Dual Role of Company

5145 words (21 pages) Essay in Business Law

02/02/18 Business Law Reference this

Last modified: 02/02/18 Author: Law student

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A company incorporated under the Companies Act has a dual role in nature firstly being an association of its members and secondly being a person separate from its members. Section 112 of the Companies Act 2006 defines a member of a company, whom are the subscribers of a company’s memorandum having agreed to become members of the company. In other terms, membership of a commercial limited company is based on holding of shares in the company which are issued in return for contributed capital [1] . Since a company is a legal person distinct from its shareholders, it follows that a wrong to the company is not a wrong to each shareholder, and further that the shareholders are not liable for the wrongs of the company.

In certain circumstances, when applying ordinary principles governing whether a duty of care or a duty of a fiduciary nature exists between two parties, a shareholder may have a personal cause of action for breach of duty owed to that shareholder by a person involved in the affairs of a company, including a director or a shareholder, or an outsider such as an auditor or other professional person involved in its affairs [2] .

The rights any shareholder has in any particular company depend on the company’s memorandum and articles of association. The general situation is that in return for investing in a company, a shareholder gets a bundle of rights in the company which may vary according to the type of shares acquired. Most companies only have one class of shares (ordinary shares) but the law in the United Kingdom is extremely flexible and allows other classes of shares to be created. This is done by setting out the different rights attached to the various classes (usually set out in the company’s articles or in the shareholder’s agreement) [3] .

The general powers exercisable by the members (shareholders) in a certain company are provided by the Companies Act 2006 (CA hereinafter) and the Insolvency Act 1986 (IA hereinafter). These include the right to amend the articles of association (s.21 of CA), to reduce share capital (s.641 of CA), the power to dismiss directors (s.168 of CA), power to petition for compulsory liquidation (s.122 of IA), and many other reserved rights.

The issue that arises in company law most of the time is the degree of indifference between the treatment of minority with the majority shareholders of a company. Within companies, problems may arise; where the majority shareholders conspire to outvote the minority shareholders to achieve their own objectives, or when the majority shareholders are also the directors of the company are able to pass resolutions and/or ratify any decision which they may take [4] .

One of the issues that commonly arise is what happens when the minority shareholders disagree with the majorities’ (who are also the directors) decisions and what are the rights of the minority against majority? The general rule in Foss v Harbottle (1843) [5] translates the doctrine of separate legal personality, the statutory contract and the principle of majority rule into a rule of procedure governing ‘locus standi’ [6] . In that case, it was held that the company itself (rather than the individual shareholder) is the “proper plaintiff” in any action where there is an alleged wrong against the company. This is perfectly in keeping with the doctrine of corporate personality but is harsh for minority shareholders because very often it is the directors who have committed the alleged wrongdoing [7] .

The anxiety of the law is to strike an optimum balance between the principle of majority rule on the one hand, and safeguarding minority shareholders against abuses of power, on the other. However it would appear that minority shareholders are in a particular weaker position within the company’s matrix as the effect of the principle of majority rule gives considerable power to those who control the board of directors or the general meeting [8] . As always the issue in most company law cases, the minority shareholders are always left without an apparent remedy because the majority shareholders whom are also the directors will not approve the company taking legal action against themselves (“proper plaintiff” rule).

Therefore the question posed is how can these minority shareholders then bring an action against the wrongdoers (majority shareholders whom are also the directors)? Well, this essay is split into two halves. The first part of the essay looks at the enforcement strategies and avenues the shareholders of a company may seek to protect their rights, both in common law and under statute namely derivative actions, unfair prejudice and just and equitable winding up. The second part of the essay takes a look at the advantages and disadvantages of shareholders bringing a class action litigation against the company and whether it further helps protect shareholders rights.

Derivative Action

Shareholders in UK companies have the ability to bring a minority shareholders’ action against errant directors as a derivative action. A derivative action is defined as an action brought by minority shareholders on behalf of a company in respect of a wrong done to the company [9] . It is described as “derivative” because the shareholder’s right to sue is not personal to him but derives from a right of the company but which the company has failed to exercise [10] . The main purpose of a derivative action is to protect the company by bringing actions which the company’s management itself will bring on behalf of the company and typically they involve allegations of management misconduct [11] . The decision to commence litigation in the company’s name is a normally a corporate action, and one which is usually made by the company’s board of directors. A derivative action, if authorised, bypasses these procedures so as to permit a minority shareholder to bring an action on the company’s behalf, constituting an exception to the ordinary principle of corporate action; the principle of majority rule [12] .

