Management Efficiency and Minority Shareholder Protection

Introduction

Voting powers play a crucial role, especially where directors also happen to own a majority of the shares. Such shareholders can easily implement some decisions against the interests of minority partners. This situation reflects a case where a wrongdoer also possesses the power to support his or her mistaken opinions to the detriment of minority shareholders. Consequently, minority shareholders have their interests substantially reduced, yet they have no course of action, especially when courts fail to intervene. Courts intervention involves the use of laws to resolve cases before them. Through a detailed discussion of legal recourses for minority shareholders and providing evidence from various courts cases involving the breach of duties owed to companies by directors in violation of minority shareholders’ interests, this essay argues that Company Law currently strikes a good balance between management efficiency and minority shareholder protection.

Literature Review and Gap Analysis

According to Deakin and Pistor, Company Law in different jurisdictions establishes a balance between the need for effective management of organisations and the protection of minority shareholders through various cases, legislations, and statues.¹ However, the theory suggests that the extent of protecting minority shareholders depends on the nature of the legal systems in a given jurisdiction. As Deakin and Katharina assert, nations that have their systems originating from Common Law present considerably better mechanisms for protecting minority shareholders.² This assertion arises from the argument that various elements that characterise a particular law and its quality in terms of enforcement are important in creating confidence in shareholders. Therefore, it follows that the UK whose Company Law stems from Common Law has better ways of protecting shareholders while maintaining a balance on the need to manage an organisation by mitigating unnecessary litigations brought against directors or companies’ managers. In fact, the UK case of Hutton v West Cork Railway Co limits the level of a director’s freedom to expend an organisation’s finances to serves the interest of non-shareholders.³

Guillén and Capron support the idea that the nature of a legal system in a nation has implications in terms of the ability to protect minority shareholders.⁴ The authors argue that jurisdictions, which embrace the civilian law, present weak mechanisms for protecting minority shareholders compared to those whose Company Law is based on Common Law. Huang and Yeung add that such jurisdictions embrace concentrated company ownership structures, which correlate negatively with shareholders’ protection.⁵ Indeed, Howson and Donald also conclude that the UK’s Common Law system provides more elaborate and reliable protection to investors compared to civil law jurisdictions such as Germany and France.⁶

As stipulated in the case of Automatic Self-Cleansing Filter Syndicate Co v Cunninghame, company administrators should not be viewed as shareholders’ mediators who can freely execute any decisions on their (shareholders) behalf.⁷ While most of the scholarly discussions on the protection of minority shareholders dwell on how the existing legal provisions, including legislation, court cases, and statues, can protect shareholders, the UK recognises the need for mitigating the capacity of minority shareholders to take any action against directors. Indeed, consistent with this concern, there exists a scholarly literature gap on how the nature and origin of legal systems in a nation balance shareholders’ abilities to sue on their behalf or in place of the company and the potential negative implications for efficient management of business due to actions brought by minority shareholders against directors.

In the UK, statutory derivative claims only permit shareholders to sue directors and organisational managers under some particular circumstances. However, challenges emerge in case people bestowed with the power of controlling companies utilise their positions in a manner that benefits themselves to the detriment of minority shareholders. In such scenarios, Howson and Donald reveal how the law intervenes to protect various minority shareholders.⁸ Courts have maintained a tradition that it is not within their mandates to review or interfere with a company’s administration processes. Nevertheless, they assert their roles through various judicial precedents upon ensuring the protection of minority shareholders’ interests. Company Law establishes various legal mechanisms for protecting minority shareholders, including derivative actions and statutory remedies. Nevertheless, questions remain on the capacity of these mechanisms to provide substantive protection to minority shareholders, especially where majority vote counts in the decision-making process.

Main Argument

According to Davies, Company Law protects minority shareholders from losses arising from undue actions by managers or directors while ensuring an efficient company’s management.⁹ For example, the statutory derivative guarantees the flexibility, effectiveness, and efficiency of law in maintaining the balance. One major concern is that creating laws that give minority shareholders the power to sue directors who are the company managers under any circumstances will open room for raising vexatious claims.¹⁰ Consequently, many people refuse to take appointments to serve in positions of organisational management in fear of the associated liabilities. This concern led to a recommendation by the Law Commission and Scottish Law Commission (no. 267) that any legal proceedings against company managers initiated by shareholders should be permitted under exceptional and rare circumstances.¹¹ Hence, without any substantive cause, shareholders should not have the freedom to engage a company in any form of legal litigation.

