EXTENDED RIGHT FOR SHAREHOLDERS TO SUE DIRECTORS

142.Derivative actions by which a shareholder can bring a claim in respect of a cause of action vested in a company in which he holds shares have now been placed on a statutory footing. There are two important changes:

142.1the circumstances in which a derivative action can be brought have been clarified and expanded; and

142.2the procedure for bringing such a claim has been rationalised.

143.The Act implements the Law Commission’s recommendation (para. 6.15) to replace the existing derivative action with a new statutory derivative procedure which has ‘more modern flexible and accessible criteria for determining whether a shareholder can pursue an action’. The Law Commission recommended however that this new procedure should be subject to tight judicial control.

GROUNDS FOR BRINGING THE NEW DERIVATIVE ACTION

144.Relevant provisions are to be found in ss. 260 – 264 of the Act. A derivative claim under the Act is defined as being in respect of a cause of action vested in the company but brought by a member seeking relief on behalf of the company (s. 260(1). A member includes a person to whom shares have been transmitted or transferred by operation of law (s. 260(1)). A claim may be brought in a wider but still limited range of circumstances than at present namely in respect of ‘…an actual or proposed act or omission involving negligence default breach of duty or breach of trust by a director of the company’ against any director or relevant third party or both (s. 260(3). ‘Director’ as defined under the section includes both former and shadow directors (s. 260(5)) and a claim as now may be brought by a person who was not a member at the relevant time complained of (s. 260(4).

145.A statutory derivative claim therefore can be brought for breach of the duty to exercise reasonable care skill and diligence (ie negligence) even if the director has not benefited personally and it will not be necessary for the applicant to show that the wrongdoing directors control the majority of the company’s shares and that there has been ‘a fraud on the minority’. Claims against third parties must be relatively limited in scope to claims which mirror or buttress the principal defaults of the directors such as dishonest assistance in a director’s breach of duty or knowing receipt of property in like breach. These rights amount to a considerable expansion of the present jurisprudence. The uncertainty in the old case law as to when a member could bring a derivative claim has consequently to a large extent been swept away.

146.The new statutory right provides another tool for use by activist shareholders to push for change at under-performing companies. There is some concern the new provisions may be abused by disgruntled or activist shareholders but it seems to me for the reasons discussed below that the Court’s filter as to the scope of actions allowed to proceed is quite fine in that in that in practice it at all times must have regard to the objectively assessed best interests of the company. Certainly the new express duties of a director regarding competence the success of a company and its wider impact on the community and environment will give food for thought as to a directors vulnerability to suit. Directors’ decisions should be carefully minuted as a first line of defence in any event.

THE EXISTING LAW

40.Currently as a general rule (the rule in Foss and Harbottle[1]) if a wrong is done to a company only the company itself (and not a shareholder) can bring an action for damages or some other remedy. In practice the directors must decide whether or not to bring a claim. However if the wrong was done by the directors themselves or a majority of them no claims are likely to be pursued unless shareholders are able to force the board to bring a claim either by passing an ordinary resolution to replace the existing directors with new appointees or by giving a direction to the board by means of a special resolution.

41.At present the principal circumstances in which a derivative claim may be brought are limited to where the company itself would be permitted to sue and where there is:

41.1fraud on the minority shareholders and the wrongdoers control the company; or

41.2illegality; or

41.3failure to approve the matter in question by passing the requisite special or extraordinary resolution as appropriate.

  1. If a wrong has been effectively ratified by the company this will be a complete bar to a derivative claim. In addition if a wrong is capable of being ratified then even if there has been no formal ratification it may not be possible for a minority shareholder to bring a derivative claim.

COURT PERMISSION REQUIRED TO CONTINUE THE CLAIM

43.The Act appears to prescribe a two-stage procedure for permission to continue a derivative claim which is to some extent a development and refinement of the current position under CPR 19.9. There are still some differences of substance however. Under the CPR however (CPR 19.9(7)) the Court has an express power to order the company to indemnify the relevant members against liability in respect of the costs incurred in the claim. That express power is missing from the drafting of the new regime. Further both the company and the alleged wrongdoers (ie all defendants) are currently entitled to be heard on the application for permission to continue the claim. The right to be heard under the new regime would appear to be limited to that of the company alone if the matter proceeds to such stage. However if permission is obtained it appears that the usual procedure of controlling stages of the litigation can still apply.

