Statutory Derivative Action and Governance of Modern Companies


Statutory derivative action plays a vital role in the proper governance of modern companies,  however reform is needed to realise that role. 

Nearly 180 years ago, the celebrated case of Foss v Harbottle (183) 2 Hare 461 laid down two  important rules related to the governance of modern companies. The first is proper plaintiff  rule, which is premised on the separate legal personality of the company. It states that where a  wrong is alleged to have been done to the company, such as when the directors have breached their  fiduciary duties, it is only the company that can initiate legal action and not the shareholders. The  second is ‘majority rule’ which means the will of the majority of the members of the company  should prevail in running the company. But when the directors of a company have, through their  acts or omissions, benefited themselves to the detriment of the company, then most probably they  will not be willing to take legal action on behalf of the company. In this case the company is the victim and has the cause of action but Foss case rules makes it unlikely that any action will happen. To solve this, courts around the commonwealth have carved out a few exceptions to Foss rules. Primary  among them is derivative action by a shareholder on behalf of the company, when a wrong act or  omission of directors benefited directors of the company to the detriment of the company. When a shareholder is the victim of wrongdoing by the board of directors, then the shareholder may bring legal  action personally not through the company. This is an instance of direct action bought by a shareholder,  this includes actions for oppression, unfair prejudice, mismanagement etc.  

How derivative action plays a vital role in proper governance of modern companies? There can be many benefits from effective and proper use of derivative action. First, it makes  managers and directors accountable for what they do in their posts. Second, the action can function  as a way of giving some teeth to the process of monitoring of directors that shareholders might  undertake. If their monitoring detects something wrong then shareholders can do more than simply “jump up  and down” and complain. Third, the action, if successful, will lead to the company being  compensated in relation to the wrong that has been done to it. Fourth, the action can permit  something to be done if there is a dispute within the company about what the directors have done.  Of course, this can always be seen as interference in the management of the company, and UK  courts as well as courts in other jurisdictions, are usually wary of interfering in the internal affairs of  companies save where there are very good grounds for doing so. There are grounds in the  companies Act2006 which require a shareholder to obtain permission before being able to continue  a derivative action. Requirement also contributes to the position that generally exists in the UK that  there should not be interference in the management of companies generally and if there is to be  interference then there must be substantial reasons for it. 

Now derivative claims may only be brought by following the procedure set out in Part 11 of the  2006 Act, or by pursuing an unfair prejudice claim under section 994 of the 2006 Act. Permission to  bring a claim must be sought from a court, which has to balance the right of the majority with the  rights of minority shareholders. It also needs to check unwanted interference in the internal affairs of  companies. The gaining of permission is only able to be secured if a shareholder can pass  successfully through two stages. First, shareholders have to establish a prima facie case on the  merits. The aim of this stage of the permission process is to assess whether the company and the  respondent should be put to the expense and inconvenience of considering and contesting the  application for permission. If an application is successful on this point, then the matter proceeds to a  second stage. In the second stage, according to section 263(2), a court must refuse permission if it is  satisfied that one or more of three criteria exist. There is no discretion given to the courts at this  point. But if none of the criteria in section 263(2) apply then the court has a discretion whether to  allow the claim to proceed. In the process of exercising this discretion the court must take into  account factors that are set out in section 263(3) and (4). The UK courts have, compared with the  courts in other jurisdictions, a broad discretion when it comes to permitting shareholders to proceed.  For instance, in some jurisdictions, such as Germany, if a person has a certain percentage of the  issued share capital of the company then he or she has the right to bring derivative proceedings  without the need to obtain permission. 

But despite making derivative action a statutory scheme there aren’t many shareholders using it as  a tool to make companies accountable. In other words there aren’t many takers of statutory  derivative action in the real world.  

Reasons for few people using statutory derivative action. 

There are very few proceedings in the UK courts for allowing derivative action. The following  might be reasons for the paucity of cases in the UK. First, shareholders seem to be using section 994  petitions, alleging unfair prejudice against directors, rather than initiating derivative proceedings, as  the same facts might lead to a claim on either basis. Second, there is a cost element to any action  and it might dissuade the institution of proceedings. If a permission action is not successful then an  applicant shareholder might not only be liable for his or her costs, but the costs of the other parties.  Third, there is lack of a financial incentive for a shareholder to take the time and incur possible  costs that prosecuting derivative actions entails, because any relief ordered will be in favour of the  company. A shareholder does not receive any direct benefit from the action that he or she takes. In  fact the shareholder might not receive any indirect benefit. While a successful outcome to an action  might lead to an increase in the value of shares, this is not guaranteed. In fact, there is data from an  American empirical study suggesting that there is little positive impact on share values following  successful derivative proceedings. The derivative action might, in relation to larger companies in 3 particular, affect the reputation of the company because of a loss of confidence in the directors , the 4 value of shares and that might in fact reduce the value of shares. 

