can be costly, time-consuming, and can tarnish their reputation. Therefore, many choose to settle rather than litigate. Settlements often include financial compensation for shareholders affected by the fraud or mismanagement, along with reforms to the company’s governance. These reforms aim to address the original issues that precipitated the lawsuit, such as overreaching executive power or inadequate oversight. Additionally, settlements generally include significant legal fees, which can be substantial.

Theranos: A Case in Point

The Theranos scandal exemplifies the potential legal actions and the impact on shareholders. The company misled investors about the efficacy and technological capabilities of its tests, leading to significant financial losses. In response, shareholders initiated a class action lawsuit, alleging that Theranos and its officers engaged in fraudulent practices. The settlement in this case involved substantial payouts to shareholders and significant changes to the company’s governance structure to prevent similar issues from recurring.

Conclusion: Shareholder Power in Corporate Governance

Shareholder lawsuits, whether in the form of derivative actions or securities class actions, underscore the critical role shareholders play in corporate governance. These legal mechanisms enable investors to hold executives and the company accountable for mismanagement. While the legal process can be complex and costly, it serves as a deterrent to fraudulent practices and can lead to significant reforms. Understanding these legal frameworks and their implications is essential for shareholders to protect their investments.