Fraud and embezzlement are among the most serious breaches of trust that can occur within a corporation. When corporate insiders, such as directors, officers, or controlling shareholders, engage in misconduct that harms the corporation itself, traditional remedies available to shareholders may not be sufficient. In such cases, derivative litigation can serve as a powerful legal mechanism for holding wrongdoers accountable and safeguarding the interests of the corporation and its stakeholders.
In Ontario, derivative actions provide shareholders with a court-approved avenue to pursue legal claims on behalf of the corporation when those in control refuse to do so. This remedy is especially relevant in situations involving financial misconduct such as embezzlement, fraud, and the misappropriation of corporate assets.
Understanding Derivative Litigation in Ontario
A derivative action is a lawsuit brought by a shareholder on behalf of the corporation, rather than in their personal capacity. It arises when the corporation has suffered harm, such as financial loss due to fraud, but the individuals in charge of the corporation (often the perpetrators of the wrongdoing) are unwilling to take legal action themselves.
In Ontario, derivative actions are governed by the Business Corporations Act (OBCA) for provincially incorporated companies and the Canada Business Corporations Act (CBCA) for federally incorporated companies. Both statutes impose a leave requirement, meaning a shareholder must obtain court permission before proceeding with the claim. This ensures that derivative actions are not brought frivolously or for improper motives.
When Is a Derivative Action Appropriate?
Derivative actions are appropriate when there is credible evidence of wrongdoing that has harmed the corporation itself, not just the individual shareholder. Common grounds include:
- Fraudulent transactions conducted by directors or officers
- Embezzlement or theft of corporate funds
- Unauthorized use of corporate assets for personal gain
- Breach of fiduciary duties or conflict of interest
- Failure by the board to act against known misconduct
For example, if a company’s CFO has been siphoning off funds into a private account and the board is aware but fails to take action, a shareholder may bring a derivative claim to recover the stolen funds for the corporation’s benefit.
Establishing the Legal Threshold to Bring a Derivative Action
To proceed with a derivative action in Ontario, a shareholder must give the corporation’s directors notice of their intention to bring an action and must also satisfy the legal threshold in section 246 of the OBCA (or section 239 of the CBCA). The court will consider whether:
- The directors of the corporation or its subsidiary will not bring, diligently prosecute, defend, or discontinue the action in question;
- The complainant shareholder is acting in good faith; and
- It appears to be in the corporation’s best interests that the action be brought, prosecuted, defended, or discontinued.
The good faith requirement prevents abuse of process and ensures the claim is being pursued for legitimate purposes, not simply as leverage in a shareholder dispute or as retaliation. The “best interests test” involves a factual analysis of the corporation’s position, the severity of the alleged misconduct, and whether litigation is a proportionate and effective remedy.
Courts may also consider whether alternative remedies, such as oppression claims or regulatory reporting, might be more appropriate.
Investigating and Gathering Evidence of Fraud
A successful derivative action involving fraud or embezzlement requires clear, credible evidence. Shareholders contemplating such a claim must often undertake significant groundwork to build their case. This may include:
- Reviewing financial statements and audit reports
- Gathering internal communications or whistleblower disclosures
- Identifying suspicious transactions or unexplained expenditures
- Consulting forensic accountants or auditors
In some cases, obtaining this information can be difficult due to a lack of access. Ontario courts have recognized this challenge and may grant preliminary disclosure orders in appropriate cases. However, courts will balance the request against the corporation’s privacy and confidentiality interests.
Common Defences and Strategic Challenges
Derivative claims involving fraud and embezzlement often face vigorous defence from the accused parties. Typical arguments include:
- Denial of wrongdoing
- Allegations of improper motive on the part of the shareholder
- Claims that the transactions were authorized or ratified
- Procedural objections, such as failure to meet the leave requirement
A common strategic challenge is the power imbalance between a minority shareholder and a board or controlling group. The defendants may use corporate resources to fund their defence, while the complainant bears the cost of the litigation. However, courts have discretion to award interim costs or reimbursement in successful cases to ensure access to justice.
Remedies Available Through Derivative Actions
If the court finds in favour of the shareholder bringing the derivative claim, several remedies may be available, depending on the nature and extent of the misconduct. These include:
- Orders for the repayment of misappropriated funds
- Damages awards against directors or officers for breach of fiduciary duty
- Orders requiring disgorgement of profits obtained through fraudulent means
- Injunctions or orders removing individuals from positions of authority within the corporation
The ultimate goal of derivative litigation is to make the corporation whole and to hold wrongdoers accountable for the harm they caused.
Relationship Between Derivative Actions and Oppression Claims
In some instances, fraud or embezzlement by insiders may also give rise to an oppression remedy under section 248 of the OBCA. While derivative actions aim to redress harm to the corporation, oppression claims are personal to the complainant and focus on unfair prejudice to their interests.
Strategic plaintiffs sometimes plead both causes of action in the alternative. For example, if a majority shareholder loots company funds and refuses to investigate, the minority shareholder may argue that the failure to act is oppressive and also pursue a derivative claim for recovery on behalf of the corporation.
Courts are alert to these distinctions and may require the plaintiff to clearly delineate each claim’s basis and beneficiaries.
Policy Rationale Behind Derivative Litigation
Derivative litigation plays a critical role in Ontario’s corporate governance landscape. It empowers minority shareholders to act as corporate watchdogs when insiders breach their obligations or abuse their power. Without this remedy, corporate wrongdoers could escape accountability simply by controlling the company’s litigation decisions.
By requiring court approval, the legislature has struck a balance between enabling shareholder oversight and protecting companies from vexatious or disruptive litigation. The process ensures that only bona fide claims in the corporation’s interest proceed, while frivolous or bad-faith actions are weeded out early.
Best Practices for Ontario Shareholders
Shareholders who suspect fraud or embezzlement should consider the following steps:
- Act quickly but cautiously, as delay can be interpreted as acquiescence.
- Document concerns with as much evidence as possible.
- Consult legal counsel experienced in corporate and commercial litigation.
- Consider whether a demand should first be made to the board to take action.
- Be prepared for procedural hurdles, including the leave application process.
Timely legal advice is crucial. Missing steps or failing to meet statutory requirements can lead to dismissal of a claim before it ever reaches a hearing on the merits.
A Powerful Remedy Against Corporate Misconduct
Fraud and embezzlement by insiders strike at the heart of corporate integrity and financial health. Derivative actions give Ontario shareholders a legal mechanism to address these harms when the corporation refuses to act. While procedurally complex and often contested, derivative litigation can restore accountability, recover losses, and safeguard the corporation’s long-term viability.
Early legal guidance is essential for shareholders, directors, or corporate counsel facing allegations or suspicions of internal fraud. The stakes are high, not only for the parties involved but also for the corporation’s future.
Toronto Derivative Litigation Lawyers Helping You Protect Your Business from Corporate Fraud
If you suspect fraud or embezzlement is harming your company, you need a powerful and experienced legal team on your side. At Milosevic & Associates, our corporate commercial lawyers are seasoned litigators who have successfully navigated the complexities of derivative litigation. We understand the nuances of corporate law and the strategic challenges involved in these cases. We can help you build a compelling case, from gathering the necessary evidence to representing your interests in court, ensuring the well-being of the corporation you have an interest in is protected. Contact us online or call 416-916-1387 for a confidential consultation to discuss your options.