Path to a Successful Derivative Action

THE path to a successful derivative action for a minority shareholder is often a difficult one. In addition to demonstrating that one of the exceptions to the rule in Foss v. Harbottle applies, the courts have tended to add a number of additional requirements. One of these is the fact that the plaintiff must have “ clean hands” i.e. that the shareholder will not be allowed to take advantage of an exception to the rule in Foss v. Harbottle if there is evidence of “ … behaviour by the minority shareholder, which, in the eyes of equity, would render it unjust to allow a claim brought by the company at his instance to succeed” . This requirement needs further thought.

The equitable doctrine of clean hands is well established. Although the precise ambit of this equitable principle has been questioned, its continued existence is not doubted. It has been said that “ [t]here must be some element of dishonesty or sharp practice in the matter relied upon for saying that he does not come with clean hands” and examples of cases falling within this maxim involve individuals not being allowed to assert title to property where they have dealt with the property solely in order to defeat creditors or to evade taxes because they “ could not be allowed to take advantage of [their] own dishonesty”. The purpose of this maxim is to prevent individuals profiting personally from their own misbehaviour. This makes sense in a bipartite relationship, such as that between trustee and beneficiary, where the individual is enforcing personal rights. In the context of company law this principle has obvious resonance where a member is suing to enforce a personal claim, another bipartite relationship, this time between the shareholder and wrongdoer. If there is an element of sharp practice or dishonesty in the shareholder’s action then that personal claim may be denied.

However the concept of clean hands, as with all equitable maxims, should not be “ applied blindly and without reference to the facts of a given case”. This reminder is particularly apt where the facts involve not a personal claim by a member but a derivative action brought by a member on behalf of the company. At this point it is less easy to see why the maxim should apply since the principles of separate legal personality, majority rule and the idea of a shareholder’s vote as a piece of property combine to destroy the clean bipartite lines of the trust situation. If the wrongdoer’s duty is owed to the company and the right to enforce that claim belongs to the company and not the minority shareholders, why should any conduct by a minority shareholder destroy the company’s right of action?

There are two cases which are commonly cited in support of the proposition that the clean hands of the minority shareholder should be relevant in a derivative action: Towers v. African Tug Co. and Nurcombe v. Nurcombe.  Towers involved payments by directors of a company to the shareholders out of capital that, although honest, were nevertheless illegal. Three years after these payments were made two of the shareholders brought an action on behalf of the company seeking the repayment of these sums by the directors. However, it was clear that both shareholders were well aware of the illegal nature of the dividend payments which they had themselves received and which remained “ in their pockets” at the time of the trial. The Court of Appeal unanimously held that in such circumstances the plaintiffs’ action could not succeed:

I think that an action cannot be brought by an individual shareholder complaining of an act which is ultra vires if he himself has in his pocket at the time he brings the action some of the proceeds of that very ultra vires act. Nor, in my opinion, does it alter matters that he represents himself as suing on behalf of himself and others.

In Nurcombe a husband and wife were the only two shareholders in a company. In their divorce proceedings it came to light that the husband had breached his duty as a director of the company in diverting a lucrative contract from the company into another company in which he held a controlling interest. The wife continued with the matrimonial proceedings when this issue came to light and the improper payment was taken into account in the lump sum awarded to the wife in the matrimonial proceedings. Subsequently the wife brought an action as minority shareholder on the company’s behalf against her now ex-husband in relation to this breach of duty. Applying Towers , the Court of Appeal refused the derivative action:

In my judgment, [Towers ] establishes that behaviour by the minority shareholder, which, in the eyes of equity, would render it unjust to allow a claim brought by the company at his instance to succeed, provides a defence to a minority shareholder’s action. In practice, this means that equitable defences which would have been open to defendants in an action brought by the minority shareholder personally (if the cause of action had been vested in him) would also provide a defence to those defendants in a minority shareholder’s action brought by him.

