Derivative Claims in the Companies Act

Introduction

The Companies Act 2006 governs company Law in the UK. The Act brought many changes in Company Law in Britain. It led to codification of common law principles and introduced new provisions for companies. The Act also brought about unification of two systems of law (Britain, Wales or Northern Island). The Companies Act was also seen as the better law at the time since it amended the Companies Act 1985 and Companies (Audit, Investigations and Community Enterprise) Act of 2004.

Derivative claims

Part 11 of the Act deals with derivative claim. It is worth noting that a claim is a suit or legal action filed by one affected party to another. Filing a claim can be met with a counter claim which is a response of one party to another in trying to shift the blame of the aforesaid breach whether an action or inaction affected substantially by the financial position of one or both of the parties. The legal Library describes a derivative claim as actions brought by a member of the company or a shareholder of the company against his fellow shareholder or against the managing directors of the company for their supposed failure in management. This situation usually occurs when there is embezzlement, mismanagement, fraud or misallocation of funds by officers or directors of the company. A shareholder only files this claim in his due capacity as a member affected by the action and inactions of the company. The shareholder must have however tried to complain and his complaint was ignored.

Part 11 of the Companies Acts deals with derivative claims issues in England, Wales or Northern Ireland ¹ in chapter whereas chapter two deals with derivative proceedings in Scotland². In England, Wales or Northern Ireland, derivative claims can be brought in respect of a cause of action by the company or in seeking relief on the Company’s behalf. This is what constitutes a derivative claim under the Act. The Companies Act goes on further to lay ground /conditions which will need to be followed to ensure a successful filing of a derivative claim.

The conditions are that a derivative claim may only be used in protection of members of a company against unfair prejudice³. The cause of action can be against another person apart from the director or it can include of both him and her.⁴ It is of no consequence whatsoever whether the cause of action was brought before or after the person was, still a member or after quitting as a member of the company. Nevertheless, the cause of action will still be valid and it will still stand. The directors of the company that can be sued under this Act include shadow director and former board of directors not forgetting the current director⁵. Members of the company also need not to be original shareholders. It can be any person who has been transferred for the shares of the Company in a legal manner. Before 2006 the concepts of derivative claims were majorly dealt with in case laws. The only substantial change brought by the Act⁶ was increased liabilities on directors and the fact that a shareholder can bring a cause of action due to breach of an action or inaction of a director whether it did not give him personal financial gain.

The case law position was that a shareholder knew for certain that the breach brought financial benefit to the director in order for the claim to succeed. Permission to bring a derivative claim under the case law is applied for in accordance to the Act and is subject to two conditions. First the share holder must be capable of proving a prima facie case against the company without any need of evidence from that company. Secondly, the court has to grant permission for the claim filed before officially allowing the hearing of a substantive case.⁷ The court however holds the discretion of either accepting or rejecting the claims. The court accepts the substantive case and the following grounds after paying due regard to the evidence and independent shareholders of a company⁸.

Firstly, claims of shareholders must be brought in good faith and should not be an act of malice or an attempt to crucify a defendant for personal gains. Secondly the court will look whether the applicant of the derivative claim is acting on the company’s best interest in ensuring its future success⁹. If he does not wish to see the growth of the company then the court will refuse to grant leave. The court will also give allow a substantive case if the action or omission is likely to be authorized by the company before it occurs or ratified by the company after its occurrence. However if the cause of action has occurred and there is a likelihood that the company is going to ratify the situation the court won’t grant leave for a substantive case. In granting leave the court shall also look whether there was a signed pact in relation to the company shareholders not to take such matters to court. Existence to such agreements may lead to the court’s refusal to grant leave. Finally the court shall consider whether the shareholder has the power to sue on his own right¹⁰.

If the shareholder processes such a right the court shall not grant leave for the hearing of a substantive case. The Act started operating on 1^st October 2007 and two years down the line the court granted leave to only one shareholder to raise a derivative claim against the directors of a company.¹¹ In the English case of Alexander Marshall Wishart Caslecroft Securities Limited and others ¹², The Court in Scotland granted leave in July 2009. The Scottish case emphasized that the test to be used granting an application for leave in a derivative claim whether raised or continued in England will be substantially the same. ¹³ The court categorically stated that the prima facie of the case is depends on the merits of the case and that the people who committed acts or omission still remained in positions of influence and power.

