The new derivative claim

The New Derivative Claim: Where Does The Pendulum Swing?

Introduction

One of the disputable areas in the Companies Act 2006 (‘CA 2006') is the provisions of derivative claim. A derivative claim is a claim brought by individual shareholders seeking relief on behalf of the company against the company's directors. It is believed a successful derivative claim regime should strike the right balance between ensuring effective remedies available to minority shareholders while not allowing troublesome shareholders impeding the carrying on of the proper business of the company. However, it seems the pendulum of the new statutory provision swings in favour of the managerial freedom. Whether it could be served as a tool to ensure directors being held accountable for their breach of duties is questionable.

The article is organized as follows. Section II provides an overview of the scope and the procedural framework of the new statutory derivative claim under Part 11 of CA 2006. Section III assesses the new legislation by analysing the fact that it is designed in favour of the management and fails to provide necessary incentives for minority shareholders seeking relief under derivative claim. Section IV draws some conclusions.

The New Regime Under CA 2006

It has been long established in Foss v Harbottle that the proper claimant in an action in respect of a wrong done to a company is the company itself. The decision whether to sue or not is usually made by the board of directors acting within their normal management power. However, when the people causing harm to the company are its own directors, it is clearly unsafe to let the directors decide. Hence, under special circumstances when the company is not willing to pursue its own right, individual shareholders may be allowed to bring a derivative claim.

The derivative claim under the common law has always been regarded as complicated and unsatisfactory. As a result, it was brought far less frequent than other shareholder remedies. Will the new legislation bring any changes? Will it be an effective mechanism to hold director accountable? To answer the question, we will first look at what changes have been brought under the new regime.

  1. Scope

Under the common law, the circumstances in which a derivative action may be brought are very limited. The individual can only enforce the company's claim if the breach of duty was a ‘fraud' and the wrongdoers were ‘in control'. The new statutory provision broadens the grounds for bringing a derivative claim by including cause of action 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'. It is now no longer necessary for the claimant to show that the act alleged is a fraud on the minority, so that a claim could be brought against pure negligence without demonstrating the defendant director has gained personally. Likewise, the requirement of proving ‘wrongdoer in control' ceases to be a decisive factor for the court to consider. This makes it possible for a derivative claim to be brought in a public company where shares are widely dispersed.

  1. Procedure

Despite the general expansion of the cause of action, a safeguard is set in place to protest against the risk of a torrent of vexatious or groundless claims against the management. A two-step procedure has been adopted in the CA 2006.

First, the shareholder, by submitting paper documents, must establish a ‘prima facie' case for being given permission to proceed. The company is not required to be involved in the first stage. If the evidence submitted by the claimant is forthcoming, the court will then proceed to the second stage and order the parties to prepare for a full hearing of the shareholder's application.

At the second stage, the court must consider whether to grant permission to the shareholder to proceed with the action by reference to a series of factors. By s 263(2) of CA 2006, the court must deny permission if a hypothetical person acting in accordance with the duty to promote the success of the company would not seek to continue the claim. The bar to a derivative claim proceeding is also imposed where the matter complained of was authorised in advance or ratified since it has occurred.

S 263(3) and (4) further set out factors which the court must take into account when exercising its discretion to grant permission to continue a derivation claim, namely:

  1. whether the shareholder is acting in good faith;
  2. the importance a director acting for the benefit of the company would attach to continuing the action;

  3. the likelihood of prior approval or subsequent ratification by the company;
  4. whether the company has decided not to pursue the claim;

  5. whether the shareholder could bring a personal claim;
  6. the views of those who have no personal interest in the matter.

If the court ultimately grants permission to continue a derivative claim, the action will then be conducted in the same way as ordinary proceedings.