In their Lordships’ view, the behaviour of the plaintiff in this case, in accepting the lump sum payment and nevertheless going on to bring the derivative action, was sufficient to render it inequitable to allow that claim to proceed.

However, the decision in Towers needs to be treated with care. It is important to remember that at the time that case was decided there was some confusion concerning the distinction between actions by shareholders on behalf of themselves (and maybe other shareholders) for wrongs done to them personally and actions by shareholders on behalf of the company for wrongs done to the company. The term “ representative action” was regularly used to describe both forms. In Towers , despite the fact that the Court of Appeal viewed the action as one on behalf of the company rather than the individual plaintiffs, they clearly did not regard the action by the plaintiffs as being identical in substance to a claim by the company itself. Rather, the claim by the shareholders on behalf of the company in Towers is regarded as an aggregation of the personal claims of the shareholders: “ a shareholder, having money in his pocket which he knows is wrongfully there, ought not to be allowed to complain; and he cannot get any greater right of complaint because his action is, in form, an action by himself and all other the [sic] shareholders in the company”.

Only with the Court of Appeal’s decision in Wallersteiner v. Moir (No. 2) was the term “ derivative action” adopted to describe actions brought by minority shareholders on the company’s behalf. More importantly, this change in terminology also helped to clarify the fact that in these circumstances the individual shareholder is not enforcing a right which belongs to them but which is, rather, vested in and therefore derived from the company. Post-Wallersteiner it should be clear that the derivative action is merely an equitable procedural device to enable the court to do justice to the company. In Nurcombe it was suggested that the situation in which the shareholder brings a derivative action on behalf of the company is analogous to that “ in which equity permits a beneficiary under a trust to sue as plaintiff to enforce a legal right vested in trustees (which right the trustees will not themselves enforce), the trustees being joined as defendants”. However, this is in substance a claim which belongs to the beneficiary, albeit that the form of the claim has changed. Post- Wallersteiner it is clear that the shareholder’s derivative action is a claim which in substance does not belong to the shareholder but to the company. The two situations are not analogous and to regard them as such is dangerous as it leads to the mistaken belief that equitable defences which exist between the shareholder personally and the wrongdoers can properly be relied on by the wrongdoers in a claim brought against them by the company, albeit that that claim is brought derivatively and not directly.

It is unlikely that much clarity will be introduced into this area if the proposals for the reform of derivative actions put forward by the Law Commission and broadly endorsed by the Company Law Review Steering Group are ever implemented. No mention is made of the requirement of clean hands as such in the Law Commission’s Report, however this concept seems likely to be retained in relation to the suggested statutory derivative action. There are two ways in which this could occur. First, via the general recommendation that the courts take account of “ all relevant circumstances without limit” when determining whether to allow the derivative action to proceed and, second, via the specific recommendation that the courts take account of the good faith of the applicant. No definition of good faith is provided as it is suggested, somewhat optimistically, that this concept is “ generally readily recognisable” . Much will depend on the interpretation of the courts. It is probable, however, that this concept will be interpreted as including bad faith which exists between the shareholder personally and the wrongdoer. The mistaken application of the clean hands doctrine in the context of derivative actions therefore seems likely to continue if the Law Commission’s proposals are introduced.

The view put forward in Towers is difficult to accept in a post-Wallersteiner world where the distinction between personal actions and derivative actions is well understood. On closer inspection both Towers and Nurcombe actually involve two different, and distinct, issues which were not sufficiently unravelled in those cases: (1) should the company be allowed a claim against the wrongdoer(s)? and (2) should the shareholder(s) be allowed to profit from their own wrongdoing?

