Derivative Claims by Members of a Company

“Although a reasonable body of case law under Part 11 of the Companies Act 2006 is building up, there do not appear to be any grounds for believing that derivative claims by members of a company will be any more successful than before the Act was implemented.”

Discuss.

Introduction

When a wrong is done to the company, which exists as a separate legal person the company can claim a remedy. The problem remains with the issue of preventing the action to remedy the harm when the people controlling the company are causing the harm. Although the members are allowed to make a derivative claim on behalf of the company, the reluctance of the court to interfere with the internal management of a company (internal management principle) makes these issues difficult to address. In this answer, derivative claims by members of a company will be examined from the perspective of recent case laws and some tightly defined circumstances in Part 11 of the Company Act 2006.

Majority Rule

The principle of the majority rule is a general and sensible rule, which is a fact of business life. A company is bound by the decisions of the majority that applies to decisions in pursuing business activities. Therefore, the practice of proper majority rule sometimes specifically leads to a special maladministration purpose i.e. not to pursue corporate wrongdoers specially directors. The fact that the members of a company controlling more than half of votes at a meeting do not owe any duty infers that they have quite substantial power and can vote for their own advantage. [1] Even the well-recognized restrictions based on bona fide and proper purpose principles goes unrestrained allowing majority rule to operate lawfully. For instance, even the fiduciary duties of directors does not prohibit them acting in their own selfish interest. [2]

Statutory protection like need for a special resolution instead of simple majority vote, court’s sanction in some of the matter like reduction of capital, attempts in striking a balance in the conflicting interests of minorities and controllers. On the other hand, to prevent the abuse of power members can also bring petition for compulsory winding up and unfairly prejudicial conduct in order to exercise other statutory provisions that are provided. [3]

Foss v Harbottle [4] – Rule

Subjected to limited exceptions companies rely on the majority rule principle to settle the dispute internally by general meetings (internal management principle). Lord Cottenham LC in Mozley v Alston, abstaining himself from expressing an opinion deduced that even the courts are reluctant to interfere in internal affairs of corporations. [5] Hence, the proper claimant remains the company in an action for a wrong and not the shareholders individually (proper claimant principle). Moreover, the rule also states that minorities are not allowed to bring legal actions about a wrong done in the company except if the action falls within the exceptions to the rule. To prevent multiple actions the rule also acknowledges existence of a company as a separate legal personality.

In Pender v Lushington, [6] apart from claiming in the company’s name Jessel MR pointed out an additional ground of individual right i.e. action by Pender for himself may be maintained in his right to sue. Moreover, he referred to it as a question with no technical difficulty, which had nothing to do with Foss v Harbottle’s line of cases in maintaining such an action.

In MacDougall v Gardiner, [7] Mellish LJ, pointed out a situation in which an action for minority’s right could be initiated before the court that is to say if they are deprived by the majority’s abuse of power (e.g. Fraud), whereas situations where majority are entitled to do something, only the company have a right to set it aside. Hence, the court following the principle laid down in Foss v Harbottle and Mozley v Alston stated that in compelling the directors for a general meeting the court lacked jurisdiction.

Therefore, without being affected by the irregularity principle in Foss v Harbottle, the difficulty remains with the issue of deciding whether a personal right exists for a member. As Macdougall v Gardiner and Pender v Lushington, shows instances of being inconsistent with each other.

The common law exceptions to the rule includes situations where –

Controllers abuse their power and commit a fraud either on the minority or the company.

Acts done are ultra vires or illegal.

Matters requiring special majority are disregarded.

Maladministration harm done on personal rights of member.

Hence, where a breach of director’s duty or bad faith is inferred members are permitted to a cause of action vested in the company in obtaining a remedy for the company in a derivative claim and therefore the rights derived from the company are not personal rights of the litigating member.