Prior to the enaction of the CA, the derivative action was relied and made available only if it falls under an exception in the rule of Foss v Harbottle (1843) [13] under the common law action. As stated earlier, the common law rule in the case of Foss v Harbottle (1843) [14] was that individual members of a company cannot bring an action against the company as the separate legal personality of the company meant that only the company could have suffered the loss and so only the company could bring an action. However there are exceptions to this “proper plaintiff” rule which would allow a shareholder to enforce his rights against errant directors of the company which includes amongst others the act complained of is illegal or is wholly ‘ultra vires’ the company [15] , where the matter in issue requires the sanction of a special majority [16] , where a member’s personal rights have been infringed [17] , or where a fraud has been perpetrated against the company and where the wrongdoers are in control [18] .

The scope for a derivative action has now increased dramatically with the new provisions in CA. A derivative claim can now be brought only under part 11, Chapter 1 (sections 260-264) of the CA (more commonly known now as a statutory derivative claim). The statutory derivative action completely replaces the common law rule in that the shareholders are no longer required to establish either wrongdoer control or a fraud on the minority to be able to pursue a derivative claim [19] . Rather than enshrining the common law into statute, the new sections 260 to 269 of CA introduces a wider range of circumstance in which a derivative claim may be brought by shareholders. These changes allow shareholders to pursue a derivative claim 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 [20] .

Once derivative proceedings have commenced, the petitioner shareholder must notify the company of the claim and must obtain the court’s permission (leave) to pursue the claim (section 261 of CA). CA establishes a two part process for obtaining permission; the courts must establish there exist a ‘prima facie’ case and consider a number of factors in deciding whether or not to grant leave (permission). Under the first part (establishing a ‘prima facie’ case), the courts must consider the issue merely on the basis of the evidence adduced by the shareholder and thereafter reason out if there is a case to answer. If none, then the case is dismissed. However if the answer is yes, then the court moves on to the second part of the test to decide as to whether to allow or refuse permission to continue the claim if it is satisfied that a person acting in accordance with the duty to promote the success of the company would not bring the claim, or if the act or omission complained of has been authorised or ratified by the company (section 263(2) of CA).

Therefore, the court must consider a number of factors before deciding as to whether or not to give permission. This includes whether the company has decided not to pursue the claim (section 263(3)(e) of CA), whether the claim would promote the company’s success ( Section 263(2)(a) of CA), whether there has been any authorisation or ratification of the act or omission giving rise to the claim (section 263(2)(b) and (c) and 3(c) and (d) of CA), whether the shareholder is acting in good faith in seeking to continue the claim (section 263(3)(a) of CA), and also to consider the views of disinterested members (section 263(4) of CA) [21] .

However, the court will not allow a derivative action to be brought or continued where a company goes into liquidation. The rationale was that the liquidator then has the statutory power to litigate in the company’s name under section 165 of IA [22] . It was held in Fargro Ltd v Galfroy (1986) [23] that once a company goes into liquidation, the liquidator takes control of the company’s affairs from the alleged wrongdoers and a shareholder may apply to the court to order the liquidator to bring proceedings in the name of the company in the event the liquidator refuses to bring an action in the name of the company.

On the other hand, minority shareholders considering a derivative action may incur financial disincentives. If a derivative action is successful, the recoveries will go to the company. However, the principle of ‘loser pays’ applies to costs meaning that if a derivative action is unsuccessful, the minority shareholder faces potential liability not only for their own legal costs, but for the defendant’s as well [24] . Further the minority shareholder’s benefit is only ‘pro rata’ to their shareholding [25] . In Wallersteiner v Moir (No 2) (1975) [26] , it was held that the shareholder who initiates the derivative action may be entitled to be indemnified by the company at the end of the trial for his costs provided he acted reasonably in bringing the action [27] but the case of Halle v Trax BW Ltd (2000) [28] held otherwise. However, any such entitlement for cost would not be established before the initial application to the court for permission to commence a derivative action, hence the claimant shareholder would still bear a significant risk relating to the costs at the preliminary hearing [29] .

It is most likely that a shareholder seeking redress would prefer to bring a claim on grounds of unfair prejudice (as discussed below) under the new section 994 of CA rather than commencing a derivative action with the prospect of recovering damages on its own behalf and not for the company [30] .

