“Derivative claim” Question

Q4) Discuss whether the statutory procedure securing a process for a “Derivative claim” provides sufficient minority protection. Please support your answer with reference to relevant case law.

A derivative claim is a claim made by a nominate shareholder on behalf of the company. It is a claim made for the wrongs done to the company by a director. Prior to the introduction of part 11 of the Companies Act 2006, only under common law could a derivative action be raised. One of the disputable areas in the Companies Act 2006 (‘CA 2006′) is the provisions of derivative claim. It is believed a successful derivative claim regime should strike the right balance between ensuring effective remedies available to minority shareholders while not allowing troublesome directors impeding the carrying on of the proper business of the company. However, it seems the pendulum of the new statutory provision swings in favour of the managerial freedom. Whether it could be served as a tool to ensure directors being held accountable for their breach of duties is questionable.

The case of Foss v Harbottle leaves the minority in an unprotected position, exceptions have arisen and statutory provisions have come into being which provide some protection for the minority. By far and away the most important protection is the unfair prejudice action in ss. 994-6 of the Companies Act 2006 (UK). Also, there is a new statutory derivate action available under ss 260-269 of the 2006 Act.

Obviously, these old rulings do not protect minority shareholders from directors who commit fraud themselves and they have since been developed to provide four exceptions:

Where the transaction is ultra vires or illegal; where the transaction requires the sanction of a special majority; where the transaction infringes the personal rights of the shareholders; and where the transaction amounts to a fraud on the minority. (False assertion different from criminal)

The derivative claim at common law a shareholder did not have the right to bring an action for a wrong against a company under the common law has always been regarded as complicated and unsatisfactory. As a result, it was brought far less frequent than other shareholder remedies.

It has been long established in Foss v Harbottle that the proper claimant in an action in respect of a wrong done to a company is the company itself. The decision whether to sue or not is usually made by the board of directors acting within their normal management power. However, when the people causing harm to the company are its own directors, it is clearly unsafe to let the directors decide. Hence, under special circumstances when the company is not willing to pursue its own right, individual shareholders may be allowed to bring a derivative claim.

With the common law rule it became almost impossible for minority shareholder to institute derivative action as the procedure for locus standi was cumbersome, and the exception to the rule was uncertain. It could be argued that these difficulties are part of the reasons why directors where not cautious in performing their duties as bringing a derivative action against them was very difficult. However these criticisms lead to the new statutory derivative action statutory derivative claim is provided for under Section 260-264 of the Company Act 2006 with wider provisions and some modifications on the common Law derivative action.

The statutory derivative action permits a shareholder to bring a claim against wrong which occurred in the past before he became a member of the company. This newly widened scope is justified on the basis that the new shareholder may either benefit or suffer. Statutory derivative claim has a two stage procedure whereby permission is granted or refused. The court is guided by Section 263 on whether to grant or reject permission.  Shareholders may be discouraged from instituting derivative action due to the cost implications.

Section 994 stipulates that members may petition the court on grounds that the affairs of the company has been conducted in a manner unfairly prejudicial. However for unfair prejudice remedy to lie, the act complained of must be in the company’s affairs.

To succeed in an action for unfair prejudice, the action must be both unfair and harmful. This wide judicial discretion and broad interpretation of Section 994 aim to afford maximum justice to the aggrieved shareholders and to promote fairness in the conduct of a company’s affairs.

A minority shareholder can raise an individual action to challenge the fraudulent actions of the majority. Permitted because such actions can never be ratified. Cook v Deeks [1916]. In this case, the directors diverted business of the company to themselves, and attempted to ratify their dealings by voting their shares at a general meeting in their own favour. The Privy Council held that ratification was not possible because the directors were using their votes to expropriate the minority shareholders.

The new statutory provision broadens the grounds for bringing a derivative claim by including cause of action in respect of ‘an actual or proposed act or omission involving negligence, default, breach of duty or breach of trust by a director of the company’. It is now no longer necessary for the claimant to show that the act alleged is a fraud on the minority, so that a claim could be brought against pure negligence without demonstrating the defendant director has gained personally. Likewise, the requirement of proving ‘wrongdoer in control’ ceases to be a decisive factor for the court to consider. This makes it possible for a derivative claim to be brought in a public company where shares are widely dispersed.

S 263(3) and (4) further set out factors which the court must take into account when exercising its discretion to grant permission to continue a derivation claim, namely:

The new procedure’s failure to address the issues of cost of an individual shareholder using derivative claims. A derivative claim is brought by individual shareholder in the interest of the company. However, the cost and expenses of the action is borne by the individual shareholder unless the court issues a Wallersteiner order. Since most of the potential claimants are minority shareholders with difficulty to finance the action, are they willing to take the risk that they may not be indemnified by the company? Another issue is if the derivative claim is supported by the court, the remedy is not awarded to the individual shareholder. It is the company and all the members of it that benefit from the positive result. Hence, it is difficult to see what incentives there are for individual shareholders to bear a private cost for other shareholders. Disappointedly, CA 2006 does not make any specific provisions addressing these issues.

The new procedure’ also fails to achieve greater clarity and less complication. In order to obtain court’s permission to pursue the claim, a two-step threshold is placed in front of the claimant. To potential claimant, it implies lengthy hearings at the early stage, not to mention the difficulty to meet all the criteria listed under s.263 (2) and (3).

Last but not least, is the problem of information accessibility. Minority shareholders’ limited access to corporate information makes it difficult to provide adequate evidence to support the alleged breach of duty by directors. The new procedure does not attach much importance to the issue; however, it does contain related provision under s 261(3), which sets out that the court may require the evidence be provided by the company if the applicant succeeds to establish a prima facie case for the grant of permission. Whether the powers granted to the court will be enough to tackle the problem remains unknown.

It is important to note that a defaulting director can be disqualified under the Companies Directors Disqualification Act 1986.

To sum up, the lack of incentives provided by the new legislation together with the court’s traditional reluctance to intervene suggest that an abuse of derivative claims is unlikely. Instead, the new procedure’s balance favouring management might be a sign that the amount of derivative claim cases will remain low. Individual shareholders seeking corporate relief will hardly regard the new derivate claim as an ideal tool when the procedure works in favour of the directors instead of minority shareholders.