Development of Statutory Derivative Actions

“The statutory derivative action, which replaced the common law action from October 1, 2007, has been amongst the most publicised and debated reforms introduced by the Companies Act 2006 (‘the Act‘). The aim behind this innovation, which is largely based upon the recommendations of the Law Commission, is the simplification and modernisation of the law in order to improve its accessibility. To achieve this, the arcane rule in Foss v Harbottle, and the concepts of ‘fraud on the minority’ and ‘wrongdoer control‘, have been discarded and replaced by a judicial discretion to grant permission, which is to be exercised by reference to statutory criteria set out in sections 261-263 of the Act. These reforms have been controversial, with practitioners voicing fears that they will lead to increased litigation against directors by activist shareholders. This is because, in a change to the existing law, shareholders can now bring a derivative action against directors for negligence from which they do not benefit, as well as for other breaches of duty. Lawyers are concerned that, when married with the new duty imposed on directors under section 172 of the Act, which requires directors to promote the success of the company, this will result in shareholders bringing derivative actions alleging that directors have negligently failed to have regard to one of the factors in section 172, or placed undue weight on others.”

Keay & Loughrey, ‘Something old, something new, something borrowed: an analysis of the new derivative action under the Companies Act 2006’ (2008) Law Quarterly Review 469.

Critically evaluate this statement by reference to appropriate academic opinion and case law.

In seeking to critically evaluate the above statement in relation to the development of statutory derivative actions it is necessary to look to consider the reforms that have been put in place by the Companies Act 2006 under sections 261-263. With this in mind, it is important to look to put this essay’s discussion into its given context by first considering as to how the law in this regard previously stood under the common law leading to its development and modernisation with a view to providing shareholders with greater protection. Moreover, there is also a need to look to evaluate the concerns that have arisen in this area with regard to the relationship between taking statutory derivative action and directors duties under section 172 of the CA 2006 through reference to appropriate academic opinion and case law. Finally, this essay will look to conclude with a summary of the key points derived from this discussion with regard to the development of statutory derivative actions under the CA 2006 along with the concerns that have arisen in this regard.

A derivative action ostensibly involves a claim made by shareholders in relation to regarding a cause of action vested in a given company where the given shareholder looks to attain relief on the other shareholders behalf within the particular company regardless of its size. However, there is a need to appreciate that the law that has since developed in this area is now included within the CA 2006 at Part 11 of the CA 2006. But, with a view to putting the discussion undertaken as part of this essay into its given context, there is a need to first briefly consider the common law understanding of what a derivative action consists of through consideration of (a) fraud on the minority and (b) wrongdoers control. For example, in Burland v. Earle [1] the court determined that if a company had a right of action against a director they may be able to use their stance to stop the particular company taking action so the court would then permit a shareholder to instigate a derivative action.

The derivative action should, however, also be recognised as being based upon procedure to then remedy a wrong that otherwise would not have been effectively redressed. In addition, the plaintiffs cannot have a larger right to relief than the particular company would have as a plaintiff representing its own interests and cannot make a complaint in relation to a particular activities validity in the event that the majority shareholders approve to the minority’s detriment. On this basis, the cases where minority shareholders maintain an action were limited to those where the activities that were complained of in the circumstances were either looked upon as being fraudulent or beyond a given company’s powers. This has effectively served to mean that any damages or property received in view of the process having been instigated will then be taken by the specific company – although the shareholder that brought the action in the circumstances will almost always be required to make payment of the costs involved in the particular case. However, it is to be noted that the court determined in the case of Wallersteiner v. Moir (No. 2) [2] a company’s minority shareholders could be indemnified in relation to their costs accrued from their particular company so long as it is shown that they had looked to act upon what could be considered to be reasonable grounds and in ‘good faith’ on the basis of the facts as they stand.

