The Director’s Guide to Avoiding Class and Derivative Action Triggers

The threat of class-action lawsuits looms large for public companies. These complex legal battles can drain resources, damage reputations and disrupt operations, potentially influencing shareholder value and long-term viability. Directors must understand common triggers for class-action lawsuits and help implement proactive measures to mitigate risk to safeguard their company's future. These are key to their fiduciary duties, requiring vigilance and proactive engagement.

Fiduciary Duties and Class-Action Risk

In most jurisdictions, directors of public companies owe fiduciary duties of care and loyalty to the company and its shareholders. The duty of care requires directors to act with the prudence and diligence that an ordinarily prudent person would exercise in a similar position. The duty of loyalty mandates that directors act in good faith and avoid conflicts of interest, prioritizing the interests of the company and its shareholders over personal gain.

Understanding the Business Judgment Rule

The business judgment rule protects directors by presuming that, in making decisions in good faith, with appropriate care, and in the company's best interests, courts should not second-guess their actions. This rule benefits directors of public companies by granting them the latitude to consider a range of factors — including, where permissible, the interests of other stakeholders — without jeopardizing their primary fiduciary responsibility to the shareholders.

Mitigating Director Liability and Safeguarding Shareholder Value

Neglecting to address issues such as inaccurate financial reporting or inadequate cybersecurity measures can expose directors to personal liability for losses that ultimately impact shareholder value. Because directors' fiduciary duties are owed primarily to shareholders — even when, in some jurisdictions, considering other stakeholders may help satisfy the business judgment rule — they must:

• Remain informed. Maintain a comprehensive understanding of the company's operations and any liabilities that might affect shareholders.
• Act proactively. Address risks identified through audits, internal reviews and external reports before they escalate.
• Document decisions. Keep detailed records of decision-making processes and the underlying rationale to demonstrate due diligence in fulfilling their fiduciary obligations.

Directors who fail to meet their fiduciary duties may face a derivative lawsuit. In this type of case, shareholders sue on behalf of the company for director misconduct or breaches that harm the corporation. It's important to differentiate between derivative actions and class actions. Class actions can be filed by any affected person, including shareholders, claiming common harm. In contrast, derivative suits address breaches of fiduciary duty to the corporation, and only shareholders can file them. The harm in a derivative suit affects the company directly, with the shareholder's loss being secondary to the company's injury.

Warning Signs

Recognizing red flags is essential to identifying and mitigating class action and derivative action risks. Below are practical warning signs in some key class-action areas.

Securities Fraud

• Financial performance. Unexplained fluctuations in revenue, expenses or profits; consistent missed earnings targets.
• Weak internal controls. Failure to identify financial performance drivers; deficiencies in financial reporting; absence of robust audit committee oversight; inadequate monitoring of risk management procedures.
• Public statements. Inconsistent messaging; failing to disclose material information in violation of SEC mandates for complete, accurate and transparent disclosure; misleading stakeholders and undermining market confidence.
• Insider trading. Unusual trading activity by executives or leaks of confidential information.

Consumer Protection Violations

• Marketing practices. Exaggerated or unsubstantiated product claims; deceptive pricing.
• Product safety. Increased product returns, warranty claims or safety-related complaints.
• Data security. Weak cybersecurity infrastructure or frequent minor data breaches.

Employment Discrimination

• Employee turnover. High turnover rates in specific demographics or departments.
• Complaints. Patterns of discrimination or harassment complaints.
• Pay equity. Persistent disparities in pay between different demographic groups.

Antitrust Violations

• Competitive behavior. Discussions with competitors about pricing or suspicious bidding patterns.
• Market practices. Predatory pricing or attempts to exclude competitors.
• M&A activity. Transactions that significantly concentrate market power.

Environmental Violations

• Regulatory compliance. Failure to secure necessary permits or comply with emission limits.
• Community feedback. Complaints from neighboring properties about pollution or nuisance.
• Operational issues. Improper handling of hazardous materials or reports of contamination.

Mitigation Strategies

Implementing strong compliance measures across these key exposure areas can help companies take proactive steps to minimize the risk of class-action lawsuits.

For example, maintaining robust financial reporting is essential in securities fraud. This includes strengthening internal controls, conducting regular audits and ensuring active oversight by the audit committee. Transparent communication is equally crucial. Organizations should establish clear protocols for public disclosures to guarantee accuracy and completeness. Additionally, insider-trading policies must be strictly enforced, with pre-clearance procedures for trades and ongoing employee training to mitigate risks.

Businesses must prioritize truth in advertising by thoroughly vetting marketing materials to avoid exaggerated or misleading claims and prevent consumer protection violations. Product safety is another critical area requiring comprehensive quality control measures throughout the product's life cycle, from initial design to post-market surveillance. With cybersecurity threats rising, companies should also invest in data protection strategies, including encryption, multifactor authentication and a well-structured incident response plan.

Addressing employment discrimination requires a firm commitment to policy enforcement. Organizations should implement clear antidiscrimination and harassment policies reinforced by regular employee training. When complaints arise, swift and thorough investigations, followed by appropriate corrective action, are crucial in demonstrating a commitment to a fair workplace.

Businesses should establish comprehensive programs for antitrust compliance that provide employees with regular training on antitrust laws. Seeking legal counsel before engaging in transactions or business practices that could raise concerns helps mitigate potential legal exposure. Monitoring market share and competitor activities also ensures compliance with regulatory standards and prevents inadvertent violations.

Finally, environmental compliance may be scrutinized at all levels of government. Developing a comprehensive environmental management program that includes regular audits and risk assessments helps organizations avoid potential issues. Additionally, proactive engagement with local communities fosters transparency and helps address ecological concerns before they escalate.

Benefits of Transparency, Compliance and Accountability

Class- and derivative-action lawsuits pose significant risks to public companies and directors. Still, proactive boards can minimize exposure by understanding common triggers, recognizing warning signs and implementing effective mitigation strategies.

While directors are not expected to have an in-depth, technical understanding of every operational risk their company faces, their fiduciary duties require them to be adequately informed and act proactively to identify, mitigate and address potential failures. Across all these areas, directors should stay engaged by requesting periodic reports, consulting experts when needed and ensuring appropriate risk-mitigation strategies are in place. Documenting board decisions and their rationale is critical, as it provides a clear record of due diligence and commitment to responsible corporate governance. By taking these steps, directors can discharge their duties, bolster their invocation of the business judgment rule, and protect the company from legal and financial risks while reinforcing trust with shareholders, regulators and the broader public.

Staying ahead of potential liabilities is a legal obligation and a cornerstone of sound corporate governance. Fostering a “transparency, compliance and accountability culture,” directors fulfill their fiduciary duties, safeguard the company's reputation and long-term success, and demonstrate their commitment to shareholder and stakeholder value.