The derivative claim under the Companies Act 2006 is a codification of the old
common law derivative action.
There is now a new statutory derivative
claim in section 260-264, which has
the effect of abolishing the old common law derivative action.
The grounds of the claim have been widened
and now cover a breach of any director’s duties, including negligence.
Moreover, the old common law difficulties such as proving fraud on the
minority by the controlling wrongdoers, and mere negligence alone would not
be enough to constitute a claim for fraud on the minority, have been
resolved by the new statutory derivative claim.
Where a company goes into liquidation
the court will not allow a derivative action to be brought or continued
because the liquidator then has the statutory power to litigate in the
company’s name under the Insolvency Act
1986 (Cinematic Finance Ltd v Ryder
(2010)).
You can download Companies Act 2006 here: http://www.legislation.gov.uk/ukpga/2006/46/pdfs/ukpga_20060046_en.pdf
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Old
common law derivative action – Fraud on the minority
It has been long settled that the one
true exception to majority rule is where a fraud has been perpetrated
against the company by those who hold and control the majority of shares in the
company in the company and will not permit an action to be brought in the name
of the company (per Lord Davey in Burland v Earle (1902)).
A shareholder will be permitted to sue on
behalf of the company where a fraud has been perpetrated against the company
by those who hold and control the majority of votes and can therefore block
any resolution to bring proceedings in the company’s name (Pavlides v Jensen (1956)).
Old
common law derivative action – The meaning of ‘fraud’
According to Lord Davey in the case of Burland v
Earle (1902), a fraud is occurs ‘when the majority is endeavouring directly
or indirectly to appropriate to themselves money, property or advantages which
belong to the company or in which the other shareholders are entitled to
participate’.
Templeman J in Daniels v
Daniels (1978) took the view that the exception would permit a majority to
sue even in absence of fraud where directors have abused their powers,
‘intentionally or unintentionally, fraudulently or negligently,
in a manner which benefits themselves at the expense of the company’.
Megarry
VC in Estmanco (Kilner House) Ltd v
Greater London Council (1982) was of the opinion that ‘the essence of the
matter seems to be an abuse or misuse of power’ and that the term
‘fraud’ carried its meaning both in common law and equity.
Vinelott
J in Prudential Assurance Co Ltd v
Newman Industries Co Ltd (No. 2) (1982) stated that the requirement of
‘fraud’ would be satisfied where the interested shareholders use their voting
power to stultify any proceedings being taken against them.
However in Pavlides v Jensen (1956), a minority member was not allowed
to maintain an action on the company’s behalf even though the directors were
negligent, because the directors was acting in good faith and did
not derive any personal benefit. Interestingly, Danckwerts J accepted that the forbearance of shareholder extends
to directors who are ‘an amiable set of lunatics’.
In Pavlides
v Jensen (1956), the company’s assets were sold below market value due to the negligence
of the directors. It was held that the
action was not beyond the powers of the company, nor there was evidence
of fraud (the directors was not acting mala fide and did not
deprive any personal benefit), therefore the minority could not bring
a derivative claim.
In Menier
v Hooper’s Telegraph Works (1874), majority shareholders of HTW were also shareholders
of the ETO. As part of the business strategy, the majority shareholders
resolved to wind up ETO and transfer the company asset to HTW. A minority shareholder in the ETO was
permitted to bring a derivative action against HTW to compel it to account for
any profit it had made from the dealing. The HTW’s action was amounted to fraudulent
appropriation of the company’s assets.
In Cooks
v Deeks (1916), the three directors took a contract in their own name. They
held the majority of the shares and therefore secured the passing of a ratifying
resolution to approve their action. A minority shareholder (Cooks) brought
an action to force the directors to account to the company for the profits made
on the contract. The Privy Council held that the directors held the contract on
constructive trust for the company. The business opportunity was belonged
to the company in equity and shall be treated as an asset of the company.
By taking the contract for themselves and abusing their votes to ratify their
own wrongdoing, they are in breach of fiduciary duty. Such a breach cannot
be ratified otherwise it would be to allow a majority to oppress the
minority.
Old
common law derivative action – The meaning of ‘control’
In order for a minority shareholder to
bring a derivative action on behalf of the company it must also be established
that the wrongdoers held or controlled sufficient votes to prevent
legal proceedings being bought against them in the name of the company.
There has been judicial debate over whether
actual (de jure) control is required, for example whether the wrongdoers
control 51 per cent or more of the votes, or whether de facto control is
sufficient.
In Smith
v Croft (No. 2) (1988), the minority shareholders claimed to recover money
paid away contrary to the financial assistance prohibition and being ultra
vires. The claimant minority had 14% of the company’s shares, the defendants
held 63%, and the other shareholders, who did not want the matter to be put
on litigation, held 21%. The court takes into account the stand of the remaining
shareholders, who were independent of the wrongdoers (termed ‘the majority
inside the minority’) who did not wish the action to proceed ‘for
disinterested reasons’, held that the plaintiff minority shareholders were
therefore no locus standi to sue.
