As a general rule, shareholders cannot sue for wrongs done to their company or complain of irregularities in the conduct of its internal affairs. However, minority shareholders are allowed under limited circumstances to sue on behalf of the company by way of derivative action. This article provides an introduction to derivative action.

What is Derivative Action?

A company, having a separate legal entity from its members, can sue or be sued on its own behalf. It was established in the historic decision in Foss v Harbottle (1843) that if a wrong has been inflicted on a company, the proper plaintiff is the company itself. However, very often, the persons who commit the misfeasance are the persons who are in control of the company, who are unlikely to allow the company to sue. A common law right is therefore reserved for shareholders to sue the wrongdoers on behalf of the company by way of derivative action under limited circumstances. This provides an important remedy for minority shareholders.

Statutory Derivative Action

In 2004, Hong Kong enacted the Companies (Amendment) Ordinance to provide for a statutory derivative action ("SDA"). New sections 168BA to 168BI were added to the Companies Ordinance (Cap. 32) (the "Ordinance"), under which a member of a specified corporation (a Hong Kong incorporated company or a non-Hong Kong company) has a statutory right to bring proceedings on behalf of the specified corporation or to intervene in proceedings to which the specified corporation is a party if:-

(a) the cause of action or right to continue, discontinue or defend the proceedings is vested in the specified corporation and relief is sought on behalf of the specified corporation;

(b) the bringing of proceedings is in respect of misfeasance committed against the specified corporation (misfeasance is defined under section 168BB(2) to include fraud, negligence, default in compliance with any enactment or rule of law or breach of duty);

(c) the specified corporation fails to bring proceedings or diligently continue, discontinue or defend the proceedings; and

(d) leave is granted by the Court to bring or intervene in such proceedings.

Conditions for Granting Leave

A preliminary hearing will be held for a determination of the standing of the applicant and the member who intends to bring a derivative claim has to show why he/ she should be so allowed. The Court may grant leave if the following conditions are fulfilled:

(a) it appears to be prima facie in the interest of the specified corporation that leave be granted to the applicant;

(b) there is a serious question to be tried and the specified corporation has not itself brought the proceedings (if the application is for leave to bring proceedings);

(c) the specified corporation has not diligently continued, discontinued or defended those proceedings (if the application is for leave to intervene in proceedings);

(d) unless dispensed with by the Court, a 14 days' written notice has been served on the specified corporation.

Relatively Low Threshold in the Leave Requirements

It was decided in Re F & S Express Ltd [2005] 4 HKLRD 743 that where the Court has to be satisfied the proposed action would appear to be in the interest of the company, what is sufficient at the stage of granting leave is that "an arguable case be shown to subsist". In addition, in order to ascertain if there is a serious question to be tried, the court will not normally enter into the merits of the proposed derivative action to any great degree, and the applicant has the same relatively low threshold to surmount as in the case of an application for an interlocutory injunction.

Derivative Action under the Common Law

The SDA does not affect any common law right of a member of a specified corporation to bring a derivative action on behalf of the specified corporation under the common law. However, It should be noted that under section 168BC(5) of the Ordinance, the same member cannot commence or intervene in the proceedings if a common law derivative action has been commenced or intervened in respect of the same cause or matter.

Costs of Proceedings

Minority shareholders in derivative actions often face the problem of costs by taking the risk of being liable for his own and the defendant's costs in the event of failure. Section 168BI of the Ordinance allows the Court to make a cost order requiring the specified corporation to indemnify out of its assets against the costs incurred or to be incurred by the member in making the application for leave or in bringing or intervening in the proceedings ("Indemnity Order"). The Court may only make such an order if it is satisfied that the member was acting in good faith and had reasonable grounds.

It has been observed that the Court has been reluctant in making a pre-emptive Indemnity Order for the costs incurred in the action. Before the court can make such an order, there must be evidence as to the company's ability to pay the costs of the proposed derivative action as at the time that leave is sought. Hence in Re Lucky Money Ltd and Others (HCMP505/2006), S Kwan J declined to grant an Indemnity Order for the costs to be incurred in the derivative action, as it did not appear to the Court that the companies concerned were in a position to meet any payment as to costs. Pending final resolution of the action, the Applicant also had to bear the costs of engaging the independent person appointed by the Court. Further in Re MyWay Ltd [2008] 3 HKLRD 614, Barma J refused to grant an Indemnity Order for all the costs the Applicant may incur in pursuing a legal action on the company's behalf on similar grounds.

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.