“Unfair Prejudice”

The second enforcement strategy a minority shareholder may take into account is the use of the statutory remedy for “unfair prejudice” in quantifying shareholder actions to enforce breaches of directors’ duties. The relevant provision, which was originally introduced in 1980, then re-enacted as section 459 of the Companies Act 1985, is now section 994 of the Companies Act 2006 [31] . Section 994 of CA provides that “A member of a company may apply to the court by petition for an order on the ground either that the company’s affairs are being or have been conducted in a manner that is unfairly prejudicial to the interests of members generally or of some part of its members or, that an actual or proposed act or omission of the company (including an act or omission on its behalf) is or would be so prejudicial”. Thus, the courts have to examine carefully the meaning of the terms “interests of members” and “unfairly prejudicial” as both these elements must be present to succeed the claim of “unfair prejudice”.

In establishing the first element, the petitioner must prove that his interests qua member have been unfairly prejudiced as a result of conduct on the part of the company [32] . The case of Re A Company ex p Schwarz (No 2) (1989) [33] held that the conduct complained of must be both prejudicial in the sense of causing prejudice to the relevant interests and conducted unfairly. The House of Lords in O’Neill v Phillips (1999) [34] stressed that the qua member requirement should not be too narrowly or technically construed [35] . The use of the term “interests” is designed to be expansive in effect, thereby effectively avoiding the straitjacket which terminology based on the notion of legal rights would impose on the scope of the provision [36] . The interests of a member are not necessarily limited to the strict legal rights conferred by the constitution of a company, as accordingly a member’s interests can encompass the legitimate expectation that he will continue to participate in management as a director and his dismissal from that office and consequent exclusion from the company’s management may be unfairly prejudicial to his interest as a member [37] . A member’s interest is not, therefore, limited to his strict legal rights, but can extend to legitimate expectations arising from the nature of the company and agreements and understandings between the parties [38] .

In establishing the second element, there must always be a causal link between the conduct complained of and the unfair prejudice suffered by the shareholder [39] . The test as to what amounts to unfair prejudice is objective, therefore a member will be able to establish prejudice where he can show that the economic value of his shareholding has been seriously diminished or put in jeopardy [40] . Although it is not necessary for the petitioning shareholder to show that anybody acted in bad faith or with the intention of causing prejudice, the courts however will regard the prejudice as unfair if a hypothetical reasonable bystander would believe it to be unfair [41] . Fairness is judged in the context of a commercial relationship, the contractual terms of which are, in the main, set out in the articles of association of the company and in any shareholders agreement [42] . In the case of O’Neill v Phillips (1999) [43] , Lord Hoffman commented that a member of a company will not ordinarily be entitled to complain of unfairness unless there has been some breach of the terms on which he agreed that the affairs of the company should be conducted. In Re Guidezone Ltd (2000) [44] , Justice Jonathan Parker reaffirmed Lord Hoffman’s judgment in O’Neill v Phillips (1999) [45] by stating that “unfairness” is not to be judged by reference to subjective notions of fairness, but rather by testing whether, applying established equitable principles, the majority has acted, or is proposing to act, in a manner which equity would regard as contrary to good faith.

Unfair prejudice is a flexible concept, and incapable of exhaustive definition. The categories of conduct which may amount to unfairly prejudicial conduct are not closed [46] . Some examples of conduct on which a petition of “unfair prejudice” may be grounded are exclusion from management [47] , mismanagement [48] , and breach of directors’ fiduciary duties etc [49] . The remedies for a petition based on “unfair prejudice” are Orders the court may make under section 996 of CA. Under this section, the court may regulate the conduct of the company’s affairs in the future, require the company to refrain from doing or continuing an act complained of, authorise civil proceedings to be brought in the name and on behalf of the company, require the company not to make any, or any specified, alterations in its articles without the leave of the court, or provide for the purchase of the shares of any members of the company by other members or by the company itself. The typical and most common order made on petitions under section 994 of CA is for the majority shareholder to buy out the minority’s shares. Alternatively, an order may be sought requiring the respondent to sell their shares to the petitioner, in which case the petitioner will also seek an order on the company’s behalf to recover misappropriated corporate assets [50] (as seen in the case of Bhullar v Bhullar (2003) [51] ).

Although it is not possible to estimate the level of costs that may be incurred in “unfair prejudice” proceedings, they are by their nature, expensive and time consuming. Alternatively, shareholders whose rights have been diminished in a company may also bring a claim under the principle of “just and equitable winding-up” pursuant to section 122(1)(g) of the IA [52] .

