Company Law-Statutory Derivative Claim

Company Law-Statutory Derivative Claim

  

Introduction

Under the common law approach, a shareholder of a company lacks the right to bring an action against the company for wrongs committed, and neither can they raise complaints regarding any internal irregularities. Known as the rule in Foss v Habottle, it seeks to sanction the majority rule in which the majority shareholders can bar a derivative action bought against the company by a minority shareholder. There are, nonetheless, certain exceptions to the rule in Foss, as highlighted in Edwards v Halliwel. These are:  in case the act committed contravenes members' personal rights; where the Articles have been violated; in case the act committed was ultra vires; and where there is evidence of wrongdoer-control and fraud on the minority. The common law rule has however come under a lot of criticism, not least because it was deemed to encourage directors to be complacent in executing their duties given the difficulty in bringing a derivative action against them. The rule in Foss v Harbottle has been described using such terms as complex, old-fashioned, vague, inflexible, and cumbersome. Following these developments, the UK Law Commission recommended that a new derivative procedure be formed. The proposed derivative procedure would be characterised by accessible, modern, and flexible criteria to ascertain if a shareholder was in a position to pursue the action (Law Commission 1997). The remedy to these and other criticism is provided for by the 2006 Company Act (s 260-264).  The overarching aim of the Statutory Derivative Claim as provided for under s260-264 of the 2006 Companies Act is to shield minority shareholders from potential abuse by majority shareholders while at the same time also trying to uphold the majority rule principle as spelled out by Foss v Harbottle and in this way, strike a balancing act. The focus of this essay, therefore, is to explore the extent to which the statutory derivative claim as provided under the 2006 Companies Act has succeeded in realising this balance.    

Foss v Harbottle (Overview)

Foss v Harbottle hinges on two overarching principles: the principle of 'proper plaintiff', and the principle of 'internal management'. The 'proper plaintiff' rule identifies the company itself as the right individual to file a claim for wrongs committed to a company. This particular rule is strongly affiliated with the SLP (separate legal personality) principle that views the company as a distinct legal entity, separate from its members. This doctrine was highlighted by Lord Halsbury in Salomon v Salomon in which he stated that after a company has been legally incorporated, it effectively became an independent person with its individual liabilities and rights. In other words, the company reserves the discretion to settle its liabilities and pursue its rights.

On the other hand, the 'internal management' rule, which shares a lot of similarities with the 'majority rule', hinges on the premise that the courts will desist from a company's commercial management decisions. The reasoning behind this rule is that the court is of the view that shareholders are best suited to arbitrate the company's internal issues. However, the 'fraud on the minority' is an exception to the 'majority rule' whereby an individual shareholder is in a position to seek legal redress for wrongs committed to a company.

Based on this exception to the rule, an individual shareholder is permitted to pursue a claim for wrongful actions against the company, but they must first obtain a corporate remedy and pursue such a claim in their shareholder’s name. In order that this exception may be qualified, it has to satisfy two conditions. First, the wrongful act must constitute fraud. Second, the wrongdoers must be majority shareholders, meaning that they have a controlling stake in the company. Nonetheless, the rules in Foss v Harbottle, along with the associated exceptions, could only be accessed by specialist practitioners, given the need to evaluate a case law that goes as far back as 150 years. In addition, the restrictive judicial attitudes that characterised courts raised doubts about whether courts were in a position to design logical rules capable of establishing a balance between improving 'shareholder confidence' and desisting from inflicting a considerable burden on the company’s management.

Nonetheless, only under exceptional circumstances has the minority shareholder been granted permission by the courts to institute legal proceedings for a derivative claim for wrongful acts on the company, where the majority shareholder is the wrongdoer.  In order for a minority shareholder to bring a derivative action under common law, there is a need first to fulfil two fundamental requirements. First, the supposed breach of duty or wrong to the company should be such that it cannot be approved by a simple majority.  Second, the supposed wrongdoers ought to have a controlling stake in the company, meaning that the company is not in a position to stake a claim on its own behalf, despite being the “proper claimant.”