Part 11 of the CA 2006 looked to introduce what could perhaps best be labelled as being a new statutory derivative action under section 260 to then provide for a more effective process to then permit a particular company’s shareholders to look to act on their company’s behalf in relation to the duties of directors of companies having been breached. [3] More specifically, the CA 2006 recognised at section 260(1) it is only possible for a claim for a derivative action to be instigated with regard to a cause of action arising in a case from out of an act or omission pertaining to negligence, default, breach of duty or trust. [4] At the same time, however, there is a need to show an understanding of the fact that it is actually immaterial if the cause of action in a given case was to have arisen either before or after the individual that sought to bring or continue the derivative claim became a shareholder within a particular company – even in the event that the shareholder in a particular case was found to be in the minority. On this basis, the CA 2006 at section 263(3)(f) has also served to provides in the event that a cause of action is brought for purpose in the ulterior, the courts would then not permit a derivative action to be followed through with in the event that the particular company may be placed into liquidation, whilst the cause of action was looked upon as having been undertaken by the shareholder in the minority for reasons of a personal nature in seeking to provide for redress. [5] Nevertheless, there is still a need to appreciate that the shareholder of a company would be permitted to make a claim on behalf of their company if they look to bring what is best labelled as being a bona fide action for the benefit of a given company in the event that there are not any other remedies available to be used. [6]

Under the CA 2006 at section 263(4) there is also a need to understand that the court in the case of Smith v. Croft (No 3) [7] had recognised previously – in looking to establish if the decision of the court in Foss v. Harbottle [8] is applicable to stop a shareholder in the minority looking to then claim redress on their given company’s behalf – what is of fundamental concern in this regard is if the particular claimant in a given case has been stopped improperly from undertaking proceedings. Conversely, however, it was found by the court in Prudential Assurance Co v. Newman Industries [9] that a company shareholder can claim damages simply in view of the fact that their particular company was damaged. It is also to be appreciated that company shareholders are not able to reclaim sums equivalent to the market value of shares reduction or reductions in the dividends reduction as a reflection of the losses accrued by a given company – although it may have directly brought about shareholders parting with their shares at an undervalue so that a personal action may potentially arise. [10] Nonetheless, there is a need to understand that the decision of the court in Foss v. Harbottle [11] was illustrative of the fact that the judiciary were becoming increasingly flexible and creative with regard to conduct including – (a) providing for the exclusion of company directors from a given company’s management without there having been an offer that is made to purchase the shares of a petitioner fairly; [12] (b) business being diverted; [13] (c) directors awarding themselves benefits excessively; [14] (d) directors breaching their Articles of Association; [15] and (e) their relationship being destroyed. [16]

With this in mind, as has already been recognised at the start of this discussion, the statutory derivative action that has been implemented via the CA 2006 was supposed to replace the common law derivative action that had, due to both its complexity and cost, along with the favoured use of minority shareholders remedies under the Companies Act (CA) 1985 at section 459 that had gone into disuse. [17] This has effectively served to me that the statutory derivative action’s recognition under the CA 2006 serves to allow any given shareholder of a specific company to instigate action on behalf of their company against any of its company directors in relation to their having been negligent or breached their duty or trust. Therefore, this means that the company shareholders that are considered to be involved with any specific company are then theoretically considered to have the power directly to prevent company directors from breaching their duties. But, although such provisions of the CA 2006 have been in place as of October 2007, there have been hardly any reported cases to evaluate which is somewhat surprising since many academics believed shareholders would seek to utilise the CA 2006 at section 260 to instigate litigation tactically against directors because their duties were now significantly broader under the CA 2006 since they codified the fiduciary duties of directors along with their duty of ‘good faith’ under sections 168-172. [18]

That this has proved to be the case is marked by one of the few examples to have arisen before the courts for the judiciary to establish precedent in the form of the decision that was reached by the court in Franbar Holdings Ltd v. Patel & Others. [19] Before looking specifically at this case, however, there is a need to show an appreciation of the fact that the CA 2006 at Part 11 has a two stage process for instigating a statutory derivative action since – (a) a company shareholder must first provide evidence of their having a prima facie case to be reviewed by the courts without hearing evidence from the defendant and then, in the event that there is a prima facie case, (b) it will be for the court to direct the company to provide evidence to determine if the action should be permitted. Such a process’ implementation under the CA 2006 is supposed to stop claims being brought frivolously so that it is for the courts to not permit a claim to be brought if, for example someone who acts to promote the success of the company would not allow a claim to continue or the activity or the omission was authorised or ratified by a specific company. [20] The courts must also determine – (a) if a shareholder acts in ‘good faith’; (b) the importance attached to the claim; (c) if the act or omission will be authorised or ratified by their given company on the facts; (d) if the given company is already not continuing a claim; (e) if either an activity or omission will lead to a shareholder pursuing their own cause of action against a director; and (vi) if there is any evidence regarding the views of other shareholders. [21]

