Henrik K.

Thorrud

To what extent does the statutory right of shareholders to bring a derivative claim in respect of a company mirror the derivative claim evolved at common law as an exception to the rule in Foss v Harbottle? Introduction Claims for maladministration are often not pursued because the people controlling the company do not bring suits against themselves.1 Company law should allow claims by individual members in exceptional cases in order to sanction poor corporate governance and avoid corporate injury. At the same time, companies should be protected from disruptive litigation over matters of internal management and challenges to the directors reasonable commercial judgment.2 In common law, shareholders remedies are governed by the rule in Foss v Harbottle (Foss).3 A shareholder who wished to bring a derivative claim had to establish an exception to the rule.4 The Companies Act 2006 (CA 2006) introduced important new provisions that for the first time codify the right of shareholders to bring a derivative claim.5 The purpose of this paper is to provide a basic outline of the relationship between the statutory derivative claim and that of common law.

The General Rule in Foss The fundamental principle of Foss is that (i) only the company itself can bring claims on behalf of the company (proper plaintiff rule), and (ii) as long as the alleged wrong can be

Len Sealy and Sarah Worthington, Cases and Materials in Company Law (Eight Edition, OUP, Oxford 2008) 498 (S&W). 2 Brenda Hannigan, Company Law (Second Edition, OUP, Oxford 2009) 447 (Hannigan). 3 (1843) 2 Hare 461. 4 Andrew Keay and Joan Loughrey, Derivative proceedings in a brave new world for company management and shareholders (2010) 3 JBL 151, 151 (Derivative proceedings). 5 Alistair Alcock, John Birds and Steve Gale, Companies Act 2006: The New Law (Jordans, Bristol 2007) 163 (Alcock).

 Henrik K. Thorrud

approved or ratified by a majority of the shareholders, then no individual shareholder can bring an action in respect of that wrong (internal management/majority rule).6

Exceptions to the General Rule in Foss An exception to the rule was developed under common law, by which a shareholder, to a certain degree, may sue derivatively, i.e. on behalf of the company to obtain a remedy for the company.7 (The proceedings derive from the rights of the company).8 A shareholder was permitted to bring a derivative claim in spite of the majority rule and the proper plaintiff principles if the acts complained of are of a fraudulent character or beyond the powers of the company.9 In order to succeed with a derivative claim, the claimant first had to establish a prima facie case showing that the company was entitled to the relief claimed and that the action fell under the exception to the rule in Foss, as explained above, namely: (i) that the wrong was a fraud on the minority, which constituted an unratifiable wrong unable to be cured by the majority; and (ii) that those against whom relief was sought controlled the company, thereby preventing an action being brought against them in the companys name.10 Even if a prima facie case was established, a derivative action could only proceed in situations where a majority of shareholders independent of the wrongdoers wished the proceedings to continue.11

6 7

Arad Reisberg, Derivative Actions and Corporate Governance (OUP, Oxford 2007) 77 (Reisberg). Hannigan, 444. 8 Derivative proceedings, 151. 9 Burland v Earle [1906] AC 83 at 93. 10 Hannigan, 444; Prudential Assurance Co Ltd v Newman Industries Ltd (No 2) [1982] 1 All ER (Ch) 354, 366; Smith v Croft (No 2)[1987] 3 All ER 909 (Ch), 945. 11 Hannigan 444.

 Henrik K. Thorrud

Fraud on the minority means fraud in the wider equitable sense of that term.12 The term only applies in cases where the wrongdoers themselves benefit. Furthermore, it does not include mere negligence by the directors.13 The fraud on minority exception emanates from the courts desire to give a remedy for a wrong which would otherwise escape redress.14 The court, in common law, allowed a derivative action to proceed if the person who had committed a wrong against the company was also in control of that company, since he would otherwise probably hinder the company from bringing proceedings against him.15 The court required a shareholder to show wrongdoer control of the company as a condition for proceeding with a derivative action.16 In case the company was not controlled by the wrongdoer(s), the main rule that the company is the proper plaintiff prevailed.

Statutory Reform The derivative claim evolved in common law as an exception to the rule in Foss was replaced by a statutory derivative action (set out in CA 2006 Part 11, s 260 ff.), which came into force on 1 October 2007. The rationale behind the codification was to simplify and modernise the law on shareholders remedies (which was considered unclear, complicated and unwieldy)17 in order to improve its flexibility and accessibility.18 The reforms did not intend to encourage derivative claims. 19 Rather, the Law Commission wanted to maintain the sound policy underlying the common law. A

12 13

Reisberg 90; Estmanco (Kilner House) Ltd v Greater London Council [1982] 1 WLR 2, 12. Pavlides v Jensen [1956] 2 All ER 518 (Ch) 565. 14 Burland v Earle [1902] AC 83, 93 (PC). 15 ibid 93. 16 Russell v Wakefield Waterworks Co [1875] LR 20 Eq 474, 482. 17 Law Commission, Shareholder Remedies Report (Law Com No 246 Cm 3769, 1997) para 6.4 (Report). 18 ibid para 6.15. 19 Derivative proceedings 151.