The 2006 Company Law Act not only provided strict leaves but also gave courts additional powers for case management. Here, according to Davies and Worthington, the objective was to protect organisations and companies from various disruptive litigations that had inimical consequences to their interests.¹² Hence, the law should uphold the principle of majority rule. As presented in the case of Regal (Hastings) Ltd v Gulliver, company managers and staff members are barred from taking advantage of business prospects to breach their duty of allegiance.¹³ Nevertheless, deviating from the case, the law guarantees adequate protection of minority shareholders from actual or potential abuse emanating from majority stakeholders as a mechanism for striking a balance to all competing interests.

Under statutory derivative claims, shareholders can only take action against the management in case of any omissions due to negligence, breaching a duty, defaults, and/or where directors breach trust endowed to them by an organisation. According to Kershaw, such an action can be initiated against a director, any other person, or both.¹⁴ As Davies asserts, third parties are introduced followings their efforts to offer dishonest assistance coupled with engaging knowingly in deceptive receipts.¹⁵ However, the case of Iesini v Westrip Holdings Ltd of 2010 confirms that any action against third parties can be annulled in case directors have shortcomings that are wholly attributable to them.¹⁶ As a mechanism for guaranteeing the protection of minority shareholders, a court may not envision circumstances under which the majority of shareholders can be allowed to continue with a derivative legal action.

Supporting the Main Argument

In case companies suffer losses when directors breach their duty, shareholders equally experience the hitch. According to Howson and Donald, this situation occurs since their shares deprecate contrary to what would have been expected if the company’s duty owed by the directors was not breached.¹⁷ The term reflective loss describes this situation since the loss suffered by shareholders is manifested in the company’s losses. This situation presents a scenario where shareholders should consider a legal remedy. However, as Kraakman et al. assert, Company Law does not permit shareholders to sue for the breach of duties owed to an organisation or a company.¹⁸

Even in a scenario where wrongdoers may owe shareholders an additional but separate duty, they may not have any remedy by way of suing to recover from the losses. This situation helps to avoid the liability of the wrongdoer having to compensate reflective losses to more than one party (the company and other shareholders) for the sued loss. Nevertheless, as McVea asserts, although this case is a public policy issue, shareholders also have some limited circumstances under which they can recover from reflective losses.¹⁹ For example, at an individual capacity, they can assert individual rights consistent with limited chances of the recovery of the suffered reflective loss.

The statutory derivative claims provide avenues under which minority shareholders can instigate legal proceedings against majority shareholding directors. However, the claims permit them to sue on behalf of an organisation. The Company Law Act of 2006 amplified circumstances under which derivative claims may be applied. However, according to Davies, to guarantee the balance between protecting minority shareholders and the need for efficient management, courts should permit the continuation of such claims.²⁰

Counter-Argument

The main argument section maintained that Company Law in the UK protects minority shareholders from potential damages that may arise from weak decision-making where directors are the majority shareholders. The law also establishes a balance concerning the need to have effective organisational management. However, one can counter-argue that the UK’s tradition involves analysing various remedies available to minority shareholders in the degree to which legal mechanisms help in securing them from losses accruing from self-interested directors who also form part of the majority shareholders.

According to Ireland, where insufficient behaviours or actions by directors cause or contribute to organisational losses, the organisation has the power to sue for damages that involve the recovery of losses following the breach of duty.²¹ Arguably, only companies can sue directors for the breach of duty. Hannigan supports this assertion by noting that the UK’s Company Law only recognises directors as owing duties to companies²² as established under the Companies Act of 2006 Section 170.²³ How then does Company Law sufficiently protect minority shareholders from self-interested directors who are also the majority shareholders if minority shareholders cannot sue at an individual capacity?

In situations where directors are the wrongdoers by way of poor management and inappropriate decisions, probabilities for overlooking the wrongs exist to erode any possibility of remedies. According to Gatti, this challenge may be overcome by ensuring that shareholders are the ultimate decision-makers.²⁴ Thus, shareholders can initiate legal actions against directors. However, the problem is difficult to resolve where directors constitute the majority of owners (shareholders) by way of owning the vast majority of a company’s shares. In the UK, Hannigan asserts that a company’s decisions are made based on the majority rule.²⁵ Hence, minority shareholders lack the ability to dissent decisions made by majority shareholders or directors. However, this counterargument can be proved false.

