Policy of Not Hearing Members Against Company

It has been more than 150 years since the Court of Chancery passed its’ seminal judgment in Foss v Harbottle. [1] The case itself gave birth to the infamous “Rule in Foss v Harbottle [2] “, which is use to depict the courts policy of not hearing a claim which concerns the affairs of a company brought by a member or members of the company. According to Lord Davey in Burland v Earle [3] , the policy itself is manifested in three principles. First, the “Proper claimant” principle which states, the company itself is the proper claimant to the alleged wrong done to it. Second, the “Internal management” principle, which illustrates the courts’ lack of enthusiasm to interfere with an alleged wrong the company is competent in dealing with. Third, the “Irregularity principle” during which in cases of irregularity, no member is permitted to bring an action if the act itself can be condone by internal procedures. Although the rule appears inherently logical, it remains a rule that is likely to exclude certain forms of legitimate action to redress breaches of directors’ duties. Accordingly this formed the basis for the exceptions that have been devised by the courts to enable minority shareholders to pursue such an action where the company is either unwilling or unable to do so. [4] These so call “exceptions”, are vital components forming part of the enforcement mechanisms in preserving the “equilibrium” of corporate governance.

The Cadbury Committee defines corporate governance as “the system by which companies are managed and controlled.” [5] In other words, it is the quintessential tool in ensuring that the company is properly directed and steered. Lessons can be learned from high profile scandals such as Enron, Worldcom, and Parmalat, followed by the burst of the global financial bubble in 2008 which triggered market hysteria about the misgivings in corporate governance regulations. [6] It is by fostering better regulatory compliance only then can the company attain the necessary momentum towards achieving a higher altitude of growth. This paper shall attempt to provide a roadmap of the enforcement mechanisms made available to the disgruntled shareholder. For this purpose, the structure of this essay is divided into four parts. Part 2 deals with derivative claims. Part 3 deals with the unfair prejudice remedy. Part 4 addresses the area of just and equitable winding up. Part 5 then attends to the question as to whether a species of multi-party litigation, the class action would serve as a better protection for shareholders.

2.0 Derivative claims

2.1 Common law derivative claims

It may be the case that when a wrong is done towards the company, the offending officers may well block the commencement of an action through being in control of board meetings. As such, in order to do justice to the company, individual shareholders were under limited circumstances permitted to bring an action on behalf of it. This was an exception to the proper claimant principle of the “Rule in Foss v Harbottle” [7] .Known as a derivative claim, in bringing proceedings to enforce a right of the company, a member is said to be deriving a right of action from the company. Thus the derivative claimants claim will be in the representative capacity of the company as held by Chadwick J in Cooke v Cooke. [8] Prior to the Companies Act 2006, the common law derivative claim took a rather restrictive approach, making it almost inaccessible for shareholders to bring a claim. A derivative claim was only permitted to be brought forward if the company was under the control of the wrongdoer and there had been a “fraud on the minority” which could not be ratified by the shareholders in a general meeting. The uncertainties relating to the meaning of control in the “fraud on the minority” exception and the fact that fraud has been interpreted to exclude negligence unless the negligence confers a benefit on the controlling shareholders [9] has restricted the ease of budding claims benefiting from derivative claims. Very few claims were reported under common law as seen from their infrequent appearance in case law. [10] Payne has drawn attention to the fact that the courts deliberately made the derivative claim cumbersome to protect the company against the single, irritating and misjudging shareholder who would waste the company’s money if allowed to litigate on the company’s behalf. [11] This was evidenced in Barrett v Duckett [12] where the court in deciding that the claim was not pursued bone fide on behalf of the company, refused to allow the derivative claim. This restrictive approach coupled with the fact that a derivative claim only permits a member to bring an action on behalf of the company, remains one of the weaknesses of derivative claims as a basis of protection for shareholders.

2.2 Statutory derivative claims

On account of the complexities of the common law, the Law Commission supported the foreword of a statutory derivative action, which was supposedly to rise to a more modern, flexible procedure, providing an accessible criterion in determining whether a shareholder should be able to pursue the action. [13] Its principle aim was to deal with technical hitches brought forth by the “fraud on the minority”. These were namely the scope of the acts which constitute a derivative action and the issue with regards to the wrongdoers’ control. Chapter 1, Part 11 of the Companies Act 2006 “remedied” the former by extending the right to instigate proceedings beyond situations of “fraud on the minority”. The new statutory derivative claim now covers acts 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. [14] The later barrier was treated by empowering the courts, for the sake of granting permission, to be more involved in order to determine the circumstances alleged. [15]

