UK: Deriving Protection Against Shareholder Claims

Last Updated: 8 August 2006

Article by Francis Kean and Rosalyn Chipperfield

When the Company Law Reform Bill ("CLRB") is enacted it will be possible, for the first time under English law, for minority shareholders to bring an action in the name of and for the benefit of the company against a director alleging merely that he or she has been negligent.

The new statutory derivative action has attracted an unusual degree of publicity over recent months and directors may be fearing the prospect of greater personal liability. It is not, however, all bad news.

There have been recent significant revisions to the new derivative action regime as the CLRB has journeyed through its various committee stages in Parliament. Although the possibility of further revisions cannot be ruled out, the broad ambit of the new action is now sufficiently clear to be able to examine in more detail the effect it may have in practice for directors and their insurers.

Grounds for bringing the new derivative action

The current position under common law is that a shareholder is only permitted in very limited circumstances to sue the directors in the name of the company. This is essentially where there has been conduct amounting to a "fraud on the minority"; i.e. the wrongdoers are in control of the company and have abused their power. By contrast, the new regime will permit such ‘derivative’ claims in a far broader range of circumstances – in respect of any "negligence, default, breach of duty or breach of trust by a director". Moreover, it is sufficient for a shareholder to hold only a single share at the time the action is brought. It is important to note, however, that the proceeds (i.e. the damages) of any successful derivative action will not enure for the benefit of the claimant shareholders but for the company itself.

The procedure for seeking permission

Once the Claim Form has been issued and served on the directors, the shareholder must make an application to the court for permission to continue the proceedings (clause 244(1)). At this stage, the shareholders are required to establish a prima facie case for the grant of permission and the court is likely to decide this issue on the basis of the shareholders’ evidence alone, without requiring evidence from the directors. If the shareholders cannot show a prima facie case, the court will dismiss the claim and may also make consequential orders such as for costs to be paid by the shareholders. Quite what shareholders will need to be able to demonstrate in order to satisfy a court that they have a prima facie case will depend on the facts and circumstances of each case.

An early tactical consideration for the directors will be whether voluntarily to provide the court with any information or evidence. That may be worthwhile if they believe they have information that could deliver an early knock out blow. In most cases, however, the better course for directors is likely to be to sit tight and keep their powder dry.

Factors to be taken into account

Clause 246 of CLRB sets out the approach which a court must follow in deciding whether or not to grant permission for a shareholder derivative action to proceed. It provides that the court must refuse permission and dismiss the claim if it is satisfied:

  1. that a person acting in accordance with his or her duty to promote the success of the company would not seek to continue the claim;
  2. where the cause of action arises from an act or omission which either has been authorised or will be ratified by the company.

The second of these two mandatory grounds of refusal of permission reflects the common law as it stands, and enshrines the basic principle that companies are ultimately governed by the wishes of the majority of their shareholders. It should be remembered, however, that obtaining the necessary authorisation or ratification from a company (especially a large public company) for a particular course of action from the shareholders in general meeting is often neither a straightforward nor an inexpensive option.

The other ground on which permission must be refused is where a person acting in accordance with the duty to promote the success of the company would not seek to continue the claim. The practical and tactical challenge for directors seeking to resist a derivative action on this ground will be to decide what evidence if any to lead on this question. Would a director other than the one whose conduct is challenged take the risk of saying that he or she would not seek to continue the claim?

There are then a range of discretionary factors listed in Section 246(3) to which a court may have regard in deciding whether or not to give leave. These include:

  • whether the member is acting in good faith in seeking to continue the claim;
  • the degree of importance which a director promoting the success of the company would attach to continuing the claim;
  • the conduct complained of and whether it would be authorised or ratified by the company; and
  • whether the company has decided not to pursue the claim.

Clause 246(4) also provides that a court should have "... particular regard to any evidence before it as to the views of members of the company who have no personal interest, direct or indirect, in the matter". Again, this subsection and the factors listed above present the directors and their legal advisers with interesting and important tactical questions as to how best to respond to the application. Should they perhaps obtain evidence from other major shareholders, i.e. perhaps institutional investors to the effect that the proposed derivative shareholder action is not in the interests of the company and should not be allowed to proceed? This might appear an attractive option, but what if the views from other shareholders are less than unambiguous? Also, would the soliciting of offers of assistance of this kind from major shareholder groups give rise to negotiations and compromises in relation to other aspects of the company’s strategy and objectives?

The question of costs

It is true that shareholder groups bringing claims under the new derivative procedure face an exposure to costs in the event that the application is dismissed. The Government has expressed its view in parliamentary debates on the new derivative action that this exposure to costs coupled with the fact that an action, even if successful, will not result in damages being awarded to the shareholders bringing the claim should act as a major disincentive to the bringing of such claims. Whether that is so or not remains to be seen.

What is clear, however, is that it is open to shareholders seeking to bring a derivative claim to apply to the court for an order that the costs associated with the derivative action should be met by the company irrespective of the eventual outcome. Under established common law principles, the court has a discretion in the context of derivative claims to make such an order. How this discretion will be exercised under the new statutory regime remains to be seen.

It is also a fairly safe bet, given the complexity of the permission process, that the costs associated with a full blown derivative claim will be substantial. Although the Government has said it is keen to avoid satellite litigation, the number of potentially heavy-weight interlocutory stages within a derivative action are likely to involve significant costs.

What does the future hold?

It is certainly true that quite powerful safeguards have been built into the new statutory derivative claim aimed at protecting directors from frivolous claims. The Government is also placing a lot of faith on judges to adopt a robust and sensible approach to the new laws. Despite all this we remain of the view that attempts will inevitably be made by minority shareholder groups to avail themselves of the new law. Obvious candidates include political pressure groups and hedge funds. The prize or incentive which motivates this type of potential claimant is not so much a large award of damages (which they would not in any event receive) as publicity and/or leverage aimed at changing a particular company’s approach to a specific issue. The worry is that in order to achieve their objectives, a serious threat of a shareholder derivative claim may be almost as effective as the claim itself. The early decisions of the Courts (and in particular any appellate authority) will be of key importance.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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