On this basis, it was found by the court in Franbar Holdings Ltd v. Patel & Others [22] that permission for the action undertaken in this case would not be allowed on the basis of the the facts. This decision was undertaken based upon the available remedies for unfair prejudice already recognised under the CA 1985 of section 459 [23] with the claimant having already instigated proceedings. [24] As a result, it was found by the court that the statutory derivative action recognised under the CA 2006 at Part 11 was supposed to allow for shareholding of the claimant to be preserved. But although the court in this case found there was no part of the derivative claim that could not be provided for now under the CA 2006 at section 994 (in place of the CA 1985 at section 459), it was also found that, whilst prima facie breaches of company directors’ duties had been established, these were not sufficiently formulated to provide for a definitive route to recovery. [25] Therefore, the court considered the claim would have low importance for a company director looking to promote their company’s success so the claim for a statutory derivative action was not permitted.

This effectively means that the alternative remedies available for a company’s shareholders that are considered to be aggrieved is key for being able to ascertain if the court in the circumstances of given case would grant permission to maintain a statutory derivative action. [26] In the event that a specific company is managed by directors that have looked to act in the wrong and are also recognised as being significant shareholders within a given company, the CA 2006 at section 994 would be looked upon as what is considered to be most appropriate. Therefore, the new statutory derivative action under the Act at Part 11 would only be used for recognising the rights of shareholder in limited cases that want to apply ‘pressure’ to their directors to look to act. [27] Instead, shareholders need to take action against their company directors under section 994 of the CA 2006 so any legal action needs to be financed personally by a shareholder with the most commonly used remedy being a fair buyout of a shareholder’s holding.

It is to be appreciated that the shareholders of a given company is only able to provide for the ratification of a directors’ actions if this would not be looked upon as being a fraud on the minority under the CA 2006 at section 994 in relation to claims for unfair prejudice. But, even where shareholders disprove of their particular directors activities, a shareholder is only able to bring an action in the minority in the event that proof of control is found. Therefore, the procedure used could only be considered to apply in the even that it is possible determine independence – although this could prove more complicated regarding smaller incorporated companies activities. [28] On this basis, a given court could look to make “an order . . . for giving relief in respect of the matters complained of” with examples typically inclusive of – (a) being excluded from management on the understanding of participation without an offer to purchase the shares of the petitioner fairly; [29] (b) diversion of business to another company in the event that the shareholder in the majority is found to hold an interest; [30] and (c) the shareholder in the majority granting themselves benefits financially that are considered to be excessive. [31]

As for the potential for minority shareholders to claim unfair prejudice, it is possible that a court could possibly seek to offer remedies for either the party or parties that are afflicted in relation to the affairs of a given company since the decision of the court in Foss v. Harbottle [32] provided for the limitation of what exceptions there are for the courts. It was found by the court in this case that every given shareholder of a company is contractually bound to every other shareholder so as to then be bound by the majority shareholders decisions otherwise their companies would fail to function effectively – although it is to be appreciated this is considerably less problematic in the event that the companies under consideration themselves are smaller in view of the fact that those that are affected will look to just walk away. [33] This effectively means that the proper claimant is the company itself so the general rule favours an exclusion of an individual shareholder pursuing such an action. [34] However, there is also a need to show an understanding of the fact that it is considered to be an inexcusable truth that looking to provide for rule in the majority will sometimes prove to be more than a little unfair. Such a view is effectively illustrated by the court’s decision in Edwards v. Halliwell [35] where Lord Justice Jenkins found in this judgement that there are several exceptions to the understanding of majority rule – (a) ultra vires and illegal acts; (b) where special majorities are needed; (c) where personal rights are impacted upon; [36] and (d) in the event of there having been where there has been a fraud on the minority along with the party/parties against whom relief is sought holds and controls the majority leading to a derivative action.