Refuting the Counter-Argument

Company Law recognises the probability of directors constituting the majority of shareholders. Indeed, the derivative claim protects minority shareholders who may experience such situations as evidenced by the case of Cook v Deeks of 1916.²⁶ In the case, three directors breached their fiduciary duty as set out now in s175 by securing a contract under their name while excluding that of the company. Considering they had a share of 75 percent of the total shares, they passed a resolution indicating that the company was not interested in the secured contract. Section 168 of the Companies Act of 2006 provides room for removing any victimised manager from office to safeguard shareholders’ interest.²⁷ According to Dignam and Lowry, the court held that the company owed the contract as a matter of equity.²⁸ Consequently, the directors had no legal capacity to use powers vested to them as a matter of being the majority shareholders to pass resolutions for securing the contract under their name while excluding that of the company. The case of Cook v Deeks evidences that in circumstances where majority shareholder directors and company boards are unwilling to initiate legal action, minority shareholders can sue on behalf of an organisation or a company.²⁹

The case of Edwards v Halliwell, settled in 1950, also exemplifies the protection of minority shareholders by Company Law from potential detriments arising from majority shareholders who are also the directors.³⁰ The court heard that a trade union’s constitution prohibited the alteration of any contributions unless members engage in a secret ballot vote with two-thirds of majority voting in favour of the changes. Contrary to this provision, a resolution by the simple majority passed a decision to change the contributions. Two members of the union decided to sue to ask the court to make a declaration that the resolution was invalid. The union challenged the two members’ capability of suing to quote the case of Foss v Harbottle.³¹ However, it ruled that the case did not prevent a member of the company to sue in a situation where the matter called for sanctioning through a special majority as opposed to the simple majority.

Summation and Conclusion

Directors are obliged to respect faithfully the trust bestowed upon them by shareholders in the management of a company on their behalf. Therefore, they should not engage in acts of omission, default, and negligence when making decisions that may have negative implications for a company and by extension on their share value. Such an act is against the shareholders’ interest. Under these circumstances, statutory derivative claims allow minority shareholders to initiate legal actions against such directors. Where they (directors) are not the shareholders or are the minority shareholders, legal redress is readily available since the board and other directors are willing to initiate legal action for the breach of duties owed to an organisation.

However, where directors are the majority shareholders, the possibility of legal action is slim upon considering their unwillingness to sue. Hence, shareholders’ interests remain violated and unaddressed. Resolving the situation calls for allowing minority shareholders to sue the directors on behalf of a company since the UK’s Company Law does not permit them to take legal action on their behalf to avoid a situation where wrongdoers will have to compensate more than one party. Such judicial precedence implies that directors will make any decisions irrespective of whether or not they negatively impair the efficiency of a company’s management. Rather, under the Company Law, they will only focus on ensuring that all decisions satisfy the minority shareholders. Hence, it suffices to argue that the UK’s Company Law strikes a good balance between management efficiency and minority shareholder protection.

Bibliography

Davies, Paul, and Sarah Worthington, Gower and Davies: Principles of Modern Company Law (9th edn, Sweet & Maxwell 2012).

Davies, Paul, Introduction to Company Law (2nd edn, OUP 2010).

Deakin, Simon and Katharina Pistor (eds), Legal Origin Theory: Economic Approaches to Law Series (Cheltenham 2012).

Dignam, Alan, and John Lowry, Company Law (9th edn, OUP 2016).

Gatti, Matteo, ‘The Power to Decide On Takeovers: Directors or Shareholders, What Difference Does It Make?’ (2014) 20 Fordham Journal of Corporate and Financial Law 73.

Guillén, Mauro, and Laurence Capron, ‘State Capacity, Minority Shareholder Protections, and Stock Market Development’ (2015) 61 Administrative Science Quarterly 125.

Hannigan, Brenda, Company Law (4th edn, OUP 2015).

Howson, Nicholas, and Donald Clarke, Pathway to Minority Shareholder Protection: Derivative Actions in the People’s Republic of China (Cambridge University Press 2012).

