The Statutory Derivative Action & Unfair Prejudice Remedy

This chapter seeks to analyse the remedies available to a company in event of a breach of duty by directors. Thus the statutory derivative action and the unfair prejudice remedy will be examined as to how readily available these remedies are to act as a check on directors in the execution of their duty. It is important to note that as at the time the financial crisis started, it is the common law derivative action that was in place. As such, before considering the statutory derivative action, the common law derivative action will be briefly analysed as to whether it’s provision was sufficient to act as a check on directors or on the contrary part of the reason why directors where negligent in their duties. Furthermore, the extent to which director’s disqualification serves as a deterrent factor to encourage good performance of director’s duty will be considered.

The general rule is that a company is a legal personality and as such, only the company has the right to sue if there is a wrong perpetrated against the company. However this duty to sue is vested on the board of directors. In John Shaw & Sons (Salford) Ltd V Shaw, Greer LJ stated that: If powers of management are vested in the directors, they and they alone can exercise those powers.Thus, practical difficulties arise where the alleged wrong doers are themselves members of the board and are in a position to prevent action being taken by the company to obtain redress for their wrongdoing. However, if they are in breach of this duty, minority shareholders can bring an action on behalf of the company.

At common law a shareholder did not have the right to bring an action for a wrong against a company. This was established in Foss V. Habottle, where the court held that, a shareholder cannot bring an action on behalf of a company based on the principle of corporate personality and secondly if the wrong is one that can be ratified by the majority known as the majority rule. However, the rule in Foss has some exceptions established in the case of Edwards v Halliwel which are that a shareholder can sue where the act complained of is ultravires the company or illegal, where there has been a non-compliance with a special procedure, where the personal right of a member has been infringed, where there is fraud on the minority and the wrongdoers are in control.

Also, derivative action being an equitable remedy, the court in exercising its discretion would consider the conduct of the claimant, his motives in seeking to sue and the availability of other remedies. In Barrett v Duckett the court struck out the derivative action on grounds that the claimant was not motivated by the company’s interest and that other remedies were available.

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

The 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

Section 260 defines “derivative claim” as procedures brought by a member of a company in respect of a course of action vested in the company seeking relief on behalf of the company. Section 260(5) defines member of a company to include a person who is not a member but to whom shares in the company has been transferred or transmitted by operation of law. 260(3) stipulates the grounds under which derivative action can be brought thus; such action can be brought only in respect of a cause of action arising from an actual or proposed act or omission involving negligence, default, breach of duty or breach of trust by a director of the company. The Act requires that the general duties be interpreted in the same way as Common Law and equitable principles.Thus, the large body of case law under common law will continue to be highly relevant.

A derivative claim can be brought against a director or another person or both and the term director includes former directors and shadow directors.However, this does not include third parties like an auditor as the decision to sue a negligent auditor lies with the board. Nevertheless, a derivative claim may lie if the decision by the board not to sue the auditor is itself a breach of duty. Thus in the case of Lehman Brother the fact that auditors hide the true financial state of the bank will not suffice as an excuse for directors under the present statute.

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. Nambisan is of the view that this newly widened scope is justified on the basis that the new shareholder may either benefit or suffer

detriment from past decisions taken by a company’s management.

However, it can be argued that statutory derivative claim is not purged of the cumbersome procedure inherent under common law. The common law exceptions to the rule in Foss V Harbottle are, sadly, still material because the conditions laid down for obtaining the court’s permission to continue the claim is rooted in the common law requirements.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 and may make an order granting or refusing permission, or an adjournment giving such direction as it thinks fit.The court shall also take cognisance of the view of members without personal interest in the derivative claim, and an adjournment is given to enable the company ratify the breach and this ratification acts as a complete bar to the proceedings.

Payne is of the view that the concept of ratification and the views of an independent organ of the company are important in a collective process where the court is trying to weight the protection of the minority from abuse by the majority against the protection of the company from unnecessary litigation.

Conversely Hirt argues that derivative action cannot be said to be justice to the company since those who have control of the majority can utilise ratification to restrict the scope of derivative action.