Despite wider grounds for action, the new regime is accompanied by additional procedural hurdles which an individual shareholder had to overcome in order to succeed in the new statutory derivative claim. According to the Solicitor-General, such purpose was “to ensure that unmeritorious claims are dismissed at the earliest possible stage without involving the company itself.” [16] In other words, the purpose of introducing the statute was to deal with the complications with regards to the “fraud on minority” exception rather than to replace the entire “Rule in Foss v Harbottle.” [17] The fact that minority shareholder derivative claims are subject tight judicial control at all stages gives you further ideas about the weaknesses of a derivative claim in enforcing shareholders rights. Minority shareholders may be dissuaded in pursuing a derivative claim on account of the cumbersome procedural hurdle he or she has to undergo for the mere purpose of enforcing a right.

The “filtering process” begins with an application to the court for permission to continue the claim. [18] Additionally, the shareholders would have to inform the company of the claim and the application. Section 261 of the Companies Act 2006 requires the court to consider an application for permission to continue a derivative claim in two stages. First, the court must only consider the issue based on the evidence filed and then decide whether there exists a prima facie case based on the evidence. If the court is not convinced that there exists a prima facie case, the court must then dismiss the application. In the event of that happening, within seven days, the shareholder may request the court to re-evaluate the decision at an oral hearing. Then again, if the court is convinced that there exists a prima facie case, stage two begins with the court giving directions for the company to file evidence, which will be considered at a full permission hearing. A permission to proceed will be barred if one of the following two grounds is present. First, if a hypothetical member of the company, acting in accordance with the duty to promote the success of the company would not seek to continue the claim. [19] Second, the act or omission complained of has been authorised or ratified by the company. [20] Otherwise, the court will then have to take into consideration the principles laid down under Section 263(3) of the Companies Act 2006 before granting the “go ahead”.

2.3 Indemnity order in a derivative claim

In addition to being subject to tight judicial control at all stages, minority shareholders pursuing a derivative claim should also bare in mind the cost implications of bringing such a claim. One of the obvious financial disincentives of bringing a derivative claim is that upon a successful action, the recoveries will go to the company. The minority shareholders would then only benefit upon pro rating their shareholding. Further to that, as a result of the “loser pays” principle being applied to cost, had the derivative claim been unsuccessful, minority shareholders are thus faced with potential liabilities of not only having to pay for their own legal cost, but also for the defendant’s as well. Also unlike an unfair prejudicial petition, a claimant shareholder is not entitled to legal aid in pursuing a derivative claim. [21] It would be difficult to imagine how a claimant shareholder, having suffered a lost as a result of others would be able to carry on pursuing the claim if there is no adequate provision for cost. As Sugarman stated, “despite the introduction of case management, powerful parties will continue to enjoy a tactical advantage over their opponents…by additional expenditures and access to specialized legal services.” [22] Fortunately the position was partially mitigated with the introduction of Wallersteiner v Moir [23] , where the court held that it would be appropriate for the company to indemnify the claimant shareholder in respect of cost irregardless of whether the claim is successful or not. Nonetheless, such entitlement would not be established sooner than the initial application to the court for permission to commence a derivative claim. [24] Hence, the claimant shareholder would still bear the risk of being liable to pay cost at the preliminary hearing. Indeed, in Prudential Assurance Co v Newman Industries [25] , the derivative action procedure was referred to as “lamentable litigation” because of its “horrendous cost.” [26] Additionally, there also remains this constant debate as to whether the net result of such actions is to bring benefits to, or generate costs for, companies, financial markets, and the economy as a whole. [27] Even the issue as to whether a derivative claim would protect or bring forth any benefits to shareholders is far from settled. [28]

Derivative claims have come a long way since its days in the common law as an exception to the “Rule in Foss v Harbottle”. [29] Commentators have described the new development as a “massive lowering of the hurdle which will make it very easy for shareholders to commence claims.” [30] Nevertheless, regardless of its imperfection, a derivative claim remains one of the essential tool which allows for proper corporate governance.

