Statutory derivative claim regime: ten years on

15 minute read
03 July 2017

The statutory derivative claim regime in the Companies Act 2006 came into force nearly ten years ago, on 1 October 2007. At the time, there was a concern that it could be used as an additional tool in the rise of shareholder activism against quoted companies. However, the bar to bringing derivative claims is set high and they have not become commonplace.

The statutory derivative claim regime in the Companies Act 2006 (2006 Act) came into force nearly ten years ago, on 1 October 2007. At the time, there was a concern that it could be used as an additional tool in the rise of shareholder activism against quoted companies (see Opinion "Derivative claims: a step too far?").

There has not been much evidence of this, with activist shareholders choosing other channels to challenge companies on issues such as executive pay and unpopular strategic decisions (see feature article "Shareholder activism: coping with the rising tide").

Private company directors are more likely to be the subject of a derivative claim and, in order to limit their risk of this litigation, they should ensure that they have well-drafted shareholders' agreements and articles of association that set out the expected actions of those involved.

However, the bar to bringing derivative claims is set high and they have not become commonplace.

What is a derivative claim?

Derivative claims are claims brought against a company by a shareholder on behalf of the company in relation to a breach of duty by a director. The principle has its foundation in common law as a recognised exception to the rules established in Foss v Harbottle, which determined that it is for the company to bring a claim when it has suffered an alleged wrong, rather than the shareholders ((1846) 2 Hare 461).

This, together with the majority rule principle that the will of the majority of the members of the company should, in general, prevail in the running of its business, prevented minority shareholders from protecting the company's interests. The courts acknowledged the risk of abuse and established a set of exceptions to these principles, which included the right to bring a claim where there was an act which constituted a fraud on the minority.

This right was put into statute and now derivative claims may only be brought by following the procedure set out in Part 11 of the 2006 Act, or by pursuing an unfair prejudice claim under section 994 of the 2006 Act (see box "Unfair prejudice claims"). Permission to bring a claim must be sought from a court, which has to balance the still relevant law that the right of the majority must be respected with the need to improve minority shareholder protection, while preventing a rise in frivolous or spurious claims (see box "How to bring a derivative claim").

Type of derivative claims

A derivative claim may only be brought in respect of a cause of action arising from an actual or proposed act or omission involving negligence, default, breach of duty or breach of trust by a director of a company (section 260(3), 2006 Act). That cause of action must be vested in the company and the member bringing the claim must be seeking relief on behalf of the company (section 260(1), 2006 Act).

The fact that the relief must be sought on behalf of the company means that it is unlikely to be a satisfactory option for a disgruntled minority shareholder seeking a personal remedy. He might prefer to pursue an unfair prejudice claim, with the objective, for example, of having his shares bought out by the majority or bought back by the company.

A derivative claim can also potentially be brought in respect of a breach of any of the directors' duties set out at sections 171 to 177 of the 2006 Act (see feature article "Directors' duties: current interpretation and future reforms"). It is not necessary to show that the director benefitted from the breach, so a claim can be brought for negligence without having to show that the director has made a personal gain.

The parties to a claim

Only members of the company can bring a derivative claim, although this includes a person who is not a member but to whom shares in the company have been transferred or transmitted by operation of law (section 260(5)(c), 2006 Act). A shareholder may also have the right to bring a claim in respect of a cause of action that arose before he became a member because it is the right of the company, and not the right of the individual shareholder, that is being enforced.

Although there is no prohibition in the 2006 Act on a majority shareholder bringing a derivative claim, this would likely be dismissed. The possibility was considered in Cinematic Finance Ltd v Ryder and others, where the High Court said that only in very exceptional circumstances will it be appropriate to permit a derivative claim brought by a shareholder in control of the company ([2010] EWHC 3387 (Ch)). The court found it difficult to envisage what those exceptional circumstances might be.

A derivative claim may be brought against a director of the company, which includes a former director and any shadow director, or another person. The reference to "another person" could be to a person who had dishonestly assisted in a breach of duty (Iesini v Westrip Holdings Ltd [2009] EWHC 2526 (Ch)). However, a derivative claim against a third party cannot be based on a cause of action that has arisen independently from the director's default; for example, a decision made by the directors not to sue a third party for breach of contract (Iesini). If the directors breach their duty to the company by not pursing the contract breach, a derivative claim could be brought against them, but not the third party, as the directors' default was independent of the third party's breach.

The role of the court

A two-stage court procedure must be followed. The first stage requires the member to disclose a prima facie case, with the court needing to give permission for the claim to commence. The second stage involves the court considering the factors set out in section 263 of the 2006 Act (section 263).

There have been some instances of these two stages being combined, with the agreement of the parties; for example in Stimpson v Southern Private Landlords Association Ltd and Bridge v Daley ([2009] EWHC 2072; [2015] EWHC 2121). In Bridge, the High Court noted that running the stages together was a pragmatic approach. However, combining the two could just become a much more expensive and time-consuming way of finding that there is no legitimate claim to proceed with.

The first stage. A member who wishes to bring a derivative claim must issue a claim form to the court for permission to continue (section 261(1), 2006 Act). No further steps in proceedings can then be taken without the permission of the court and the court must dismiss the application if the evidence disclosed does not establish a prima facie case. It would be unusual for the company to be represented at this stage.

Case law has been rather divided on the threshold that must be reached to determine a prima facie case. In Iesini, the court held that there must be a prima facie case both that the company has a good cause of action and that the cause of action arises out of a director's default or breach of duty. In Wishart v Castlecroft Securities, the Scottish Court of Session placed a lower threshold and observed that the first stage was a gateway through which the applicant must pass to continue his action, in order to avoid an obvious risk of abuse ([2010] BCC 161).