It is argued that due to these cumbersome procedure and limitations, statutory derivative may not achieve the aim of serving as a check to breach of directors duty as most shareholders may not want to institute derivative action. However some writers are of the view that the new derivative action will open a flood gate for vexatious litigation. J.P Sykes argues that part 11 of the Act relating to derivative action will invite increased litigation against company directors. To Hannigan, “superficially, it may seem that the new statutory derivative claim is an invitation to litigation”. Kyrou is of the opinion that the statutory derivative action makes it easier for shareholders to institute action and this may lead to disincentive in accepting directorship. The new provision is a “massive lowering of the hurdle which will make it very easy for shareholders to commence claims. The [shareholder] will simply have to just make an allegation of negligence.” According to Dodd the Act goes too far as company directors will be exposed to an unacceptable degree of scrutiny and an increase threat of claims brought by militant shareholders.

However, Alex Kay arguing on both sides stated that “There will be some cases where this is a positive development and will lead to greater accountability of directors…there is also a risk that it creates a climate in which shareholders may be encouraged to raise potential arguments (characterized as negligence claims) in order to explore an issue publicly or to apply pressure to management.”Almadani is of the opinion that the provisional stage and the filtering process attached in the Act are both designed to refine any misuse or abuse of derivative action. This is supported by Payne’s view that the courts deliberately make derivative action cumbersome to protect the company against the single, irritating and misjudging shareholders who would waste a company’s money if allowed to litigate on the company’s behalf.

It is argued that the wide speculations that the implementation of statutory derivative action will increase litigation may never see the dawn of day .This is because firstly, the court has not particularly encouraged them and may never do so in the future. Presently the cases of Mission Capitol Plc V Sinclair and Another and Franber Holdings Ltd V Patals and Others are illustrative as the court refused permission for derivative action. In Mission Capitol Plc V Sinclair and Another,the court considered the damage claimed “somewhat speculative” and held that the hypothetical director would not regard pursuing the claim as particularly important.

Secondly, shareholders may be discouraged from instituting derivative action due to the cost implications. The Act does not provide for indemnity, thus shareholders are left with the responsibility of funding derivative action. Although in the case of Wallersteiner V Moir (No. 2)it was held that the court may grant indemnity, there is no compulsion. Reisbury argues that funding derivative claims is problematic and this will remain a disincentive to derivative claim, unless American class actions or contingency agreements are permitted in the United Kingdom.

It is suggested that as much as directors needs time to perform their duty of managing the company, there should be adequate provisions in place to enable shareholders monitor their actions as this is healthy for the growth of the company. It is argued that the new statutory derivative claim does not encourage shareholders to bring claims and may be a dormant provision in the future. The permission stages should be combined as one as the different stages procedure will slow down the efficacy and effectiveness of the claim which will not be in the interest of the company. However, the companies act provides another remedy in section 994 which is unfair prejudice remedy.

UNFAIR PREJUDICE REMEDY.

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 to the interest of members generally or of some part of its members (including at least himself)or any actual or proposed act or omission of the company(including an act or omission on his behalf) is or would be prejudicial. The provision includes present, past, and future. In Lloyds V Caseythe court allowed the petitioner to include acts that occurred before he became a member of the company.

However for unfair prejudice remedy to lie, the act complained of must be in the company’s affairs.

The petitioner must show that his interest qua member has been unfairly prejudiced.. Interest of a member can be ascertained by reference to the company’s constitution which includes Article of association, any resolution of the company and shareholder agreement. However it goes beyond this and includes legitimate expectations. In Ebrahimi V Westbourne Galleries, Lord Wiberforce held that “There are individuals with rights, expectations and obligations inter se which are not necessarily submerged in the company structure legal rights.

To succeed in an action for unfair prejudice, the action must be both unfair and harmful. Thus the concept of unfair prejudice has been interpreted broadly to include both unlawful conduct and lawful but inequitable conduct. 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.

The court is given a wide discretion under Section 996(2) to grant remedies as it thinks fit such as, regulation of the companies affairs, order an injunction or a derivative action, or a purchase order. However, the relief mostly sought by shareholders in practice is an order for the purchase of their shares, whereby the court values the shares in a fair manner.

Given that unfair prejudice remedy seems to be a personal remedy, the question then is if it can be used to redress corporate wrong as to act as a check for breach of directors duties.

Unfair prejudice is given a broad interpretation to include relief for corporate wrong. In Clark V Cutland it was held that relief in relation to corporate wrong can be obtained.