Regarding the second part of granting leave the court held that a lot of consideration should be placed on permission instead of emphasizing majorly on the merits of the case. The court made a decision under the basis that the claimant believed on the existence of the cause of action and whether the claimant was not acting on good faith by bringing an action for collateral purposes and factors that a director would access when promoting the company’s success. The factors that were considered include, time, the expenses involved in making the claim, whether the claim should be continued or not and if there would be interference or disruption which would frustrate the case.

The Purpose of part 11 in the companies Act was to ensure that action in relation to directors are brought in a much quicker and easier way considering that the requirement for existence and fraud and minority and wrong doer control had been done away with. This purpose has not been fulfilled sufficiently and the question is whether the English court would incorporate the decision in Wishart’s case in application of part 11 of the Companies Act¹⁴.

In relation to shadow directors, J Pall Sykes argues that considering the various extensions in directors’ duties and liabilities, and widening of the class of persons covered, practical questions arise regarding the majority shareholder’s vulnerability. He further states that a directors duties and discretion are broad and this must be taken into account and outwardly it may seem that the new statutory derivative claim is an ‘‘invitation to litigate’’, but it is by no means clear that derivative claims will become more common as a forum for disaffected members to expose contentious decisions to public and judicial scrutiny¹⁵. This position is illustrated further in the case of Ultraframe (UK) Ltd v Fielding¹⁶. In this case it was held that generally a shadow director owes no duties, unless he undertook a special responsibility regarding specific or particular assets. This constitutes fiduciary duty that is governed by common law. The Companies Act contradicts the common law as the shadow director can assume all the duties of a director however the practicalities remain unpredictable given the absence of authorities’ Despite this fact it is very obvious that liquidators would look for a person to sue when the companies collapse.

In obtaining a leave to file a leave to file a derivative action one is required to go through the following procedures. First the shareholder needs to make an ex parte application for consideration of his sole evidence¹⁷. Here the company’s evidence won’t be required. If the shareholder evidence is able to pull through and is accepted, the court will be able to accept the company’s evidence for scrutiny in the second stage¹⁸¹⁹. It is however very unfortunate that the courts process control of the natter at a very early stage through procedural discipline and judicial case management ²⁰. However, courts have been blamed many a times for lack of proper scrutiny of derivative claims presented to them which amounts to premature start of cases with inadequate written evidence. It is evident that in the past, courts were rejecting derivative claims but premature acceptance of the claims is not a solution as this makes a company lose the protection it requires. Strictness in the admission of derivative claims is therefore important but too much rigidity is also improper. This has been effectively implemented by some other courts.²¹

In cases where the claimant can present his own interest instead of derivative claim the court will always refuse a grant of leave for derivative claim and encourage the shareholder to pursue his interest. It is rather confusing how the courts are going to reach on the decision on what is personal and what is not. The Companies Act part 11 has therefore not clearly indicated how the courts will solve these issues. In the case of Clark v Cutland ²² the petitioner brought a derivative claim action acting in the best interest of the company and the court granted an indemnity order to his favour²³. In a different court the claimant was denied redress as his claim as it was seen not to be in the good of the company but instead it was seen as an effort to cause dissolution of the company²⁴. This causes uncertainty which is confusing.

The Act²⁵ provides that if the application is not dismissed by the court the court may give direction to the company to provide evidence or it would adjourn the meeting to ensure the evidence to be obtained however the Company can also reserve the right to apply under Civil Procedure Act²⁶ for striking with reasons of prejudice, and abuse of the process. This will lead to multiplication of suits wasting time for continuance of the derivative claim²⁷The Act provides that the derivative action will not be permitted if the omission or Act is ratified by majority shareholders. This will make it extremely difficult for minority shareholder to bring a derivative claim if this action is not supported by majority shareholders. The court tries to choose independent shareholders of the company for the ratification process the problem is there is no effective method of ensuring independence.

The Companies act has made it easier for derivative claim to be made but instead made it more difficult for it to be ratified. The Act provides that a claim needs not to prove fraud which is okay. However, the Act will leads to stalling of work and squabbling in the company as many derivative claims may pop up interfering with the directors work which is very vast and important. Squabbling will arise when others try to push for ratification and the others would try to frustrate the claim even if there was a reasonable cause of action.