If the majority of the minority decide
not to support the action, the individual shareholder will not be able
to initiate proceedings notwithstanding that he satisfies the requirements
of the exceptions to the majority rule (on the facts of Smith v Croft (No. 2), illegality and ultra vires).
Old
common law derivative action – Other judicial scrutiny
In exercising the discretion the courts
would have regard to all circumstances, including the claimant’s
conduct and motives in seeking to sue and the availability of alternative
remedies (Mumbray v Lapper).
For example, in Barrett v Duckett (1995), the claimant and the defendant each held
50 per cent if the shares in Travel Ltd. The claimant brought a derivative
action against the company and another company which was controlled by the
defendant and his wife. It was alleged that the defendant and his wife had set
up the other company for the purpose of diverting business away from
Travel Ltd to it. She also claimed that the defendant and his wife had profited
from various breaches of fiduciary duty and had paid themselves excessive
remuneration. The defendants presented a claim for the winding-up of the
company on the company’s insolvency and, alternatively, the just and equitable
ground on the basis of deadlock, and applied to have the claimant’s action
struck out. The COA held that the winding-up petition, which was lodged before
the claimant’s action was commenced and the claimant’s action was struck out
because the winding-up petition was indeed an alternative remedy to the
claimant. Moreover, the court also take into account the fact that the claimant
was motivated not by the company’ interests, but by personal reasons
following the divorce of her daughter from the defendant.
According to Launcelot Henderson QC in Portfolios
of Distinction Ltd v Laird (2004), stated that in determining whether to
permit a derivative action to continue the shareholder must establish a positive
case for being allowed to sue on behalf of the company, and that the
shareholder will be allowed to do so only if two conditions are satisfied,
namely that he is bringing the action bona
fide for the benefit of the company, and that no other adequate
remedy is available.
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The
current law on derivative claim – Paper hearing and grounds of action
Section
260(1) defines derivative claims as proceedings brought by a member
of a company in respect of a cause of action vested in the company and seeking
relief on behalf of the company.
Section
260(3) provides that the grounds for bringing a derivative claim is
are that the 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 requirements of ‘fraud on the minority’
and ‘wrongdoer control’ are no longer exist. In fact, even where the defendant
has acted in good faith and has not gained personally, a claim can still be
brought.
A paper hearing will take place
where the court considers the member’s evidence. On this stage the court must
make a decision as to whether permission application should be permitted to
proceed in the absence of the company’s involvement.
If the court does not dismiss the
application at the paper hearing, the application will then proceed to the full
permission hearing and the court may order the company to provide evidence at
this stage.
The
current law on derivative claim – Prima facie case and mandatory bars
Once a derivative claim is brought, plaintiff
must apply to the court for permission to continue it (section 261(1)).
The members who wish to bring a derivative
claim have the burden to prove that they have a prima facie case
for permission to continue the claim. If this is not demonstrated the court
must dismiss the application (section
261(2)).
Section
263(2) lists out the mandatory bars which the court must take into
account when determining whether to grant permission to a member to continue a
derivative claim. It states that permission must be refused if the court
is satisfied if the court is satisfied that:
(a) a person acting in accordance with section 172 would not seek to continue the claim
(b) where the claim arises from an act or
omission that is yet to occur, that the act or omission has been
authorized by the company
(c) where the complaint arises from an act or
omission that has already occurred, that act or omission was authorized
before it occurred, or has been ratified since it occurred
In relation to section 263(a), in Stimpson
v Southern Landlords Association (2010) the court found that a hypothetical
director acting in accordance with the section
172 duty would not seek to continue the claim under section 263(2)(a) because there was an
alternative remedy available to the claimant under section 994 CA 2006.
Similarly, in Franbar Holdings
Ltd v Patel (2008), the court held that a hypothetical director would not
seek to continue to the derivative claim because there is an alternative claim
available to the applicants under section
994.
In Mission
Capital v Sinclair (2008), the court found that a hypothetical director
acting in accordance with the section
172 duty would give little weight to continue the claim. Even though
a hypothetical director might continue the claim, he would not
attach much importance to it, especially as the damage that the
company would suffer from the alleged wrongful dismissal of the director was speculative.
It was more likely that the company would replace the director
than take action against those responsible for the damage caused by their
wrongful dismissal. In addition, the applicants could recover what they sought
by means of an unfair prejudice petition under s.994.
In Iesini v Westrip Holdings Ltd (2009), the court held that the
directors had not breached their duties so that there were no grounds
for launching a derivative claim. With respect to section 263(2)(a), Lewison J
observed that there is a range of factors that a director, acting in
accordance with section 172, would
consider in reaching his decision. They would include: “The size of the claim;
the costs of the proceedings; the company’s ability to fund the proceedings;
the ability of the potential of the ability defendants to satisfy a judgment;
the impact on the company if it lost the claim and had to pay not only its
costs but the defendants as well; any disruption to the company’s activities
while the claim is pursued; whether the prosecution of the claim would damage
the company in other ways and so on. The weighting of these considerations is
essentially a commercial decision, which the court is ill-equipped to take,
except in a clear case.”