In Atlasview Ltd v Brightview Ltd, the court accepted that a breach of duty would be the classic example of conduct which is unfairly prejudicial to the interests of members “ generally” , so to deny the application of CA 2006 s.994 in such a case would be to deprive the section of much of its value. Thus in circumstances where a wrong is done to the company, and corporate relief is sought by the petitioner, the court can award corporate relief directly under the unfair prejudice action.

However, Hannigan argues conversely that a petition seeking in essence corporate relief should be struck out and the claimant required seeking permission to continue a derivative claim under Part 11. Using Section 994 to redress corporate wrong without going through the huddle of derivative proceeding may lead to abuse of process which as Hirt remarks, “the courts discretion at the remedial level would be substituted for the standing requirement for derivative actions based on the exceptions to the rule in Foss V Habottle”.

According to Sealy, unfair prejudice may be used as a means of oppression by minority shareholders because of their broad scope and easy access. Thus if unfair prejudice remedies are to be used for pursuing corporate relief, safeguards should exist against such abuse. Payne argues that although concepts such as ratification and the view of independent organs have no place in unfair prejudice petitions because of the personal nature of the remedy; these concepts should however be relevant if the remedy is to be used as a vehicle to obtain corporate remedy. . It follows that a petition seeking in essence corporate relief should be struck out and the claimant required to seek permission to continue a derivative claim under Part 11.

A better view is that the provision for unfair prejudice provides that action can be brought if there is a wrong against the company generally. Thus it can be used to redress corporate wrong and could serve as a check on directors. However it is suggested that it might be limited by the fact that it is basically a personal remedy and a shareholder will likely bring an action under this when he is personally aggrieved thus putting the company at the mercy of shareholders who may not bring action even if the company has been wronged except their personal interest is involved.. Nevertheless, this seems to be the ready and easy available remedy under the companies Act 2006 as derivative action does not seem to be frequently used. Though it may be argued that derivative action will be more frequently used in the future, it is suggested that it lies greatly in the discretion of judges to grant permission. Thus the statutory derivative action does not seem to serve as an adequate deterrent factor on directors as to prevent or reduce the likelihood of a breach in their duty, thus increasing the risk of a financial crisis in the future.

DIRECTORS DISQUALIFICATION.

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

Disqualification is a scheme specifically aimed at the removal of unfit directors from the market and the protection of the public from individuals whose past record showed them to be a danger to the creditors and others.However, the term unfitness is not certain. Nevertheless, case law point to the fact that recklessness, gross incompetence are standards for disqualification for unfitness.In Barings Plc (No.5), Re, Jonathan Parker J in disqualifying all three directors stated that “……..Directors have, both collectively and individually, a continuing duty to acquire and maintain a sufficient knowledge and understanding of the company’s business to enable them properly to discharge their duties as directors.” He suggested that “unfitness” may be manifested by conduct which is dishonest or by conduct which is merely incompetent. Notably, numerous cases indicate that the courts are prepared to disqualify directors who, although honest individuals without special financial expertise, “have nevertheless been lax in attending to accounting matters and have engaged in conduct which overall illustrates an element of recklessness”In Linvale, Re, although directors did not deliberately try to defraud creditors, they were found to be unfit on the grounds that they recklessly incurred debts that they were unable to repay.

It can thus be argued that the directors of the nearly collapsed and collapsed companies during this financial crisis can be disqualified as lack of diligence can be a strong ground for disqualification. However, what is more crucial is whether disqualifications of directors serve as a deterrent factor to make directors perform their duty with care. Although the availability of disqualification looks attractive, studies has showed that the treat of disqualification is relatively ineffective in terms of encouraging directors to act with due care towards their company.An empirical study has shown that disqualification does not affect the director’s chances of getting employment as most of them were reasonably successful in setting themselves up again, usually in self-employment. Also the issue of cost is also an inhibiting factor to sue for disqualification. As Hick puts it, disqualification is a costly process for all concerned suggesting that it seems anomalous that anyone can become a director, but if problems arise, tens of thousands of pounds of public money can be spent on disqualifying that person for the next three to four years.

In effect, it is suggested that the law on disqualification of directors does not serve as a sufficient check on directors to ensure the proper performance of their duty.