Huang, Flora, and Yeung Horace, ‘Regulatory Cooperation between Securities Commissions: A Reflection from Hong Kong’ (2013) 1 Chin J Comp Law 112.

Ireland, Paddy, ‘Company Law and the Myth of Shareholder Ownership’ (1999) 62 MLR 32.

Kershaw, David, Company Law in Context: Text and Materials (2nd edn, OUP 2012).

Kraakman, Reinier et al., The Anatomy of Corporate Law (2nd edn, OUP 2009).

Law Commission and Scottish Law Commission, Company Directors: Regulating Conflicts of Interest and Formulating a Statement of Duties (No 261) September 1999.

McVea, Harry, ‘Section 994 of the Companies Act 2006 and the Primacy of Contract’ (2012) 75 MLR 1123.

Automatic Self-Cleansing Filter Syndicate Co v Cunninghame [1906] 2 Ch 34.

Companies Act 2006, ss168, 33.

Companies Act 2006, ss170-178.

Cook v Deeks [1916] 1 AC 554 UKPC 10.

Edwards v Halliwell [1950] 2 All ER 1064.

Foss v Harbottle [1843] 67 ER 189.

Hutton v West Cork Railway Co [1883] 23 Ch D 254.

Iesini v Westrip Holdings Ltd [2010] All ER D 108.

Regal (Hastings) Ltd v Gulliver [1942] 1 All ER 378 [1967] 2 AC 134.

Footnotes

1. Simon Deakin and Katharina Pistor (eds), Legal Origin Theory: Economic Approaches to Law Series (Cheltenham 2012) 15.
2. Deakin and Pistor 15.
3. Hutton v West Cork Railway Co [1883] 23 Ch D 254.
4. Mauro Guillén and Laurence Capron, ‘State Capacity, Minority Shareholder Protections, and Stock Market Development’ (2015) 61 Administrative Science Quarterly 125, 127.
5. Flora Huang and Yeung Horace, ‘Regulatory Cooperation between Securities Commissions: A Reflection from Hong Kong’ (2013) 1 Chin J Comp Law 112.
6. Nicholas Howson and Donald Clarke, Pathway to Minority Shareholder Protection: Derivative Actions in the People’s Republic of China (Cambridge University Press 2012) 47.
7. Automatic Self-Cleansing Filter Syndicate Co v Cunninghame [1906] 2 Ch 34.
8. Howson and Donald 47.
9. Paul Davies, Introduction to Company Law (2nd edn, OUP 2010) 73.
10. Davies 74.
11. Law Commission and Scottish Law Commission, Company Directors: Regulating Conflicts of Interest and Formulating a Statement of Duties (No 261) September 1999 35.
12. Paul Davies and Sarah Worthington, Gower and Davies: Principles of Modern Company Law (9th edn, Sweet & Maxwell 2012) 73.
13. Regal (Hastings) Ltd v Gulliver [1942] 1 All ER 378 [1967] 2 AC 134.
14. David Kershaw, Company Law in Context: Text and Materials (2nd edn, OUP 2012) 137.
15. Davies 79.
16. Iesini v Westrip Holdings Ltd [2010] All ER D 108.
17. Howson and Donald 112.
18. Reinier Kraakman et al., The Anatomy of Corporate Law (2nd edn, OUP 2009) 92.
19. Harry McVea, ‘Section 994 of the Companies Act 2006 and the Primacy of Contract’ (2012) 75 MLR 1123, 1125.
20. Davies 77.
21. Paddy Ireland, ‘Company Law and the Myth of Shareholder Ownership’ (1999) 62 MLR 32, 33.
22. Brenda Hannigan, Company Law (4th edn, OUP 2015) 32.
23. Companies Act 2006, ss170-178.
24. Matteo Gatti, ‘The Power to Decide On Takeovers: Directors or Shareholders, What Difference Does It Make?’ (2014) 20 Fordham Journal of Corporate and Financial Law 73, 75.
25. Hannigan 42.
26. Cook v Deeks [1916] 1 AC 554 UKPC 10.
27. Companies Act 2006, ss168, 33.
28. Alan Dignam and John Lowry, Company Law (9th edn, OUP 2016) 162.
29. Cook v Deeks [1916] 1 AC 554 UKPC 10.
30. Edwards v Halliwell [1950] 2 All ER 1064.
31. Foss v Harbottle [1843] 67 ER 189.