Derivative Actions
Written by Ed Weeks
Statutory Derivative Actions – S.260 Companies Act 2006
This article looks at the statutory derivative action enabling disgruntled shareholders to take legal action on behalf of a company and in particular at the effect of the availability of alternative remedies on applications for permission to bring such an action.
The background
Part 11 of the Companies Act 2006 came into force on 1 October 2007. It introduced a new statutory derivative action intended to provide a simplified procedure to enable members of a company to take action on behalf of the company in relation to breaches of duty by its directors.
It was intended to replace the common law derivative action which, owing to its complexity and expense, and the wide range of remedies available to minority shareholders under S.459 of the Companies Act 1985 (now S.994 of the Companies Act 2006), had rather fallen into disuse.
The statutory derivative action allows any member of a company (even if they joined after the act complained of) to launch an action on behalf of the company against any of its directors in relation to the negligence, breach of duty or breach of trust by that director. This in theory gives shareholders the direct power to stop directors breaching their duties (rather than relying upon the board of directors themselves to bring an action on behalf of the company).
At the time of writing this note the provision has been in force for a year but there have been hardly any reported cases. Many commentators had suggested that activist shareholders would seize upon the provision to launch tactical litigation against directors. It was noted that the new statutory duties of directors were much broader than previously and included, for example, requirements to have regard to environmental issues.
Why has this flood of activist shareholder litigation not appeared? The recently reported case of Franbar Holdings Ltd –v- Patel & Ors [2008] EWHC 1534 (Ch) may provide some clues.
Obtaining permission to continue a derivative action
Part 11 has a two stage process for getting permission to continue a derivative action. At the first stage the shareholder must show a prima facie case. The court will review this without hearing evidence form the defendant. If a prima facie case is established then it moves to the second stage. The court will direct the company itself to give evidence and after hearing this will decide whether to give permission for the action to continue.
The purpose of this process is to weed out frivolous or unmeritorious claims. The court must refuse permission where:
• A person acting under a general duty to promote the success of the company would not seek to continue the claim;
• The act or omission complained of has been authorised or ratified by the company.
In deciding whether to give permission the court must also have regard to:
• Whether the member is acting in good faith;
• The importance that a person acting in accordance with the duty to promote the success of the company would attach to continuing the claim;
• Whether the act or omission could be or is likely to be authorised or ratified by the company;
• Whether the company has already decided not to pursue the claim;
• Whether the act or omission gives rise to a cause of action that a member could pursue against the director in his or her own right;
• Any evidence as to the views of other shareholders with no personal interest in the matter.
The decision in Franbar
The court looked at these factors in the Franbar case and refused permission for the action to be continued.
The principal reason for the court’s decision appears to have been the availability of a remedy under S.994 of the Companies Act 2006 (the old S.459 unfair prejudice action). The claimant had in fact launched parallel S.994 proceedings. The purpose of the derivative proceedings was therefore to preserve the value of the claimant’s shareholding for the purposes of that action.
The court took the view that the existence of the S.994 remedy was an important factor in its considerations. It concluded that there was no aspect of the derivative claim that could not be compensated for by relief in the S.994 action. It also decided that although prima facie breaches of duty on the part of the directors had been established these were not sufficiently formulated at that stage to indicate a clear route to significant recovery on the part of the company.
In these circumstances the court considered that the claim would have low importance from the point of a view of a hypothetical director acting to promote the success of the company. For this reason permission was refused.
In passing the court also touched upon the question of ratification. S.239 of the Companies Act 2006 provides a mechanism for the company to ratify the actions of a director that might otherwise amount to a breach of duty to the company. The decision in Franbar appears to confirm that this is not a simple route by which directors or majority shareholders can stick together to protect one of their number. The court will still look at all the circumstances and not allow a company to ratify breaches by directors where ratification was obtained by unfair or improper means, was fraudulent or oppressive to opposing shareholders.
Conclusions
The availability of alternative remedies for an aggrieved shareholder is an important factor in determining whether the court will grant permission to continue a derivative action. The court will look at the bigger picture of what is best for the company as well as what is best for the member.In cases where a company is controlled by wrongdoing directors who are also major shareholders it is likely that an action under S.994 will be more appropriate. What this means is that it may only be in limited cases that the new derivative action will be a useful tool for activist shareholders who want to apply pressure on directors. They will instead be directed towards an action under S.994. This means that any legal action will have to be personally financed by the member and the most likely remedy will be a buyout of shares at a fair value, which in the case of a very small minority shareholding may not be worth pursuing.
Ed Weeks
Cripps Harries Hall LLP
September 2008