Fourth, a shareholder taking action might think that he is taking all the risk but all other shareholders  get the benefit without any action or risks on their part, if he becomes successful. Fifth, The judges  do appear to be invoking a fairly strict approach to permission applications, and this might  discourage shareholders from taking action. Fifth, Only members of the company can bring a  derivative claim, although this includes a person who is not a member but to whom shares in the  company have been transferred or transmitted by operation of law (section 260(5)(c), 2006 Act), but  it does not include many other stakeholders of a company, such as employees, creditor etc. Finally, A derivative claim may only be brought 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 a company (section 260(3), 2006 Act). That cause of action must be vested in the  company and the member bringing the claim must be seeking relief on behalf of the company  (section 260(1), 2006 Act). 

Reform needed. 

While the statutory scheme has provided a little more certainty concerning when a derivative action  might be initiated, when compared with the position at common law, it has clearly not given much  encouragement to shareholders, and arguably has not made the derivative action more accessible for  shareholders. So in order to make it effective following possible changes might be introduced. 

  1. Class of people who can take derivative action can be broadened. The UK scheme limits the  bringing of derivative actions to members of the company. This is a more limited approach than  that found in other jurisdictions. For instance, section 236 of the Australian Corporations Act  2001 allows, besides members, former members and officers of the company to bring derivative  proceedings . Interestingly, the Company and Securities Law Review Committee, a body that 5 reviewed company law and considered changes to corporate legislation in Australia, favoured  giving a derivative action to creditors as well as shareholders , but this view did not gain the 6 imprimatur of Parliament and, hence, did not find its way into legislation. As Janice Dean has  asserted in relation to derivative claims : “there seems to be no a priori reason why others  [besides shareholders] should not enjoy similar access to the courts to protect the company from  harm, under a regime of judicial supervision similar to that envisaged to ‘manage’ shareholder  actions.” Often many or all of the shareholders do not know what is going on in a company; 7 they are poor monitors. Broadening the range of those who can bring proceedings increases the  chances of a company’s interests being protected, because someone else might well be aware of  something that the shareholders and others are not. For example, employees may be more  conversant with the affairs of the company and what directors are doing, and might, therefore,  be far better monitors. This is perhaps demonstrated to some degree by the fact that we see, not  infrequently, employees acting as “whistleblowers,” and disclosing some improper or  inappropriate practice of corporate managers. 
  2. The present legislation should be broadened to allow so-called “multiple derivative actions”  (sometimes referred to as “double derivative actions”) to be brought within the ambit of the  statute. A “multiple-derivative” action is a derivative action that is entitled to be brought by  minority shareholders of a parent company for a breach of duty owed to a direct or indirect  subsidiary, certainly where control of the subsidiary is not independent of the parent company’s  board. UK Parliament should amend the provisions in the legislative scheme for derivative  actions so as to accommodate multiple derivative actions. It might be appropriate to proceed  along the lines of section 236 of the Australian Corporations Act 2001 where it is provided, in  section 236(1)(a)(i), that a claim may be brought by a member of the company or of a related  

New Zealand also permits directors to apply : Companies Act 1993, s.165. 5 

Enforcement of the Duties of Directors and Officers of a Company by Means of a Statutory Derivative Action, Report No 12, 1990. 6 Directing Public Companies (London, Cavendish, 2001), body corporate, as a subsidiary company comes within the latter expression . The New Zealand 8 legislation takes a similar approach. This suggestion could be implemented with little difficulty 9 and, perhaps, would not be as contentious as the proposal I have made earlier about expanding  the range of applicants. 