The Company’s Claim Against The Wrongdoer(S)

Post-Wallersteiner it is clear that the claim against the wrongdoer(s) belongs to the company and that the derivative claim should be treated first and foremost as though it were equivalent to a claim by the company itself. As a result, the misbehaviour of the minority shareholders ought to be irrelevant. In cases involving actions actually brought by the company itself or by the liquidator of the company, whom the courts have never had any difficulty regarding as stepping directly into the company’s shoes, the courts ignore the misbehaviour of a minority shareholder when determining whether to allow a derivative action to go ahead. The same result should occur where the action is brought derivatively, since although the form of the claim has changed the substance has not. As a general rule the cleanliness of the hands of the shareholders should be irrelevant in the courts’ assessment of whether the derivative action should go forward since the issue for the court is doing justice to the company, and not to the shareholder, through the derivative action device.

However, there is a gloss to add to this otherwise straightforward proposition. In addition to asking whether the company has a right of action, the court may ask whether it should permit this shareholder to bring an action on behalf of the company. Take, for example, the situation in which A buys shares in a company, B Ltd. A is also the majority shareholder in C Ltd., which is a competitor of B Ltd. A brings a derivative action on behalf of B Ltd. against its directors. There are adequate grounds for this action on the basis of the directors’ behaviour, but A’s purpose is not to protect the company but to tie up management time and to provide a substantial distraction to B Ltd.’s business in the hope of providing an advantage to C Ltd. Should the court allow A to bring this derivative action?

The problem is not A’s improper motive per se, which should not be a basis for denying what is otherwise a valid derivative action. Rather, in attempting to obtain a collateral benefit for him or herself alone A is abusing the derivative action jurisdiction which exists to do justice to the company. In bringing the derivative action A is acting on behalf of the company, and in a solvent company this effectively means the other shareholders. If A has a unique interest in bringing the petition which is not shared by the other shareholders and if a majority of those shareholders are opposed to A’s action then it is right and proper that the derivative action brought by A should be denied. This principle was articulated in the context of derivative actions by Knox J. in Smith v. Croft (No. 2) who was clear that shareholders do not have an indefeasible right to bring an action on the company’s behalf and that it is proper for the court to have regard to the independent shareholders in determining whether to allow the derivative action to proceed. Therefore, the court could allow the independent shareholders in B Ltd. to determine whether it is in the interests of the company to let the derivative action brought by A to proceed.

However, in certain circumstances, such as in very small companies, there may be no independent group of shareholders who can take this decision. In such circumstances the court is left with no assistance in determining whether A should be prevented from bringing this action on behalf of the company. If A is acting in his or her own self-interest and not in the best interests of the company then it may well be legitimate to deny the action on the ground that A is attempting to abuse the derivative action jurisdiction. An example of this situation is Barrett v. Duckett in which a derivative action brought by a shareholder against a director for diverting company money into bank accounts held by him for himself and his wife jointly was muddied by the fact that the plaintiff’s daughter was engaged in a bitter matrimonial dispute with the defendant. There was no independent group of shareholders available in this very small company, since the only shareholders were the plaintiff shareholder and the defendant director. Although the Court of Appeal used the rather more emotive, and less appropriate, language of motive when denying the derivative action brought by the plaintiff, the thrust of the court’s decision seems to be an aversion to allowing the plaintiff to misuse the derivative action process since the claim was not being pursued “ bona fide on behalf of the company”.

It is possible, then, for the court to accept that the company may have a valid claim, but to deny the right to this shareholder to pursue that claim on behalf of the company because of some aspect of that shareholder’s position. This principle does not involve a transfer of any equitable defences available between the plaintiff and the wrongdoer to the action between the company and wrongdoer. It does not fall within the clean hands doctrine. Rather, the court is here concentrating on its stated aim of using the derivative action to do justice to the company when determining that in particular circumstances it would be an abuse of that jurisdiction to allow an action brought by a particular shareholder to proceed.

Should The Shareholders Be Allowed To Benefit From Their Own Wrongdoing?

In Towers the court was concerned that the shareholders bringing the derivative action had received, and indeed retained, illegal dividends in full knowledge of their illegality. Likewise, in Nurcombe, the court felt that: “ In this action [the plaintiff] is in effect saying: although I have shared with the first defendant his ill-gotten gains, I want the court to order that he should pay over to [the company] his share of them plus my share so that I can have a chance of getting some more because of my status as a shareholder.” In both cases the court was concerned to see that these shareholders did not profit personally from their misbehaviour. This is a different issue from that of whether the company should have a claim.