 Henrik K. Thorrud

shareholders ability to bring an action on the companys behalf should be strictly limited and occur only in exceptional cases.20 The government agreed that derivative claims were a weapon of last resort.21 Six guiding principles underpin the reform: (i) proper plaintiff (ii) internal management/majority principle (iii) non-interference by the courts with commercial judgment of directors (iv) sancity of contract (v) freedom from unnecessary shareholder interference and (vi) efficiency and cost effectiveness.22 The common law approach is reflected in the first, second and fifth guiding principles.23 The reform has resulted in some changes.24 Firstly, the claimant no longer has to show wrongdoer control, which under the old common law, could make it impossible for a shareholder in a widely held company to bring a derivative claim. Secondly, the restrictive concept of fraud on the minority no longer applies.25 According to s.260(3), a derivative suit is now available for any breach of duty by a director, including negligence from which a director does not benefit (subject to the ability of the majority to ratify breaches of duty).26 This overturns Pavlides v Jensen, which excluded simple negligence from the scope of the common law derivative action. A derivative claim may also be brought against a director and/or another person: s.260(3). The common law rules on third-party liability in relation to breaches of duty by directors are preserved but not codified.27 A member is not, however, free to bring all types of derivative claims. He has to obtain permission or leave from the court, as in the old common law procedure.28 Pursuant to

20 21

Report para 6.4. Derivative proceedings 151. 22 Report, para 1.9. 23 ibid para 6.4. 24 Alcock, 163. 25 Paul von Nessen, S.H. Goo and Chee Keong Low, The statutory derivative action: Now showing near you (2008) 7 JBL 627, 648 (Goo). 26 Hannigan, 449. 27 S&W, 537. 28 Goo, 648.

 Henrik K. Thorrud

s.261, the claimant must, as a first stage, show a prima facie case in order to obtain the permission to proceed. The Law Commission concluded that, in common law, the prima facie criterion could lead to a mini trial.29 Thus, the concern was to make this process more efficient and cost-effective.30 In case a prima facie case is established, the court will as a second stage require evidence to be provided in accordance with s.261(3) to consider whether to grant permission to proceed. Permission must be refused if the court is convinced that: (i) a director acting in accordance with s.172 (duty to promote the success of the company) would not seek to continue the claim (s.263(2)(a)); or (ii) the act or omission (occurred or yet to occur) has been authorised or ratified by the company (s.263(2)(b)(c)).31 In other situations, the court must consider the following factors (which are set out in s.263(3)) when deciding whether to grant permission: (i) Whether the member is acting in good faith in seeking to continue the claim [s.263 (3)(a)]

This requirement was criticised in common law as uncertain and unworkable, but was nevertheless carried into the Act. 32 (ii) The importance that a director acting to promote the success of the company would attach to continuing it [s.263(3)(b)]

The focus on the directors duty to seek to promote the success of the company in good faith under s.172 is an innovation of CA 2006. The test for the grant of leave in common law was based on whether an independent board would proceed with the action.33 Both approaches

29 30

Report, para 6.4. Hannigan, 451. 31 ibid. 32 Derivative proceedings, 165. 33 Derivative proceedings, 158; Mumbray v Lapper [2005] EWHC 1152 (Ch).

 Henrik K. Thorrud

seem rather similar and are associated with the idea of acting in the best interests of the company.34 (iii) Whether the act or omission (occurred or yet to occur) could be, and in the circumstances would be likely to be, authorised or ratified by the company [s. 263(3)(c),(d)]

This reflects the majority principle, to a certain degree. In common law, the fact that an act was capable of being confirmed by the majority was enough to bar a derivative claim in respect of that act.35 Under s.263(3)(c) and (d), this is now merely a matter to be taken into account by the court in the assessment as to whether to grant permission. The rules on ratification have been altered to preclude directors, as shareholders, voting to ratify their own wrongdoing (s.239).36 Beyond that, the common law on ratification (that certain wrongs are unratifiable) has been preserved by s.239(7).37 (iv) Whether the company has decided not to pursue the claim [s.263(3)(e)]

This criterion makes it clear that the derivative claim remains an exception from the proper plaintiff principle. It should, however, be treated with caution, as the company or the board (which decides on behalf of it) may have been induced by the wrongdoers not to pursue the claim. (v) Whether the member could bring a personal action for the same act or omission [s.263(3)(f)]

Although the principle derives from common law, the court must now consider whether a member could pursue an alternative cause of action in his or her own right. This is a minor

34

Andrew Keay & Joan Loughrey, Something old, something new, something borrowed [] (2008) 124 L.Q.R. 493 (Something old). 35 Hannigan, 448. 36 ibid 446. 37 ibid 454.