Assessment Of The New Derivative Claim

Concerns have been expressed that the widening of the scope of the new statutory provisions could be abused as a tactical litigation tool by activist shareholders and hence lead to a torrent of derivative claims. However, after more than two years since Part 11of CA 2006 has been in force, we have not seen the flood of shareholder actions brought under the new framework. In fact, few cases of shareholders trying to use the procedure have been reported so far and two have failed at an early stage. The fact that the new legislation remains in favour of the management and its failure to provide incentives to minority shareholders who wish to bring a derivative claim are the main reasons why the tool is still seldom used.

  1. Balance In Favour Of The Management

There has been nervousness among industry bodies that the new derivative claim procedure will make it easier for individual shareholders to bring claims against directors. Their main concern is the expansion of the cause of actions under the new legislation combined with the codification of directors' duties under Chapter 2 of Part 10 of CA 2006 will open the floodgate of derivative claims. However, directors may feel much comfortable if they understand that the balance of the new law still remains in favour of them.

First, the new legislation does not change the established rule in Foss v Harbottle. In fact, the government has never intended to alter the tradition of court's reluctance to intervene with the business management. The Law Commission made it clear in its final report:

Our view was that the basic approach to the right to bring a derivative action was a sound one: an individual shareholder should only be able to bring such an action in exceptional circumstances.

Part 11 of CA 2006 adopted most of the recommendations of the Law Commission. It is, in essence, not a substantive rule designed to replace the Foss rule, but a modified procedure for bringing actions based on the existing rules.

Second, it seems directors could be too well protected by the new procedure if the court's attitudes towards derivative claim do not change. As is mentioned, the concerns raised by directors are largely focused on the inclusion of pure negligence as a cause of action. However, the issue of breach of duty will not be addressed unless the minority shareholder survives the two-stage procedural threshold provided under CA 2006. The two-fold procedural hurdle is intended to safeguard the company and its directors from being harassed by frivolous shareholders. However, it might go too far and provide too much protection for directors by denying minority shareholders a better prospect of obtaining permission to continue.

Except for the two circumstances under which the court is required to deny permission to pursue the derivative claim, judges have extensive discretional rights on the issue with reference to criteria laid down in s 263(3) and (4). It is believed whether directors are exposed under the risk of increasing lawsuits and whether the new derivative claim could be an effective governance tool will largely depend upon how the courts discharge the wide discretion entrusted on them.

It is doubted the traditional suspicion of the English courts towards derivative claims will be changed. Though it is still early to draw conclusion before a body of case law have developed under the new legislation, two cases (Mission Capital Plc v Sinclair and Franbar Holdings Ltd v Patel) reported since Part 11 came into force in October 2007 may provide some reference regarding the court's traditional reluctance to allow derivative claims to continue.

It is noteworthy that the two reported cases have both been denied permission to continue. The court found that the circumstances of mandatory refusal did not exist in either case. It went on to consider the discretional factors, and two of them are identified as of particular importance.

One factor is the importance that a person acting to promote the success of the company would attach to continuing the claim. The court in both cases applied the hypothetical director test in s 263(3)(b) and found that from the view of a hypothetical director acting for the benefit of the company, the claim has low importance. It seems the court also adopted a relatively restrictive approach in the hypothetical director test as the considerations William J regarded in the Franbar case as of relevant were fairly wide:

In my judgment, the hypothetical director acting in accordance with section 172 would take into account a wide range of considerations when assessing the importance of continuing the claim. These would include such matters as the prospects of success of the claim, the ability of the company to make a recovery on any award of damages, the disruption which would be caused to the development of the company's business by having to concentrate on the proceedings, the costs of the proceedings and any damage to the company's reputation and business if the proceedings were to fail.

The other discretional factor was whether alternative remedies were available to the claimants. In particular, the availability of the remedy under s.994 to initiate a claim against a prejudicial conduct became the decisive reason for the court to deny permission in the Franbar case. This echoes the English court's tradition to view derivative claim as the last resort rather than the first port of call.