In Smith v Croft (No 2), [8] it was held that the company is entitled to relief since the plaintiffs had made out a prima facie illegal and ultra vires case in a derivative claim. However, it was also pointed out that they had no right to sue if a majority of the independent shareholder i.e. independent of the defendants did not want the claim to continue. As a result, particular regard must be given to the views of independent member of a company in such claims.

Litigations are admitted when they fall under the exception to the rule i.e. where controllers in their abuse of powers commit a fraud on the minority or the company etc. The procedural rule that is maintained by Foss v Harbottle acts as a barrier for minority members in their quest for justice in remedying for the grievance. Although the Companies Act 2006 reforms the rule it is still subjected to various criticisms.

Company Act 2006 – on the rule

The Company Act (CA) 2006 introduced some changes to the rules on the minority members’ remedies and actions in pursuing company claims after the Law Commission and the Company Law Review suggested and recommended a new statutory derivative procedure with modern, accessible and flexible criteria while studying the issues. [9] Consequently, reforms were brought for a statutory derivative action in replacing the common law exceptions to the rule in Foss v Harbottle by few statutory conditions without affecting the underlining principle of the rule. However, many of the prerequisites that were imposed by common law still have a link with the conditions imposed by the reforms introduced by CA 2006.

Director’s duty – under Section 172

Director’s duty under s. 172 precisely defines his legal obligation to promote the success of the company for the benefit of its members. [10] Hence, interpreting the company’s objectives in making decisions and to act in good faith to promote success that is calculated for long-term benefit remains with the directors. [11]

Section 172 in relation with Section 170 expresses that duties imposed also regards (without owing a direct duty) the interest of employees, suppliers, customers, community i.e. persons other than the company. Section 172 assumes the ‘enlightened shareholder value’ principle of the Law Commissions and Company Law Review (CLR). [12] Directors acting in accordance with Section 172 must have regard to the consequence of his decisions in the long term, the need to promote company’s business relationships, company’s reputation for business conduct, impact on the community and environment. [13] Therefore, director is likely to be in breach of these duties if it is found that the basis of his actions could not reasonably promote the success of the company. [14] In Fassihi, the issue that the breach of director’s duty is extended to his duty to disclose the breach to the company under the equitable duty to act bona fide in the interest of company was also put forward for consideration.

Derivative Claims

Section 260(1) of the CA 2006 explains the meaning of the term ‘derivative claim’ as an action brought by a member of a company in a court deriving the right of action from the company in seeking relief or to enforce a right of the company. Derivative claims acts as an exception to the proper claimant principle i.e. when a wrong is done to a company only the company may sue for a remedy. In addition when it is not possible to bring the claim in the companies own name the name of the member of a company is taken in a derivative claim for a remedy that will accrue to the company.

To begin with a derivative claim only a cause of action that emerge from director’s [15] actual or proposed act or omission involving negligence, default, breach of duty or trust are recognized. [16] As a proceeding in derivative claim recognizes breach of directors’ duty it is inferred remedies that are available in such a claim would be the same as those, which might be claimed in proceedings brought by the company. [17]

Courts – permission and discretion

Permission: –

The CA 2006 puts an obligation on members attempting to bring a derivative claim i.e. must apply to the court for permission. An application for permission to continue the claim stands dismissed if it appears from the evidences that a prima facie case is not established. If not, the court may adjourn proceedings to enable the company in obtaining evidence and then allow or dismiss the application accordingly. [18] The Act also acknowledges existence of certain circumstances where an action initiated by the company or a derivative claim brought by another member that a member can take over, by way of a derivative claim. [19]

Mandatory determining Factors: –

Matters that are completely barred for which the court must refuse permission are set out in Section 263(2). Therefore, if any of the circumstances like – person acting in a manner conforming to Section 172 i.e. duty to promote success of the company would not ask for continuing the claim; or if an act of wrongdoing has been authorized or subsequently ratified by the company is satisfied then the permission to pursuit a derivative claim is refused. [20]

Section 263(2) reflects and follows the fundamental nature of derivative claim as they permit a derivative claim for the benefit of the company and not for the benefit of individual member. Moreover, personal claims that may establish the possibility of personal benefit are addressed under the statutory provisions on unfair prejudice. [21]

Discretionary Factors: –

When the permission to continue derivative claim is not refused in accordance with Section 263(2), the court exercising its discretion then decides whether to grant permission for such an action. The guidelines for courts in doing so are set out in Section 263(3), which regards certain circumstances that must be taken into account.