3.0 The Unfair Prejudice Remedy

3.1 The “Oppression” Remedy

Owing to inadequacy of the exceptions to the “Rule in Foss v Harbottle” [31] , the Cohen Committee [32] made recommendations which led to the introduction of Section 210 of the Companies Act 1948. The section paved the route for members to petition the Court if the affairs of the company were conducted in an oppressive manner. In order to succeed in a claim, the petitioning shareholder had to establish that it was just and equitable for the court to make an order to wound up the company and that the section was a more suitable remedy as oppose to the alternative winding-up provision. Unfortunately, the success story of the so call “Oppression remedy” is not one which Parliament intends to boast about. There were many short comings, which included the narrow definition given to the term “oppression”. Lord Simmonds in Scottish Co-operative Wholesale Society v Meyer [33] , defined the term “oppression” to mean, “burdensome, harsh and wrongful”. [34] It was this austere definition which limited the application of the section to only two successful actions. [35] Further restrictions included the need to establish a continuing course of oppressive conduct [36] and that such conduct affected the petitioning member, qua member [37] . Authors such as R. Instone, in conceding to the limitations of the section said that “it is this limitation which long ago gave rise to a general recognition that the section was inadequate”. [38]

3.2 The Current remedy: Section 994 Company Act 2006

In acknowledging the minute amount of successful cases reported, the Jenkins Committee recommended the provision be amended by replacing the phrase “oppressive conduct” with that of “unfairly prejudicial”. Further amendments were made by removing the pre-requisite of having to justify equitable winding up. The amendments made initially took the form of Section 75 of the Companies Act 1980, followed by Section 459 of the Companies Act 1985. The relevant rule can now be found under the new regime, that is Part 30(Sections 994-999) of the Companies Act 2006 which gives the court extensive powers to remedy conduct of a company’s affairs “that is unfairly prejudicial to the interests of its members generally or of some part of its members.” [39] The Act therefore has curbed one of the major deficiency of derivative claims by enabling any [40] member of the company to pursue a claim that is unfairly prejudicial to the member himself and or his co-members. As the Law Commission commented “the unfair prejudice remedy has in essence become an exit remedy, which ensures that an aggrieved shareholder can leave the company with proper compensation.” [41]

A brief glance through the relevant provisions of the Act would reveal that no specific definition is given to define the terms “unfair” and “prejudice”. Indeed in its 1997 report [42] , the Law Commission resisted calling for any statutory definition of the terms. Instead common law is relied upon in defining the terms. Neils LJ in Re Saul D Harrision and Sons plc [43] said that “the words ‘unfairly prejudicial’ are general words and they should be applied flexibly to meet the circumstances of the particular case…” [44] However his Lordship went on to say that it would not be sufficient if the conduct satisfies merely one out of the two elements. There is no pre-requisite that the concept of unfairness must confer some element of bad faith. [45] Instead, the presence of unfairness is to be determined objectively. In following the previous decision of O’Neill v Phillips [46] , Jonathan Parker J in Re Guidezone [47] said that “unfairness is not be to be judged by reference to subjective notions of fairness, but rather by testing whether, applying the established equitable principles, the majority has acted or is proposing to act, in a manner which equity would regard as contrary to good faith.” [48] With regards to the notion of “prejudice”, according to Harman J in Re Unisoft Group Ltd(No 3) [49] , prejudice must be “harm in a commercial sense, not in a merely emotional sense.” [50] Nonetheless, this does not necessarily mean that a petition for an unfairly prejudicial conduct should be limited to cases concerning serious diminution in the value of the members’ shareholdings. It is submitted that prejudice may manifest in a number of ways ranging from those arising out of a legitimate expectation to conducts that are detrimental to the interest of the company, which may include an oppressive conduct [51] , an abuse of power [52] , failure to pay dividends [53] , and cases of serious mismanagement. [54]

As mentioned in the above paragraph, the notion of “prejudice” has been interpreted in such a fashion as to encompass not only acts that are contrary to the company’s constitution and the general law but also “legitimate expectations.” Such expectations may arise “out of a fundamental understanding between the shareholders which formed the basis of their association but was not put into contractual form.” [55] This concept of “legitimate expectation” can be traced back to the 1973 case of Ebrahimi v Westbourne Galleries Ltd [56] where Lord Wilberforce held that in certain circumstances equity permits the court to subject the exercise of legal rights to “personal characters arising between one individual and another, which may make it unjust, or inequitable, to insist on legal rights, or to exercise them in a particular way.” [57] In general, the court’s recognition of a legitimate expectation will require the petitioner shareholder to point to some sort of arrangement or understanding [58] . While the rights of members are attached to the company’s constitution as well as the many statutory rights found within several companies’ legislation, none of them takes into account the interests of the members [59] . It is therefore humbly submitted that the concept of “legitimate expectation” may have induced the courts to pay closer attention to those agreement and understandings between members, indirectly according better protection to the interests of the member. However, the concept is not as pristine as it seems as it only applies to quasi-partnership companies. This was confirmed in Re Astec (BSR) Plc [60] in which Jonathan Parker J. concluded that “the concept of ‘legitimate expectation’ … can have no place in the context of public listed companies.” [61]