The courts have traditionally adopted a conduct-based approach to the question of whether the shareholders should be affected personally, punishing only wrongdoing shareholders. In the context of illegal dividend payments, for example, trust concepts have been utilised so that shareholders with actual or constructive knowledge of the illegality of the payment can be ordered to indemnify the directors to the extent of the amounts they have received, but innocent recipients are exempt. This conduct-based approach has also been enshrined in statute. A good example of this approach is Moxham v. Grant, reported four years before Towers. In that case the directors of the company made illegal distributions to the shareholders, to which the shareholders unanimously agreed. When the company was subsequently wound up the liquidator brought an action whereby the directors were ordered to compensate a company for the whole of an illegal dividend paid while they were directors. In addition it was held that the directors could recover from each member who knew or ought to have known of the circumstances which made the dividend illegal the amount of dividend paid to that shareholder. If the confusion over the nature of the derivative claim in Towers is removed, and it is properly regarded as a claim belonging to the company, as the claim was in Moxham, then the two strands which *CLJUK 85 should have been unravelled in Towers, but were not, become clear. The unclean hands of the shareholders should have personal consequences for them (they should repay the dividends which they knew to have been paid illegally), but should not have consequences for the company.

However, the neatness of this proposition hides the fact that in some circumstances, namely where the company is very small, as in Nurcombe, imposing personal consequences on the plaintiff shareholder will inevitably impact upon the company itself. This may arise if, in a very small company, the minority shareholder effectively promises the wrongdoer that he or she will not bring a claim against that wrongdoer. The minority shareholder may then be estopped from bringing a claim, and if no-one else exists to bring a claim on the company’s behalf at that time then no derivative action will be possible. Although this is a relationship between plaintiff and wrongdoer, since this is a right which the wrongdoer can enforce personally against the shareholder, the practical effect of such an estoppel in very small companies will be to deny an action for the company. In the view of the court in Nurcombe the wife had a choice of either bringing the derivative action or continuing with her application for financial provision in the divorce proceedings. In choosing the latter course, a decision on which, in the view of the court, the husband relied in paying the lump sum, “ she was as effectively barred from commencing the [derivative] action as she would have been if she had entered into a binding obligation not to sue”. This does not involve an application of the clean hands doctrine, but is merely a practical consequence of dealing with a situation in which the size of the company dictates that the acts or views of the minority shareholder affect the company because no one else is left to bring an action on the company’s behalf at that time.

Conclusion

Equitable defences, such as clean hands, which exist between a minority shareholder personally and a wrongdoer should not be available to a wrongdoer in an action brought against that wrongdoer by the company, whether that claim is brought directly or via the procedure of a derivative action. It is notable that the courts have already recognised that in an action under section 459 Companies Act 1985, which has been recognised as enabling the court to outflank the rule in Foss v. Harbottle in some circumstances, the cleanliness or otherwise of the plaintiff’s hands is irrelevant in deciding whether to allow the action to proceed. While minority shareholders’ misbehaviour might well have consequences for themselves, such as requiring the repayment of dividends known to have been paid unlawfully, those actions ought, in the normal course of events, to be irrelevant for the purpose of deciding whether to allow a derivative action to proceed. To the extent that circumstances have been suggested here in which a minority shareholder’s situation or actions may affect the decision to allow a derivative action brought by that particular shareholder to proceed, these do not spring from the clean hands doctrine, but rather from the particular factual circumstances of the case or from an entirely proper desire on the court’s part to use the derivative action only where it is necessary to achieve justice for the company.

Travers Smith Braithwaite lecturer in Corporate Finance Law, Merton College, Oxford. I am grateful to Dan Prentice and Roger Smith for their comments on an earlier draft. Any errors remain entirely my own.