Derivative claims have recently been restricted by the courts since the courts realized numerous cases were arising because of the ease of bring the causes of action. The courts have started employing the objective test. In the case of Airey v Cordell²⁸ the courts introduced a new rule of derivative claims. A derivative claim was brought by a minority shareholder but it was defeated on grounds of reasonability the dissenting judge Warrren J the test was whether a reasonable independent board could decide that it was appropriate to bring proceedings.

Section 261 makes it easier for individuals to bring up derivative claims but it is unfortunate that others have started using the openness for their personal vendetta. This wastes a lot of time and interferes with the productivity of both the company and the courts.

The Act still repeats other common law features for examples indemnifying minority shareholders²⁹. Minority shareholders are at a serious advantage as derivative claims brought by them can be dismissed at any stage. The court can dismiss it that is unreasonable; the company majority shareholders can also vote against the claim. For this reason the Court of Appeal came up with the remedy of indemnity similar to application of the common law to indemnify minority shareholders even is struck out as long as they were reasonable in bringing it. The law ought to be uniform and by doing this they employ double standards in its application.

The directors of the company are the key company figures and actions against them would be like a smear campaign to the company. This may lead to adverse results since it may frustrate the companies’ contracts with investors and create a bad public image. For this reason, the directors employ any means necessary to prevent the claims from making their way to the courts. This frustrates the very purpose of part 11 of the Companies Act.

There are certain claims which fall out of Part 11 of the Companies Act. This involves derivation claims from foreign companies and derivation claims from other members who are not shareholders of the company. The frequently asked question is whether the Companies Act still embraces the doctrines of common law. Komaneni v Rolls Royce Industrial Power³⁰ (India) Limited is an example of causes of action in foreign companies. An example of case where the claimants were not members of the company is the Airway v Cordell discussed above³¹.

Conclusion

Although part 11 of the law brought some changes in the Companies Act there are several areas which should be reformed. Most scholars and lawyers recommend that no part of the Companies Act should rely on the common law therefore the need to severe the strains of common law in the Act. Areas where the Act does not cover should be included to avoid ambiguity in the decisions made by the courts. These areas include Derivative claims to a company that is already in liquidation and foreign companies. It is therefore imperative that part 11 should be reformed since it has substantial legal defects.

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Footnotes

1. See sections 260-264 of the Company Act 2006.
2. See sections 265-269 0f the Company Act 2006.
3. 7 Cumana Ltd, Re [1986] B.C.L.C. 430 CA ( Civ Div).
4. See section 260 of the Companies Act Sub sections (1-4).
5. Companies Act 2006, Sec 260(5).
6. Companies Act(2006) Section 260.
7. See section 261 of the Companies act.
8. See section 267(2) 0f the Companies act.
9. See Section 263(2) of the Companies Act.
10. CPR r.19.9A(2).73.
11. [2010] CSIH 2.
12. See Chapter two of the Act.
13. Contrast wishart with Iesini v Westrip Holdings Ltd.
14. J. Paul Sykes, C.J.Q., Vol 29, Issue 2 2010 Thomson Reuters (Legal) Limited.
15. Ultraframe (UK) Ltd v Fielding [2005] EWHC 1638 (Ch); [2006] F.S.R. 17.
16. Companies act Sec 261.
17. Kiani v Cooper [2010] BCC 463.
18. Stainer v Lee [2010] EWHC 1539..
19. Companies Act, 2006 Sec 261(3).
20. See Force vs Harbottle.
21. Clark v Cutland [2003] EWCA Civ 810; [2003] 2 B.C.L.C. 393 at 406.
22. In CCUIST v C.U.F.C. Holdings Ltd [2010] EWCA Civ 463.
23. 88 Mumbray v Lapper [2005] EWHC 1152 (Ch); [2005] B.C.C. 99.
24. See Companies act 2006 sec 263(4).
25. CPR r.3.4.
26. Smith v Croft (No.2) [1988] Ch. 114; [1987] 3 All E.R. 909 at 957.
27. Airey v Cordell [2006] EWHC 2728 (Ch); [2007] Bus. L.R. 391.
28. See R&H Electric Ltd v Haden Bill Electrical Ltd [1995] B.C.C. 958 Ch D; [1995] 2 B.C.L.C. 280.
29. 2002] 1 WLR 1269 at [43] and [44].
30. [2006] EWHC 2728 (Ch); [2007] Bus. L.R. 391.