3.3 For the better protection of shareholders

Section 996(1) of the Companies Act 2006 empowers the court “to make such order as it thinks fit for giving relief in respect if the matters complained of.” Section 996(2) gives a list of orders available to the court, in spite of which the most common order would be an order for the majority shareholder to buy out the petitioners’ shares. Not only does a buyout order provides a personal remedy to the aggrieved shareholder, but also since compensation is borne by the wrongdoer director, there will be no reduction in the company’s assets. However, there are issues with regard to the valuation of shares in a buyout which require special considerations. For instance, a petitioner in seeking the court to grant a buyout order must not do so without first attempting to exercise any rights given by the company articles to offer the shares to the other members at a fair price. [62] It is submitted that a “fair value” may not always reflect the true “market value”. This was acknowledged by Hoffman J in Re a Company (No 006834 of 1988) ex parte Kremer ,who said that the prescribed valuation‘… has a rough and ready aspect to it, and will not be nearly as fine-toothed as a valuation carried out before the court.’ [63] Unfortunately Hoffman J went on to conclude that it would be quicker and cheaper to do so and that it was not unfair for the petitioner to be bound by the articles.

In addition, there has also been some disquiet about the way the unfair prejudice provisions have been operating in practice. This is with particular reference to the cost of proceedings. In Re Unisoft Group Ltd(No 3) [64] , Harman J made mention of the fact that the “Petitions under[CA 2006, s994], have become notorious to judges of this court..for their length, their unpredictability of management, and the enormous and appalling costs.” [65] It is submitted that the overall net result can be that the cost go beyond the value of the shares being fought over. For instance in Re Elgindata [66] the cost of £320,00 were incurred while arguing over shares worth a mere £24,600. Authors such as Sealy have argued that:

“the fact that litigants continue with these cases may reflect more on depth of personal animosity involved than a desire for compensation for financial loss, but it is an important criticism of the legal system that it cannot provide a simpler method of dealing with such disputes and requires so much publicly funded court resources to be devoted to them”

As a result of problems of excessive length and cost, the Law Commission have considered several methods in reforming the unfair prejudice proceedings. [67] For instance, recommendations were made for an arbitration scheme to deal with disputes which might otherwise be taken to court under Section 994 of the Company Act 2006. In its White paper [68] , the government made clear of its intentions to consult Alternative Dispute Resolution providers in identifying the best way forward for the new arbitration scheme [69] .

The law has come a long way since its early days in dealing with the oppression remedy. Despite minor technical hitches here and there, the advent of the now Sections 994-996 of the Companies Act 2006, as according to Bryan Clark, was “herald as a giant step forward for the rights of minority shareholders.” [70] By paving new ways for the enforcement of rights, the relevant provisions gave what was necessarily a “face lift” towards the protection of minority shareholders. It is not contended that the unfair prejudicial remedy is the ultimate enforcement mechanism; nonetheless it remains one of the better sought after enforcement tools in maintaining the system of corporate governance.

4.0 “Just and equitable” winding up

Ever since its introduction in the 1980’s, the unfair prejudice remedy was seen as a better alternative to what many have termed the “sledgehammer” remedy under Section 122(1)(g) of the Insolvency Act 1986. The obvious reason for this was due to the potential obliteration a winding-up order would cause to an otherwise viable business. As Lord Wilberforce said in Cumberland Holdings Ltd v Washington H Saul Partinson [71] , “…to wind up a successful and prosperous company and one which is properly managed must clearly be an extreme step.” [72] The following paragraph shall explore the mechanism behind the “just and equitable” winding-up remedy as an alternative, though least favourable, mean for minority shareholder protection.

Section 124 of the Insolvency Act 1986 grants the necessary standing to a present member of a company to make an application requesting the court to order that the company be wound up. This is by virtue of the member being a “contributor” of that company. The member however must have a sufficient interest in having the company wound up. [73] Thus a member whose shares are fully paid up is barred from petitioning an order unless dividends will be made available to the member upon winding up. [74] Upon a petition being made, the court must then by virtue of Section 122(1) (g) of the Insolvency Act 1986 consider whether it would be “just and equitable that the company should wound up.” In the absence of a statutory definition, common law is referred to in an attempt to give a meaning to the phrase “just and equitable”. In Ebrahimi Westbourne Galleries Ltd [75] Lord Wilberforce attempted to provide some guidance by saying that a contributory petitioning under Section 122 (1) (g) may rely “upon any circumstances of justice or equity which affect him in his relations with the company, or …with other shareholders.”