  1. It would be much better if the UK scheme permitted shareholders to bring derivative  proceedings against anyone under any cause of action that the company has, and where no  action has been instigated by the board. Under the present scheme, the action must be one that  arose as a result of the actions of the directors. Thus an action that exists because of 10 something that is independent of the actions of the directors cannot be subject to a derivative  action. It is unlikely that an action that was not dependent on a breach by a director would be  pursued frequently, but there is always the possibility that a board could refrain from  proceeding against a third party because that party is associated with one or more of the  directors or the controller(s) of the company. 
  2. Incentive to the person taking the initiative of derivative action should be made much better  from what it is now. The court has the power at a permission hearing to order the company to  indemnify the successful shareholder in relation to his or her costs. But, notwithstanding the 11 fact that the Law Commission said that the inclusion of the power to provide for an indemnity  was a significant incentive to shareholders to initiate proceedings, in reality there is little 12 incentive for shareholders because any relief that is ultimately ordered by a court will go wholly  to the company itself. The best that shareholders can hope for is that their costs will be 13 covered. Frank Easterbrook and Daniel Fischel have observed that : “A dominating  characteristic of the derivative action is the lack of any link between stake and reward – not  only on the judge’s part but on the plaintiff’s.” As indicated earlier, this could be a reason for 14 shareholders not commencing derivative actions. To provide some incentive for shareholders it  is submitted that UK courts should be given the power that has been bestowed on New Zealand  courts by section 167(d) of the Companies Act 1993, namely to : “make an order directing that  any amount ordered to be paid by a defendant in the proceedings must be paid, in whole or part,  to former and present shareholders of the company… instead of the company…” This would  be of particular benefit where the company against which proceedings have been instituted is  completely controlled by the wrongdoers and it is possible that they will use any benefit that is awarded by a court in derivative proceedings improperly. The Law Commission did not favour  this approach as it said that it blurred the distinction between personal and representative  actions. But without such a course of action it might see the virtual demise of derivative actions. 
  3. Use of ratification by the majority shareholders to end the cause of action needs to be checked.  As at common law, the question of whether a wrong has, or could be, ratified might remain  

 

For instance see I. Ramsay, “Corporate governance, Shareholder Litigation and the Prospects for a Statutory Derivative Action (1992) 15 13 University of New South Wales Law Journal 149, 150 and 164. Economic Structure of Corporate Law (Cambridge, Mass, Harvard University Press, 1991) critical as to whether permission will be given to allow a derivative claim to continue. Section 15 263(2)(c) provides that if the cause of action that is the subject of a derivative claim has been  ratified then permission cannot be granted to the shareholder. Also, under section 263(3)(c) the  court must take into account in its decision whether to give permission the likelihood of the  cause of action being ratified if it had not been ratified before the permission hearing. The law  on ratification was described by the Australian Companies and Securities Advisory Committee  in its report on the possible introduction of a statutory derivative action as : “Undoubtedly the  greatest legal difficulty with the existing derivative remedy.” One commentator has said, in 16 relation to how it affected derivative actions at common law, that : “the mere possibility of  ratification was sufficient to deprive a shareholder of the ability to bring a derivative action.”17 Certain wrongs are not able to be ratified, so the issue of ratification will not always apply, but  the danger is, as Tony Boyle pointed out, it may result in leave hearings becoming dominated  by arguments over whether the alleged wrongs were ratifiable or not. The Law Commission 18 was concerned in its report in 1997 that its efforts to simplify the derivative action could be  undermined by the complexities that arise where an alleged wrongdoing has been or might be  ratified. What is proposed here, namely the removal of any reference to ratification, would 19 address those fears. Ratification should not prevent a person from bringing proceedings with  leave as in the case of Australian legislation. 

If derivative actions are to be anything other than a dead letter then something needs to be done on  the above discussed lines. What the law has to do is to find a balance between, on the one hand,  ensuring that proceedings cannot be brought so as to disrupt corporate life unnecessarily, and, on  the other, ensuring that shareholders are not overly deterred and that they have a reasonable avenue  for complaining about wrongs against their company. 

 In addition even where the wrong is ratifiable , the court will need to determine whether the conditions for ratification are met and in particular 15 where the purported ratification is by the general meeting, whether the shareholders were properly informed given that the directors who have been  engaged in wrongdoing are likely to conceal matters that might result in the shareholder vote being adverse for them: see Stainer v Lee [2011] EWHC  2287 (Ch).

 

Table of Authorites

Legislation’s  Precedents
New Zealand‘s Companies Act, 1993, s.165.  Oates v Consolidated capital Services Pty Ltd  [2008] NSWSC 464.
Companies Act 1993, s.165(1)(a). Iesini v Westrip Holdings Ltd [2009] EWHC  2526 (Ch); [2010] BCC 420, [75].
UK’s Company Act, 2006Section 260(3)  Stainer v Lee [2011] EWHC 2287 (Ch), [45]- [46]
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