Two-Stage Procedure

The 2006 Companies Act adopts a two-set procedure.  The first step demands that the shareholder who is pursuing a claim on behalf of the company, must by the act of submitting paper documents towards the same, prove a 'prima facie' case in order that they may receive permission to proceed.   At this stage, the involvement of the company is not necessary. In the event that the evidence submitted by the shareholder is accessible, this acts as a signal for the court to move on to the second stage. At this point, both parties are ordered to prepare in readiness for a full heating of the application made by the shareholder.  

During the second stage, the courts have to refer to various factors in arriving at a decision on whether the shareholder should be permitted to move on with the action. S 263(2) of the 2006 Companies Act advised the court to deny the shareholder permission to proceed with the action in case a speculative individual whose actions are consistent with the task of advancing the company's success would not request to proceed with the claim. The court may also decide to deny the shareholder permission to proceed with a derivative claim in the event that the matter that forms the basis for the complaint was sanctioned beforehand or approved since it happened. 

Additionally, s 263(3;4) spells out other factors which the court should consider while exercising its discretion to give the shareholder permission to move forward with a derivative claim. They include: (i) if the shareholder's actions are in keeping with good faith; (ii) the prospect of past consent or succeeding approval by the company; and (iii) the possibility of the shareholding raising a personal claim. In the event that the court finally permits the shareholder to proceed with a derivative claim, the procedure involved is similar to that of ordinary proceedings.

The new directive allows the shareholder who has petitioned the claim to convince the court that he is a prima facie case involving breach of duty by the company's director (s). Should his petition succeed, the court then permits the case to move forward. The minority shareholder thus represents the company. It follows then, that any damages accruing from the director's inability to advance the company's success would be payable not to the shareholder, but to the company. Hughes v Weiss acts as a good example of this. In this case, two lawyers established a company with the objective of offering consultancy services on diverse financial issues. The two lawyers were directors of the company, not to mention they had equal shares in terms of management and ownership of the company. However, Weiss took hold of a sizable portion of the company's funds and offered various reasons to justify his claims which the court deemed unconvincing. The court ruled that Weiss had not acted in a fair manner going by the stipulations of s.172 (1)(f) and considering the prima facie case made by Hughes on the same.

Analysis of the new derivative claim

Ever since the 2006 Companies Act was sanctioned, concerns have emerged regarding the possibility of activist shareholders using the new statutory provisions as a tactical tool to institute litigation against company directors, thereby resulting in a torrent of derivative claims. The new directive claim procedure has elicited feelings of nervousness among company directors who are now fearful that individual shareholders will find it easier to bring claims against them. Directors are especially concerned that the new legislation has expanded the cause of actions. This, along with the structuring of directors' duties as spelled out in Part 10 of the 2006 Companies Act will permit an outpouring of derivative claims. 

Nonetheless, it would be comforting for directors to realise that the balance of the new legislation is still in their favour. To begin with, the new law has not altered the rule as established in Foss v Harbottle. The Law Commission, in its final report, made it very clear that the government had no intention to change the court's tradition in terms of its unwillingness to get involved in business management. The Law Commission further acknowledged that only in exceptional circumstances can an individual shareholder bring a derivative claim.  While part II of the 2006 Companies Act may have adopted most of the recommendations that the Law Commission made, it is worth noting that this is not definite legislation aimed at replacing the rule in Foss v Harbottle. Instead, it should be seen as a revised approach for bringing actions subject to the prevailing rules.   

            Also, the new procedure would still protect directors in case there is no change in the court's attitude regarding derivative claims. Directors are concerned about the addition of pure negligence as a possible cause of action. Nonetheless, the court can only address the issue of breach of duty in the event that the minority shareholder who has brought a derivative claim goes through the two-stage procedure successfully. The two-fold procedure is a legal hurdle whose goal is to protect the directors of a company and the company itself against possible harassment by frivolous shareholders. Nevertheless, it could offer the directors too much protection to the extent that minority shareholders lack access to a better probability of being granted permission to proceed. Barring two situations under which the court is compelled to reject a minority shareholder's request to undertake the derivative claim, s 263(3&4) grants judges considerable discretionary rights over the matter. Therefore, regardless of if the directors are highly vulnerable to increased lawsuits on account of the new directive claim or whether it can be used as an effective tool of governance, this is mainly determined by the manner in which the courts go about exercising their discretionary powers over the issue.