44. So what are the stages:

Stage 1- a shareholder who has brought proceedings on behalf of and for the benefit of the company must apply to the court for permission to continue the claim (s. 261(1). The court must dismiss the claim if the evidence filed by the shareholder does not disclose a prima facie case for giving permission and it can make any consequential order it considers appropriate including a costs order (s. 261(2). In order to establish a prima facie case the applicant has to address the statutory tests which reflect to a very large extent the current approach[2] of proving entitlement in all the circumstances to sue on behalf of the company (s. 263(1)).

45.In exercising its discretion to allow an action to be continued the court must consider in particular:

45.1whether the applicant is acting in good faith (this surely is the principal element of the Court’s fine filter to which I referred earlier);

45.2the importance a director promoting the success of the company would attach to continuing the claim;

45.3whether the putative or actual conduct would be likely to be authorised or ratified by the company in due course;

45.4 whether the company has decided not to pursue the claim (and presumably why); and

45.6whether the applicant should pursue a remedy in his own right (i.e. by way of s 459 petition) instead of on the company’s behalf (s. 263(3)).

The Court must also pay particular regard to any evidence before it with regard to the views of members who have no personal interest whether direct or indirect in the outcome of the claim (s. 263(4). Some may say that this is a merely a reflection of the usefulness in many legal contexts of disinterested third party evidence. In this context it cannot mean disinterested in the sense of having no interest in the outcome of any continued action. All members of the company have an interest by virtue of their shareholding. Rather it must mean in this context a member who is neutral as to the dispute.

46.It seems to me that an applicant (especially the one share ‘agitator’ member) may have some real difficulty in satisfying the Court as to the likelihood of authorisation or ratification of the act complained of. He or she is unlikely to have access to any evidence which would make their evidence on the point sufficiently persuasive. When one looks at the combination of tests it seems to me key are the importance attached to the claim in promoting the success of the company and the views of disinterested members. How is any applicant to put such evidence before the Court absent co-operation save by witness summons?

47.In these circumstances and given the existing approach of the Court under the CPR I have some doubt whether the Court could be persuaded to otherwise substitute its own judgment at this stage (standing in the shoes of a director) without hearing some evidence from the company save in the clearest of cases?

48.If my analysis is correct then the vast majority of applications will proceed to:

Stage 2 – the Court may give directions for evidence to be provided by the company and may adjourn the application for such to be carried out (s. 261(3)). On hearing the application having considered evidence from both sides the Court may then deal with the application as it sees fit including further adjournment and directions if thought appropriate (s. 261(4)).

49.A company acts through its directors. The Court has express power to call for evidence from the company. Even if at the first stage hearing the Court accepts it is highly desirable to obtain the evidence of ‘disinterested members’ how is it to compel it absent co-operation. Such order as is made in respect of evidence will be against the company as party to the action and in practice will be addressed at director level. The directors cannot be forced to consult or canvass members under such an order. Individual members are not subject to the order in their own right although the Court could order a copy of the application and evidence to be served on such members as it sees fit. Surely the parties will simply seek to persuade the Court that some part of their evidence deserves to be treated with that degree of attention given its provenance.

50.Perhaps I have read too much into the wording of the section. Put at its highest I can see it encompassing some form of ‘industrial jury’ (to borrow an employment law term) to assist the Court. I do not see how in practice it can work. Perhaps that is why the subsection talks of ‘…any evidence before it…’.

51.The Court may also direct the continuance of a claim initially commenced by the company as a derivative claim on the application of any member on the grounds that the claim as commenced by the company is an abuse or that it has not been prosecuted diligently (s. 262). Likewise derivative claims brought by another member (s. 264).

52.Although the tests and structure of the new statutory right are arguably clearer than before looking overall at the position I do not see it having become any easier in principle to bring a claim as an individual against alleged wrongdoing by on behalf of a company. The hurdles to be surmounted by a putative claimant are just as high as before. They are just easier to see.

[1](1843) 2 Hare 461

See for instance Barrett-v-Duckett [1995] 1 BCLC 243 per Peter Gibson LJ; Portfolios of Distinction Limited-v-Laird [2004] 2 BCLC 352