Insider healing

The area of derivative claims awaits legislation that could have a major impact on shareholders and directors alike, says Deepak Nambisan

Much lawyers’ ink has been spilt criticising one of the more controversial aspects of the Government’s mammoth programme of company law reform, namely the new statutory derivative claim procedure. But is the outlook really as bleak as some suggest?
On 20 July 2006 the Companies Bill (formerly the Company Law Reform Bill) completed the committee stage in the House of Commons. Although the bill is not yet in its final form, derivative claims are likely to remain the subject of tight judicial control via the new rules on permission. However, until the appellate courts provide guidance, concerns remain that the bill creates a more complex and expensive procedure than that currently in place, without any obvious corresponding reduction in the administrative burden companies face.

Definition problem

Under common law a shareholder is only allowed to bring proceedings against the directors for breach of the duties they owe to the company in extremely limited circumstances. The general principle – the ruling in Foss v Harbottle (1843) – is that it is for the company to bring proceedings where it is the injured party, unless there has been conduct amounting to a ‘fraud on the minority’. Defining such conduct with precision has been a reliable source of headaches for lawyers for more than 150 years, although it includes situations where wrongdoers are in control of the company and will not exercise the company’s primary right to sue, or have appropriated the company’s assets. In practice, there have been relatively few such claims, as can be seen from their infrequent appearances in the law reports.

Importantly, the principle that only the company can sue remains the cornerstone of this area of shareholder protection. There must be a cause of action vested in the company that is then pursued by a shareholder seeking relief on its behalf. But in contrast to the restrictions of ‘fraud on the minority’, the company’s cause of action must arise “from an actual or proposed act or omission involving negligence, default, breach of duty or breach of trust by a director of the company” and “may be against the director or another person (or both)”.

So the range of circumstances in which a claim may be brought is considerably wider than at present. For example, in common law a director cannot be the subject of a derivative claim in respect of negligence without showing that the directors have themselves profited thereby (Daniels v Daniels (1978)). There is no such limitation in the bill. There are also real concerns that the new provisions may be used by activist shareholders to launch vexatious claims for alleged breaches of, for example, the statutory directors’ duties set out in Part 10 of the bill (such as the duty to act in the way the directors consider “would be most likely to promote the success of the company for the benefit of the members as a whole”). At first look it seems that directors’ initial risk exposure may be increased as a result of the new statutory procedure.

To the dismay of many commentators, the claimant need not have been a member at the time the company’s cause of action arose. In fact, this is similar to the current position and can be justified on the basis that new shareholders may either benefit or suffer detriment from past decisions taken by a company’s management. It therefore seems fair that such shareholders, in principle, have the right to bring claims. In any case, if tactical litigation aimed at either disrupting companies’ operations or furthering political aims features in claims brought, one can safely predict that the courts will flex their muscles when it comes to granting permission to continue with such claims (see below).

Third party claims

The bill envisages that certain third parties (other than directors) might also be respondents to statutory derivative claims. The explanatory notes of the bill suggest that this will only be permitted in very narrow circumstances and still involving a director’s breach of duty, for example knowing receipt of money or property transferred in breach of trust or knowing assistance in such a breach. From what the Government has said during the bill’s progress through Parliament, it seems that a claim may also lie against a third party where the company is a victim of a tort, but the directors, in breach of their duties to the company, fail to enforce the company’s remedy.

Civil Procedure Rule (CPR) 19.9 currently requires a claimant who has commenced an old-style derivative claim to apply to the court to continue it. Under the bill, once a new derivative claim has been commenced, the claimant must apply to the court for permission to continue proceedings.

If the application and evidence filed in support do not show a prima facie case for permission, the court must refuse the application and may also make such consequential orders as it sees fit, including orders for costs. Whether a claim satisfies that test will be fact-sensitive. Again, permission must be refused if directors acting in accordance with the duty to promote the success of the company would not seek to continue the claim, or if the matter complained of was authorised in advance or has been ratified.

The scope of ratification currently looks likely to be diminished by clause 239(3) of the bill, which prohibits any director or member connected with the director from voting in favour of ratification. This wide-reaching provision has the potential to disenfranchise shareholders, including controlling shareholders connected with a company’s directors (as will often be the case where a director is also the trustee of an ultimately controlling family or charitable trust), even if they have no personal interest in the matter. The Government has agreed to reconsider this provision.

In other cases the court has a discretion whether to give permission for a claim to continue, which is to be exercised by reference to certain factors identified in the bill, including: whether the member is acting in good faith in seeking to continue the claim; the importance a director fulfilling their duty to promote the success of the company would attach to it continuing; the likelihood of authorisation/ratification; and whether the company has decided not to pursue the claim (clause 263(3)). The court must have regard to any evidence put before it as to the views of company members who are independent of the dispute (clause 263(4)), which raises interesting questions as to the correct strategy to be adopted in filing evidence in response to such claims.

Cost exposure

The Government has stated repeatedly that the reforms to derivative claims are essentially procedural only. But the procedures set out in the bill are likely to prove expensive and there is little doubt that, at least initially, the relative complexity of the permission stage will mean a potentially substantial exposure to costs for all parties.

From a director’s perspective, one would do well to remember that claims must somehow be funded and, given that members who bring an action that is dismissed will be at risk of bearing heavy legal costs, this should act as some deterrent against bringing frivolous actions, particularly because even a successful claim will result in an award of damages to the company and not to the member who brought it.

Similarly, there appears to be nothing in the bill that encourages a change in the courts’ hitherto cautious approach to applications by shareholders for an advance indemnity for the costs of the claim, regardless of the result (see Wallersteiner v Moir (1975) and CPR rule 19.9(7)).

The threat of the new derivative claim therefore may not be as great as first seems; but directors, companies, hedge funds, pressure groups and their advisers will await the first reported cases with interest. n
Deepak Nambisan is a barrister at Fountain Court Chambers