While it may be a bit premature to draw conclusions on the issue, Mission Capital v Sinclair and Franbar v Patel point toward the reluctance of the court to permit derivative claims to proceed. On both cases, the court denied the minority shareholders permission to proceed after establishing a lack of circumstances for compulsory refusal in both of the cases. So far, three cases have gone through the 'two-stage' procedure successfully. These are: Kiani v Cooper; Stainer v Lee; and Phillips v Frey. In Kiani and Stainer, however, the court held that permission to proceed to a full hearing hinged on further disclosure.

Conclusion

In developing a statutory derivative claim under the 2006 Companies Act, the Law Commission intended to strike a balance between enabling the bringing of derivative actions thereby overcoming the difficulties associated with Foss v Harbottle and its associated exceptions, and at the same time ensuring that the company directors and companies are protected for frivolous litigations by activist shareholders.  The new legislation does not offer incentives for such frivolous litigations. In addition, the courts have traditionally been reluctant to intervene in the internal management of companies and this is unlike to change. It is highly unlikely, therefore, that individual shareholder will view the new directive as an ideal tool for pursuing corporate relief since even after passing the two-stage procedure, the individual represents the interests of the company and any damages accruing from the director's failure to represent the interests of the company are payable to the company, not the individual.  

 

 

 

Bibliography

Books

Degenhardt Klaus, Companies Act 2006, Part 46 (Books on Demand 2010) 46.

Ottley Mike, Q&A Company Law 2013-2014 (Routledge 2012)112.

Sealy Len and Worthington Sarah, Sealy & Worthington's Cases and Materials in Company Law (Oxford University Press 2013) 691.

Sheikh Saleem, A Guide to The Companies Act 2006 (Routledge 2013) 55

Journal articles

Gibbs D, 'Has the Statutory Derivative Fulfilled its Objectives? A Prima Facie Case and the Mandatory Bar: Part 1' (2011) 32 Company Lawyer 41.

Hannigan B and Prentice D, Hannigan and Prentice: The Companies Act 2006 -A Commentary (LexisNexis Butterworths 2007) para 4.46

Hannigan B, 'Drawing Boundaries between Derivative Claims and Unfairly Prejudicial Petitions' [2009] 606 Journal of Business Law 623.

Keay A and Loughrey J, 'Derivative Proceedings in a Brave New World for Company Management and Shareholders' [2010] Journal of Business Law 151.

Keay A and Loughrey J, 'Something Old, Something New, Something Borrowed: an Analysis of the New Derivative Action under the Companies Act 2006' (2008) 124 Law Quarterly Review 469.

Mujih, Edwin C,’ The new statutory derivative claim: a paradox of minority shareholder protection: Part 2’ (2012) 33 Company Lawyer 99.

James S, 'The Curse of Uncertain Times' (2007) 8 Journal of International Banking and Financial Law 447.

Case Laws

Foss v Harbottle (1843) 67 ER 189

Franbar. Holdings. Ltd. v. Patel. [2008]. EWHC. 1534. (Ch).

Hughes v Weiss [2012] EWHC 2363 (Ch).

Kiani v Cooper [2010] EWHC 577 (Ch)

Mission Capital plc v Sinclair [2008] BCC 866

Phillips v Fryer [2012] EWHC 1611 (Ch)

Salomon v Salomon [1897] AC 22

Stainer v Lee [2010] EWHC 1539 (Ch)

Statutes

Law Commission, Shareholder Remedies: Report on a Reference under Section 3(1)(e) of the Law Commissions Act 1965 (Law Com No. 246, 1997) para 6.15.

Acts

Companies Act 2006.