Although it is still too early to draw hasty conclusion that English court will continue to be hostile against derivative claims, it is reasonable to expect a continuance of tight judicial control of cases brought under the new procedure. The court's reluctance to meddle with the company's internal management and the high procedural threshold provided by the new derivative claim indicate that the balance is still in favour of directors.

  1. Disincentives Facing Minority Shareholders

The fact that few derivative claim cases under the new regime have been reported may not be a good example to illustrate the question, as the new law has not been in force for long. However, we may answer the question by exploring the incentives, or rather, the disincentives the new law has provided to minority shareholders.

The new legislation's balance in favour of managerial freedom is itself a disincentive to prospective claimants. As Resiberg has observed,

If the court is effective in weeding out cases where the derivative claim is brought to further the personal interests of individual shareholder, one may wonder what incentives the shareholders will have to seek the court's leave to sue on behalf the company.

The new procedure's failure to address the issues of cost and free-rider will further deter individual shareholders from using derivative claims. A derivative claim is brought by individual shareholder in the interest of the company. However, the cost and expenses of the action is borne by the individual shareholder unless the court issues a Wallersteiner order. Since most of the potential claimants are minority shareholders with difficulty to finance the action, are they willing to take the risk that they may not be indemnified by the company? Furthermore, there is the free-riding problem. If the derivative claim is supported by the court, the remedy is not awarded to the individual shareholder. It is the company and all the members of it that benefit from the positive result. Hence, it is difficult to see what incentives there are for individual shareholders to bear a private cost for other shareholders. Disappointedly, CA 2006 does not make any specific provisions addressing these issues.

The new procedure' also fails to achieve greater clarity and less complication. In order to obtain court's permission to pursue the claim, a two-step threshold is placed in front of the claimant. To potential claimant, it implies lengthy hearings at the early stage, not to mention the difficulty to meet all the criteria listed under s.263 (2) and (3).

Last but not least, is the problem of information accessibility. Minority shareholders' limited access to corporate information makes it difficult to provide adequate evidence to support the alleged breach of duty by directors. The new procedure does not attach much importance to the issue; however, it does contain related provision under s 261(3), which sets out that the court may require the evidence be provided by the company if the applicant succeeds to establish a prima facie case for the grant of permission. Whether the powers granted to the court will be enough to tackle the problem remains unknown.

Conclusion

To sum up, the lack of incentives provided by the new legislation together with the court's traditional reluctance to intervene suggest that an abuse of derivative claims is unlikely. Instead, the new procedure's balance favouring management might be a sign that the amount of derivative claim cases will remain low. Individual shareholders seeking corporate relief will hardly regard the new derivate claim as an ideal tool when the procedure works in favour of the directors instead of minority shareholders.

Bibliography

Cases

Foss v Harbottle 67 E.R. 189

Franbar Holdings Ltd v Patel [2008] EWHC 1534 (Ch)

Mission Capital Plc v Sinclair [2008] EWHC 1339 (Ch)

Legislation

Companies Act 2006

Books, Articles And Other Sources

Arsalidou, D, ‘Litigation Culture and the New Statutory Derivative Claim' (2009) 30 The Company lawyer 205

Dignam, A and Lowry, J, Company law (5th edn OUP, Oxford 2009)

Keay, A and Loughrey, J, ‘Something Old, Something New, Something Borrowed: An Analysis of the New Derivative Action under the CA 2006' (2008) 124 LQR 469

Law Commission, ‘Shareholder Remedies' (Law Com No 246 Cm 3769, 1997)

Reisberg, A, ‘Derivative Claims Under the Companies Act 2006: Much Ado About Nothing?' in John Armour and Jennifer Payne (eds), Rationality in Company Law: Essay in Honour of DD Prentice (Hart Publishing, 2009) < https://www.ucl.ac.uk/laws/economics/WP/WP%2001-08.pdf> accessed 14 January 2010

Sealy, L and Worthington, S, Cases and Materials in Company Law (8th edn OUP, Oxford 2008)