The court is permitted to give permission, and also adjourn proceedings, on such terms as it thinks fit (section 260(4), 2006 Act). For example, it may adjourn proceedings in order to allow the board time to consider whether to pursue a claim against a third party where the board's failure to do so is the subject of the derivative claim.

The second stage. The court must then consider the factors set out in section 263, some of which require the court to refuse permission if satisfied, and some of which the court is obliged to take into account in considering whether to give permission for the claim to proceed. The court in Iesini commented that, at this stage, a court must be doing more than just establishing a case and must form a provisional view on the strength of the claim.

The court must refuse permission if:

  • A director acting in accordance with his duty to promote the success of the company under section 172 of the 2006 Act (section 172) would not seek to continue the claim (section 263(2), 2006 Act). It would be unusual for the claim to fail on this ground, particularly as the court would not have heard sufficient evidence to be in a position to determine confidently how a hypothetical director would react. In Iesini, the court held that it will apply only where the court is satisfied that no director acting in accordance with section 172 would seek to continue the claim.
  • The act or omission giving rise to the claim has been authorised or ratified by the company (section 263(2), 2006 Act). Authorisation or ratification would amount to a complete bar to bringing the claim and the court has no discretion to override the provision. The court can adjourn proceedings to allow the matter to be authorised or ratified (section 261(4)(c), 2006 Act). This could appear a significant barrier to a minority shareholder bringing a claim; however, not all acts are ratifiable. Acts that involve fraud or that are outside the powers of the company are not ratifiable (Burland v Earle [1902] AC 83). Also, the affected director, and any member connected with him, cannot vote on the ratifying resolution (section 239, 2006 Act).

    Section 263(3) sets out the more discretionary elements of the permission process. The court must take account, in particular, of the following, although it is not an exhaustive list:
  • Whether the member is acting in good faith. The court must be sure that the member is not motivated purely by personal interest (Barrett v Duckett [1995] 1 BCLC 243). Although, as long as the dominant purpose in bringing the claim is to benefit the company, a member will not necessarily be acting in bad faith if there is a collateral personal reason for bringing it (Iesini).
  • The importance that a person acting in accordance with section 172 would attach to continuing it. The court will have accepted that a hypothetical director would seek to continue the claim. The court must next determine the importance that a director would attach to continuing it. This includes assessing the business considerations that a director would regard as important, for example the likelihood of success and the costs and time involved (Franbar Holdings Ltd v Patel and others [2008] EWHC 1534). In Zavahir v Shankleman and others, the High Court held that although there was a prima facie case, a prudent director would not, given the potential costs and risks, proceed with the claim ([2016] EWHC 2772).
  • The likelihood of authorisation or ratification. This will involve an assessment of whether the act or omission is capable of ratification or authorisation and if the statutory voting restrictions will make it impossible.
  • A decision by the company not to pursue a claim. The decision may be taken by the directors or the shareholders. A court may adjourn to allow the company to discuss the issue. In Bridge, an independent board decided that it was not in the best interests of the company to pursue the claim, and the court noted that it should attach considerable weight to the commercial judgment of that independent board.
  • Whether the member could pursue a personal claim. The availability of an alternative personal remedy is not a bar to bringing a derivative claim. The member may want to remain a shareholder of the company rather than seeking a remedy under the unfair prejudice regime, which could result in him being bought out (Hook v Sumner [2015] EWHC 3820).
  • Any evidence of the views of members of the company who have no personal interest, direct or indirect, in the matter (section 263(4)). This is to give weight to the views of those who are not involved in the wrongdoing, and to cover situations where authorisation or ratification is not possible.

Unfair prejudice claims

A member of a company, or a non-member to whom shares in a company have been transferred or transmitted by operation of law, may petition the court for relief where:

  • The company's affairs are being conducted in a manner that is unfairly prejudicial to the member's interests as a member.
  • An actual or proposed act or omission of the company is, or would be, so prejudicial (section 994, Companies Act 2006) (2006 Act) (section 994).

Unfair prejudice claims are mainly a tool for minority shareholders as, while majority shareholders are able to bring a petition under section 994, prejudice will not be unfair to the petitioner's interests where he can easily rectify the prejudicial state of affairs (Re Baltic Real Estate Ltd (No 2) [1992] BCC 629).

The court has a wide discretion to make such order as it thinks fit to remedy the unfair prejudice and regulate the company's affairs in the future (section 996(1), 2006 Act). These include: ordering certain meetings to be held; setting out a code of conduct for future company business; requiring the company to carry out an act or refrain from doing an act; authorising civil proceedings to be brought in the name of the company even where the preconditions of the statutory derivative claim regime are not made out; prohibiting changes to the company's articles of association; and providing for the purchase of a member's shares by other members or by the company, on such terms as the court thinks fit.

How to bring a derivative claim

There are three ways that a derivative claim can be brought under Part 11 of the Companies Act 2006, the first being the most common:

  • A claim can be initiated by a member who applies to the court for permission to proceed (section 261(1)).
  • A claim brought by the company can be pursued as a derivative claim. A member can apply to the court for permission to continue the claim as a derivative claim if the manner in which the claim has been brought has been an abuse of process, or if the company has failed to pursue the claim diligently (section 262).
  • An existing derivative claim can be brought as a derivative claim by a different member if, for example, the original member has failed to pursue the claim diligently, or it is otherwise appropriate to do so.

This article first appeared in the July 2017 issue of PLC Magazine.

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