 Henrik K. Thorrud

deviation from the position in common law,38 in which all remedies were to be considered, including alternative measures for compensating the company itself.39 In addition, pursuant to s.263(4), the court shall have particular regard to any evidence of the views of company members without personal interest in the matter. This is an adoption of the Smith v Croft (No 2)40 test. When viewed in conjunction with s.260 and the above criteria, this underscores the fundamental philosophy of the derivative claim: A member may only bring a derivative claim where this is for the benefit of the company, not for the member personally (The latter should be addressed via personal claims such as the unfair prejudice provisions in s.994).41

Conclusion In summary, the major change is that the concepts of fraud on the majority and wrongdoer control have been discarded and replaced by a judicial discretion for the court to grant permission to continue with the claim. The discretion must be exercised in accordance with the non-exclusive list of matters provided in s.263(3). Many of the conditions imposed by statute have links to the common law rules relating to Foss. Hence, some aspects of the learning remain relevant. Overall, the statutory rules are broader in scope and extent than the former common law. This may have made derivative actions more accessible to shareholders, which has been subject to controversy.42 However, much in practice will depend on how the courts approach the statutory two-stage process.

38 39

Something old, 495. Barrett v Duckett [1995] 1 B.C.L.C. 243 at 372. 40 [1987] 3 All ER 909. 41 S&W, 538. 42 Hannigan, 446-447.

 Henrik K. Thorrud

Bibliography Legislation Companies Act 2006 Part 11 Chapter 1 (Section 260 ff.) Cases Barrett v Duckett [1995] B.C.C. 362 [1995] 1 B.C.L.C. 243, CA (Civ Div) Burland v Earle [1902] A.C. 83, PC (Can) Estmanco (Kilner House) Ltd v Greater London Council [1982] 1 WLR 2 Ch D Foss v Harbottle 67 E.R. 189; (1843) 2 Hare 461, Ct of Chancery Mumbray v Lapper [2005] EWHC 1152 Ch [2005] B.C.C. 990 Pavlides v Jensen [1956] Ch 565 2 All E.R. Prudential Assurance Co Ltd v Newman Industries Ltd (No.2) [1982] 1 All E.R. 354 CA (Civ Div) Russell v Wakefield Waterworks Co (1875) LR 20 Eq 474 Smith v Croft (No 2) [1988] Ch. 114; [1987] 3 W.L.R. 405; [1987] 3 All E.R. 909 Books, Articles, etc. Alcock Alistair, Birds John, Gale Steve, Companies Act 2006: The New Law (Jordans, Bristol 2007) Davies Paul L., Worthington Sarah, Michele Eva, Gower and Davies Principles of Modern Company Law (Eight Edition, Sweet & Maxwell, London 2008) Ferran Eilis, Company Law Reform in the UK (2001) 5 Singapore Journal of International and Comparative Law 516-568 Hannigan Brenda, Company Law (Second Edition, OUP, Oxford 2009) Keay Andrew and Loughrey John, Derivative proceedings in a brave new world for company management and shareholders (2010) 3 Journal of Business Law 151-178 Keay Andrew and Loughrey John, Something old, something new, something borrowed: An analysis of the new derivative action under the Companies Act 2006 (2008) 124 Law Quarterly Review 469-500 Kirkbride James, Letza Steve, Smallman Clive, Minority shareholders and corporate governance: Reflections on the derivative action in the UK, the USA and in China (2009) 51,4 International Journal of Law and Management 206-219 Law Commission Report No 246, Shareholder Remedies (1997) von Nessen Paul, Goo S.H., Keong Low Chee, The statutory derivative action: now showing near you (2008) 7 Journal of Business Law 627-661

 Henrik K. Thorrud

Reisberg Arad, Derivative Actions and Corporate Governance (OUP, Oxford 2007) Sealy, Len and Worthington, Sarah, Cases and Materials in Company Law (Eight Edition, OUP, Oxford 2008) Sykes Paul J. The continuing paradox: a critique of minority shareholder and derivative claims under the Companies Act 2006 (2010) 29,2 Civil Justice Quarterly 205-234