Hence, in constituting discretionary factors for the court, the non-exclusive list of matters includes whether the [22] –

Member is acting in good faith

Person acting under Section 172 (i.e. promoting success) would attach to claim

Act of wrongdoing is authorized or ratified by the company

Company has decided not to pursue such claims

Cause of action is in the members’ own right or direct or indirect personal interest

In Franbar Holdings v Patel, [23] certain extent to which director acting in a manner conforming to Section 172 were interpreted. At the same time, some judicial guidance were given by the court on matters such as – likelihood of success of the claim, company’s ability to recover from an award of damage, disruption caused by proceedings on development of company’s business, costs of proceedings, damage to company’s reputation – while assessing the importance of a derivative claim.

In Iesini and others v Westrip Holdings, [24] claimants asserted that defendants in breach of their duty deprived the company of its assets. Court considered the derivative procedure laid down under Section 260, 263 in conveying that the case was one for the application of Section 263(3)(b), as it was inferred that some directors would not seek to continue the claim. Moreover, it was found that the board took advise on technical matters from eminent counsels before acting. Hence, the permission to continue the claim was refused.

In Kiani v Cooper, [25] claimant’s assertion on the first defendant that – in claiming personally as a creditor of the company, insisting on winding up the company, paying another company from company’s bank account, he acted in breach of his duties involving negligence, default and breach of trust. Hence, made out a strong case for breach of fiduciary duty by the defendant. While giving the permission to continue derivative action in company’s name in accordance with the procedure followed for a derivative claim under the CA 2006, it was found that the claimant acted in good faith (Section 263(3)(a)), and having regard to all the factors it was inferred that a director would wish to continue the claim down to disclosure stage.

In Stainer v Lee, [26] court pointed out some factors, which would influence directors’ action in a manner conforming to Section 172 i.e. size and strength of the claim; cost, disruption and impact of the proceedings on the company; funding abilities of the company etc. The circumstances of the case suggested that availability of unfair prejudice proceedings could not be a valid reason to refuse permission. Moreover, having regard to the director acting in accordance with section 172 (under Section 263(3)(b)), permission to continue the claim could be given (subjected to some control) even if the likely level of recovery is not so large, as it may qualify for summary judgment or it may be in the company’s potential interest i.e. when the amount of potential recovery is large. The case is an example towards a progress and for believing that derivative claims may be more effective after the CA 2006 was implemented.

The common areas of interest in personal and corporate claims caused by breach of duty where justice to defendant requires exclusion of one or the other claim also remains the key issues in a derivative claim. [27]

Conclusion

The English common law rule referred to as the rule in Foss v Harbottle, allowed derivative claims on limited basis with restrictions on it for being initiated to promote personal objectives, whereas the case laws under CA 2006 suggests that the rule is taken in a new direction in which the court has been allocated the litigation decision with some guidance (s. 263, CA 2006) on whether the permission to a member to continue a derivative claim is to be given or refused. Moreover, the Company Act 2006 makes it clear that now a derivative claim can only be brought under the statute.

Whether the company requires a litigation claiming breach of directors’ duty that are in its interest has to be distinguished from the ones which are not in the company’s interest. However, it is difficult to show the existence of such derivative proceedings in the interest of company as it may be linked to some personal interest of a member. In spite of the fact that the case laws under the CA 2006 also brought reforms in a derivative claim by members of a company, nevertheless a case in which proceedings for derivative claim may or may not be allowed requires a close analysis of a particular case itself. Hence, derivative claims based upon its strict application, interpretation of the laws and rules remains one of the most technical matters in the company law.