Trouble at the top?

Company directors will be left open to increased litigation when the Company Law Reform Bill takes effect. Richard Matthews and John Heaps investigate

There is compelling evidence that, when the Company Law Reform Bill comes into force at the end of this year, the risks facing UK company directors will be at an all-time high. The bill introduces a statutory basis for claims by shareholders against directors for negligence, default, breach of duty or breach of trust. This will dilute the principle of ‘majority rule’, which is at the heart of English company law.

At present companies are not required to act at the behest of shareholders controlling less than 50 per cent of the shares by value. Since the right to bring a claim in respect of directors’ conduct rests with the company and not its shareholders, the odds are stacked against a minority shareholder who has suffered as a consequence of the actions of directors. An aggrieved minority shareholder will typically have to show ‘unfair prejudice’ under Section 459 of the Companies Act or a ‘fraud on the minority shareholders’ and ‘wrongdoer control’ to bring a derivative action in the name of a company at common law.

A number of procedural safeguards have been brought into the bill to meet concerns that it would make it too easy for derivative claims to be pursued by disgruntled shareholders. The financial risk of bringing a claim lies with the claimant shareholder, while any financial benefit from the action belongs to the company for the benefit of all its shareholders. The bill also prescribes that the permission of the court is required to proceed with a derivative action, and this must be refused where the claim would be contrary to the newly introduced duty of directors to promote the success of the company, or if the act or omission complained of has been authorised or ratified by the company. In other cases the court has a discretion as to whether to grant permission.

The new regime will potentially allow a broader range of claims to be brought than is the case under existing common law. There will be a degree of uncertainty until we have a body of case law establishing how the new environment will operate.

The latest reforms must be seen in the context of increasing duties placed on UK directors. Since last April directors have been at risk of criminal sanctions if they fail to provide full information to auditors covering not just what they know, but what they ought to know. They are also getting to grips with changes implemented in the wake of the Turnbull, Smith and Higgs Reports.

As directors’ responsibilities increase, so inevitably do their liabilities. Directors are increasingly seen as fair targets if there is some financial scandal or poor corporate performance. In the US large settlements were secured following class actions against the directors of WorldCom, Enron and Global Crossing. The failure of a number of high-profile claims in the UK (such as withEquitable Life) does not appear to have halted this trend. The past few years have seen the Financial Services Authority increasingly target individual officers and impose large fines on directors for regulatory breaches. It is hard to assess whether these factors are leading potential directors to decide that the risks of the job are simply not worth taking on.

Concerns were expressed in Parliament that the new UK regime for derivative actions could give rise to a culture of US-style class actions by aggrieved or even activist shareholders. The class action is a powerful tool in US litigation. It means that, through a single set of proceedings, a corporate defendant can be faced with potentially massive aggregate liability. Civil procedure in England and Wales does not permit class actions in the US sense. However, Group Litigation Orders have been allowed since 2000, whereby individual claims containing related issues of fact or law are managed together.

The trend towards increased group litigation is reflected elsewhere in Europe. Last year procedures were introduced in Germany to make it easier for claims to be pursued by shareholders or other investors in securities cases. Forms of collective action are permitted in Sweden, the Netherlands and Spain. Several other European countries, including France, Italy and Ireland, are considering proposals that would allow individual claims to be aggregated. At the same time we are witnessing a greater willingness by shareholders in Europe to take legal action to protect their position – for example, Railtrack in the UK, Deutsche Telekom in Germany and EADS in France.

The form that the action takes varies from jurisdiction to jurisdiction. Some are restricted to particular sectors or types of claim. All fall well short of the US class action regime, where class members are entitled to the fruits of the action unless they ‘opt out’ of the class.

Various aspects of US procedure, which might be seen as fuelling the class action culture, do not exist in Europe. These include the ability to advertise, the funding of actions through contingency fees, punitive damages and the absence of any rule whereby the losing party pays the winner’s costs. There does appear to be a desire in Europe not to allow the same level of compensation culture and to build appropriate safeguards into any class action procedure. However, the trend towards increased collective litigation should not be ignored.

These changes are, of course, highly political. The media increasingly draw comparisons between the way that national governments tackle a common problem. Consumer associations are increasing in power and profile. The past five years have seen a raft of new corporate governance legislation, most notably the Sarbanes-Oxley Act in the US. Governments face public criticism if their legal system does not provide a remedy for the victims of corporate misconduct. The political ramifications can be even greater where, in contrast, the laws of other countries do provide access to justice and compensation for their citizens affected by the same or similar events. Quite clearly these problems are not restricted to the UK.

Looking forward, large multinational companies may well question the benefits of trading in highly regulated environments, where the potential exposure of their directors is particularly severe. We have already seen how European companies trading or investing in the US have been exposed to class actions and enforcement action by the Securities and Exchange Commission (SEC). In 2004 there were 29 US class actions brought against non-US issuers and their directors. In the recent Shell case, the US class action brought against the company and its directors for breach of US securities laws included all Shell investors within its class, regardless of whether they were based in the US. That claim settled in August 2005 with a payment of $9.2m (£5.05m) in lawyers’ fees and an agreement to alter Shell’s corporate governance.

What can UK companies do to limit the exposure of their directors? In extreme cases they can break links with a particular jurisdiction altogether. Some have already delisted from US stock exchanges and deregistered from the SEC. High-profile examples include Premier Farnell and ITV. Second, under the Companies (Audit, Investigations and Community Enterprise) Act 2004, UK companies may indemnify their directors against defence costs and damages arising out of claims by third parties. The Department of Trade and Industry has said that ‘third parties’ should include shareholders. Finally, companies would be well advised to protect their directors through directors’ and officers’ insurance cover. Such cover may be broader in scope than the protection available through indemnities from the company.

On balance, the new bill is unlikely to prompt a significant move towards US-style shareholder class actions against directors in England and Wales. However, it should be seen in the context of an evolving regulatory landscape. Directors of UK companies will increasingly have to understand and monitor the risks faced by them and the companies they represent from regulators, investors and third parties through proceedings in the UK and elsewhere.

Richard Matthews is a partner and John Heaps is head of litigation and dispute management at Eversheds. They were assisted by associate Chris Taylor