“Just and Equitable Winding-Up”

If members are dissatisfied with the way in which their company is being run, one, rather drastic, way of dealing with the situation is to end the company’s existence by having it wound up [53] . Obviously this is a very serious course of action as it means that an otherwise successful company may be forced to cease trading and for this reason, the court will only make such an order in exceptional circumstances [54] . Usually for members of a company to adopt a resolution of winding up, a special resolution has to be passed, which requires a three-quarters majority voting in which case may not be successful as the majorities may not want the company to be wound up. The alternative is for a member to petition to the court and request the court to order that the company be wound up. The court however will not order for the company to be wound up unless it is shown that one of the circumstances listed in section 122(1) of IA exists, in which it then relies on a question of fact, in each case depending on its own circumstances.

Section 125(2) of IA requires the court to decide on the facts as to whether it is just and equitable that the company should be wound up, ignoring the possibility of other forms of relief. If the court is in opinion that in the absence of any other remedy it would be just and equitable that the company should be wound up then it must make a winding up order unless it believes that the petitioner is acting unreasonably in seeking a winding-up order rather than pursuing some alternative remedy [55] . Examples of the grounds which will support a petition of “just and equitable winding up” are fraud [56] , deadlock [57] , where the substratum of the company has failed [58] , loss of confidence in company’s management [59] , and exclusion from management [60] .

There are other circumstances and reasons where the court would not grant a winding-up order besides not pursuing a claim under another remedy. The remedy will not be available where the petitioner seeks to protect interests other than interests as a member [61] . Since the essence of the jurisdiction is equitable, the petitioner must come to court with “clean hands” and so, if the petitioner is himself solely responsible for the breakdown in trust and confidence of which he complains, the court will refuse a winding-up order [62] (as held in Ebrahimi v Westbourne Galleries Ltd 1973 [63] ).

Class Action Litigation

Shareholders can also bring a representative (class) action against the company to enforce their infringed rights, as a group. In law, a class action or a representative action is a form of lawsuit where a large group of people collectively bring a claim to court and its purpose generally is to bring together direct claims of class members [64] . Class action litigation may appear to be a modern invention, but actually has its roots from medieval English courts. The “Bill of Peace” which was introduced back then allowed the English Chancery Court to rule on disputes involving multiple parties with common questions [65] . However, it is apparent that English law has not so far developed a “class action” [66] of a kind similar to those already existing or proposed in North America and elsewhere in the common law world [67] . The goal of class action litigation, from the perspective of the judicial system, is to achieve economies of time, effort, expense, and uniformity of judicial decisions without sacrificing procedural fairness however such lofty goals are, unfortunately, not always met [68] .

If a true class action was to be developed in English law, shareholders would have its advantages and disadvantages of bringing a “class action” against a company. The advantages firstly are that a class action lawsuit allows individual claims to be aggregated into a single lawsuit, resulting in substantial advantages like increasing the efficiency of the legal process, and lowering the costs of litigation [69] . This would allow in cases with common questions of law and fact, aggregation of claims into a class action may avoid the necessity of repeating days of the same witnesses, exhibits and issues from trial to trial. A class action would also avoid a situation where different court rulings could create incompatible standards of conduct for the different defendants whom are which to follow [70] . Besides that, in limited fund cases, a class action ensures that all plaintiffs receive relief and that early-filing plaintiffs do not raid the fund of all its assets before other plaintiffs may be compensated, therefore allowing the courts to centralise all claims into one venue where it can equitably divide the assets amongst all the plaintiffs if they win the case [71] .

The disadvantages for shareholders to commence a class action suit are primarily the issue of costs. In the UK, the doctrine that although the award of costs is in the discretion of the court, in general the costs follow the event that is, the winner of litigation is entitled to recover from the loser, in addition to any judgment obtained, the costs of conducting the litigation, taxed on a “party and party” basis [72] . Many studies have shown that this principle is incompatible with the expansion in the use of class actions because the representative party incurs the same risk of liability for “party and party” costs as he would carry if the action were brought in the form of an individual action and further if the action is unsuccessful, the representative party is solely responsible for the other party’s costs [73] . In the United States, the indemnity rule of costs does not exist in civil litigation generally and thus a representative party does not carry the risk of paying the costs of the other party if he is unsuccessful and this US device of the contingent fee mechanism has been proposed to be incorporated into UK’s common law. However, English law has never accepted contingent fee arrangements and it would require a very significant shift in professional attitudes for them to become acceptable as

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