These factors were considered by the court
in Kiana v Cooper (2010), where the
claimant, who is a director and shareholder in the company, is bringing an
action against the defendant, who is also a director and shareholder in the
company. After considering the factors suggested by Lewison J, the court is satisfied that the claimant and a
hypothetical director acting in accordance with his duties under section 172 would pursue the action.
The permission was therefore granted.
The factors were considered by the court
again in Stainer v Lee (2010), where
the permission was granted subject to various reasons, including
one relating to costs. The court is influenced by the factor that the
potential recovery of almost £8 million. The court observed that sometimes if
may be in the interests of the company to continue even a weak case
if the amount of potential recovery is very large.
However the fact that the potential
recovery is modest is not in itself a bar to the derivative claim (Cullen Investments Ltd v Brown (2015)).
In Cinematic
Finance Ltd v Ryder (2010), the claimant granted loans to several
companies. When these loans were not repaid, the claimant became the sole
and majority shareholder of those companies. It sought permission to pursue
a derivative claim against the former directors of those companies for alleged
breaches of fiduciary duty. The permission was refused because as the sole and
majority shareholder of those companies, the claimant had complete control
over them and so a derivative action was neither necessary nor appropriate.
The reason for the use of the derivative claim procedure to save the cost
of pursuing the remedy through the insolvency regime is insufficient to
allow the derivative claim to proceed.
More recently, in Bhullar v Bhullar (2015) a derivative claim was allowed as an
independent board would be likely to have supported the claim in question.
The
current law on derivative claim – Discretionary factors to be taken into
account when granting permission
Section
263(3) lists out the factors which the court must take into account
when exercising its discretion to grant permission to continue a
derivative claim. These factors are:
(a) whether the member is acting in good
faith in seeking to continue the claim
(b) the importance that a person acting in
accordance with section 172
would attach to perusing the action
(c) whether prior authorization of the
act or omission would likely to occur
(d) whether subsequent ratification of
the act or omission would likely to occur
(e) whether the company has decided
not to pursue the claim
(f) whether the shareholder could pursue
the action in his own right
In Stimpson
v Southern Landlords Association (2010), the permission was refused
because the claimant had brought the action in order to retain control of
the company and because he did not want to lose his identity through a
merger. He was not acting in good faith to bring a derivative claim
on behalf of the company.
Section
263(4) states that the court must take into account the views of members of
the company who have no personal interest, direct or indirect, in the
matter. This is essentially a codification of the controversial decision in Smith v Croft (No. 2).
The common law principle stated that a
derivative action cannot be brought if there is a more appropriate
alternative remedy available to the claimant (Mumbray v Lapper).
This was followed by the court under the
regime of CA 2006, where the High
Court refused to grant permission in Stimpson v Southern Landlords Association (2010) because the two
directors could pursue their claims personally under section 994 unfair prejudice
petitions in their capacity as shareholder.
However in Kiani v Cooper (2010), the permission was granted even
though unfair prejudices petition was available to the claimant. The judge
took the view that this was merely one of the factors to be taken into
account and it was no means determinative.
As Phillips v Fryer (2012) demonstrated that the judges may exercise
his discretion to grant the permission in some appropriate circumstances,
namely where the section 994
proceedings will not necessarily result in permission to continue
a derivative claim being denied, and the court may hear both
proceedings together.
Derivative
claim – The proceedings, costs and remedies
Legal aid has never been
available to those seeking to bring a derivative action.
Wallersteiner
v Moir (No. 2) (1975) Buckley LJ
observed that the shareholder who initiates the derivative claim may be
entitled to be indemnified by the company at the end of the trial for his
costs provided he acted reasonably in bringing the action. On the other
hand, Lord Denning MR was of the
opinion that the shareholder could still be indemnified by the company
in respect of his costs even if the action fails, provided that the shareholder
had reasonable grounds for bringing the action.
Walton
J in Smith v Croft (1986) held
that the shareholder’s personal means to finance the action was a relevant
factor to be taken into account by the court in determining the need for
an indemnity.
According to Roth J in Kiana v Cooper
(2012), a shareholder is generally entitled to indemnity his reasonable
costs by the company. However this shall not be extended to those
where the amount of likely recovery is presently uncertain.
By virtue of section 58 and section 58A
of the Courts and Legal Services Act
1990 and SI 1998/1860, conditional
fee arrangements are, subject to certain limited exceptions, available
in all proceedings. Thus a solicitor may take on a case on the basis that they
will only get paid if they win the case.
You can read the majority rule and overview of shareholder's remedies here: http://thewallyeffect.blogspot.my/2017/10/the-majority-rule-and-shareholders.html
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