Stephan Weber of Sykes Anderson LLP discusses the new statutory provisions under the Companies Act 2006 in respect of derivative claims by shareholders
A derivative claim is a claim brought by a shareholder against a director (or a third party) on behalf of the company. 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. Previously, a derivative claim only existed under common law but not under statute.
This has now changed. From 1 October 2007, a new statutory claim replaced the existing common law action.
The old common law position
Under common law, a shareholder could bring a derivative action in the company’s name just in limited circumstances. Generally, only the company itself was regarded to be the proper claimant in respect of a wrong alleged to be done to the company and the court would not interfere with the internal management of the company as long as it acted within its power. Accordingly, where the majority of the company’s shareholders have made the decision not to bring a claim, this would typically be the end of the matter.
However, where the company was controlled by the wrongdoer(s) and the acts complained of were of a fraudulent character or beyond the powers of the company, a single shareholder could potentially bring a claim to remedy the wrong and such proceedings could not be blocked by the majority.
Yet, the common law was very complex and only few derivative actions ever succeeded.
The new statutory derivative claim
Rather than enshrining the common law into statute, the new sections 260 to 269 of the Companies Act 2006 (“the Act”) introduce a wider range of circumstances in which a derivative claim may be brought by a shareholder. These changes came into force on 1 October 2007 and allow a shareholder 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. The general duties of a director are now set out in Part 10 of the Act and have been the subject of considerable debate. A breach of duty will be actionable even if the director has not benefited personally from the breach. Moreover, it will not be necessary for the shareholder to show that those directors who carried out the wrongdoing control the majority of the company’s shares.
Once derivative proceedings have been issued, the claimant shareholder must notify the company of the claim and apply to the court for permission to continue the claim.
At a first stage, the shareholder must put forward a prima facie case for permission to continue the proceedings. The court will consider the issue merely on the basis of the evidence filed by the shareholder. It must dismiss the application if a prima facie case is not made out.
If the court dismisses the application at this stage, the claimant may, within 7 days, ask for an oral hearing to reconsider the decision. It is as yet unclear whether the claimant has an automatic right to an oral hearing or whether the court has the discretion to refuse such a hearing.
The company is not required to participate in any of this although it may choose to do so at its own costs.
At a second stage, the court will decide in a main permission hearing and on evidence from the applicant and the respondent(s) whether the case should proceed.
The court must 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.
Otherwise, the court must consider a number of factors in deciding whether or not to give permission, including:-
- whether the shareholder is acting in good faith in seeking to continue the claim;
- whether the company has decided not to pursue the claim;
- whether the act or omission is likely to be authorised or ratified;
- whether the act or omission gives right to a cause of action which the member could pursue in his own right rather than on behalf of the company;
- the importance which a member acting in accordance with the duty to promote the company’s success would attach to the claim.
Further, section 263(4) states that, in considering whether to give permission, the court shall have ‘particular regard to any evidence before it as to the views of members of the company who have no personal interests, direct or indirect, in the matter’.The procedure is set out in detail in new CPR 19.9 and the corresponding Practice Direction.
If the application is dismissed, the court may make any consequential order that it considers appropriate, including an order against the applicant to bear the costs of the application. Such an order is likely to be made where permission to continue the proceedings is denied. However, where permission is granted, the company may be ordered to fund the litigation both on behalf of the claimant shareholder and the defendant director.
The requirement for a claimant to make a prima facie case from the outset and the potential for the court to award costs against the claimant should serve as a deterrent preventing disgruntled shareholders from bringing vexatious claims just for the sake of causing trouble. However, whether this will be enough to prevent increased tactical litigation under the new statutory regime against directors by so-called active shareholders will depend on how the courts will react to any ‘fishing’ litigation.
It is likely that a shareholder seeking redress will still prefer to bring a petition on grounds of unfair prejudice under new section 994 of the Act (old section 459) with the prospect of recovering damages on its own behalf and not for the company rather than commencing a derivative action. Moreover, a section 994 petition now seems to be the only available remedy if the company is controlled by the wrongdoer(s). However, the legal position as to fraud on the minority and wrongdoer control might still require further clarification.
What companies should do – Practical steps
Directors should be made aware of their now codified duties and kept up-to-date. The statutory duties must be considered before any decision is taken and the fact that this was done should be recorded in the board minutes.
Further, companies should check and revise their document retention policies as supporting evidence for key decisions may be needed in the future.
Companies should also check their D&O insurance and directors’ indemnities (where provided) to ensure directors are covered for the cost of dealing with and defending derivative claims.
Please note that this area of the law is a complex subject and you should not take or refrain from taking any step without full legal advice on your particular circumstances. The content of this article is of a general nature and no liability is accepted in connection with it or if any reliance is placed on it.