The CA 2006 at section 994 now provides that a shareholder that requires redress will prefer to bring a petition for unfair prejudice instead of instigating a derivative action under the CA 2006 at Part 11. [37] There is also a need to effectively recognise the fact that a petition is now the only remedy available to a given company where the wrongdoer is (wrongdoers are) in control of the company’s affairs – although it still needs to be shown that the legal position could need to be clarified somewhat more. That this has proved to be the case is marked by the fact that directors of companies acting inappropriately in the circumstances of a given case may also be looked upon as being fraudulent trading [38] as either an offence in the civil [39] or criminal courts. [40] The CA 2006 at section 996 then goes on to provide for the listing of those orders that a court is able to make in the event that unfair prejudice is found to exist specifically under section 996(1) of the Act. Section 996(2) of the CA 2006 then also goes on to provide the courts are able to – (a) provide for the regulation of a given company’s affairs in future; (b) require a given company to either not undertake or continue an act that has been complained about or failing to act; (c) provide for the authorising of civil proceedings in a given company’s name and on their behalf where this is provided for by a court; (d) require a given company to only alter its Articles of Association with the leave of a court; and, finally, it is also necessary to look to (e) provide for the purchase of any shares by other shareholders or the company to reduce capital.

Nonetheless, there is a need to recognise that the remedy that is awarded usually involves looking to order a petitioner to have their shares purchased by those involved that looked to cause the recognised unfair prejudice – although these shares valuation in the company in the circumstances are able to bring about some problems of considerable significance – it is to be appreciated that this can be achieved in a variety of different ways. There is also a need to understand, however, that courts have generally found that the shares of companies should be valued in the event that it is found to be fair to the petitioner.. For example, it was found by the court in Irvine v. Irvine [41] where the petitioners in this case had held around 50% of the shares in a limited company the respondent was then ordered to buy out the shares at this time under the CA 1985 at section 459. The reason why this proved to the case on the facts involved with this decision is because of the fact that it had been held by Justice Blackburne that, in view of the fact the company here in the circumstances was not a quasi partnership and there was nothing exceptional about the case, there was no reason to accord a quality it lacked so the company’s shares would then be discounted as a reflection of the fact that it was representative of the shareholding of the minority in a smaller company.

To conclude, having sought to critically evaluate the above statement in relation to the development of statutory derivative actions it is necessary to look to consider the reforms that have been put in place by the CA 2006 under sections 261-263 and how this fits with the CA 2006 more generally. To this effect it has been found that the statutory derivative action that has been implemented via the CA 2006 was supposed to replace the common law derivative action that had, due to both its complexity and cost, along with the favoured use of minority shareholders remedies under the CA 1985 at section 459 that had gone into disuse. [42] Therefore, as has already been recognised, the CA 2006 at Part 11 has a two stage process for instigating a statutory derivative action since – (a) a company shareholder must first provide evidence of their having a prima facie case to be reviewed by the courts without hearing evidence from the defendant and then, in the event that there is a prima facie case, (b) it will be for the court to direct the company to provide evidence to determine if the action should be permitted. In addition, it has been found that such a process’ implementation is supposed to stop claims being brought frivolously so that it is for the courts to not permit a claim to be brought if, for example someone who acts to promote the success of the company would not allow a claim to continue or the activity or the omission was authorised or ratified by a specific company. [43] Finally, as part of the process under the CA 2006 at Part 11 it has already been found that the courts must also determine – (a) if a shareholder acts in ‘good faith’; (b) the importance attached to the claim; (c) if the act or omission will be authorised or ratified by their given company on the facts; (d) if the given company is already not continuing a claim; (e) if either an activity or omission will lead to a shareholder pursuing their own cause of action against a director; and (vi) if there is any evidence regarding the views of other shareholders. [44] As a result, it is clear that the law has moved on somewhat with a clear codified process to follow under the CA 2006 with a view to providing for greater certainty within the law for those coming to this area in search of a decision.