Flashcards
Company - W6 - Managing companies: Minority shareholder remedies
Flashcards do conjunto (78)
- 1Minority shareholders- Directors are responsible for the day-to-day running of the company and have the authority necessary to act on the company's behalf in this regard (MA 3).
- Certain key decisions require shareholder approval eg amending the company's articles (s 21), granting a director a long-term service contract (s 188), making a loan to a director (s 197), removing a director from office (s 168).
- However, all of these decisions require either an ordinary resolution (over 50% vote in favour) or a special resolution (75% or more).
- Both the directors and shareholders act by majority and the principle of "majority rule" pervades company law.
- A minority shareholder often has little impact on shareholder voting and therefore little input into the way in which the company is managed.
- There needs to be a remedy in appropriate circumstances for minority shareholders, where the majority abuse their position, mismanage the company, or act unfairly. - 2Rights of minority shareholders- Historically, the courts were reluctant to allow minority shareholders to bring claims.
- The law has now developed, and CA 2006 does allow minority shareholders certain limited remedies where the management of the company causes them prejudice or loss.
- In this topic you will consider the equitable remedy of unfair prejudice and just and equitable winding up.
- Minority shareholders can also bring derivative claims against directors on behalf of the company, and you will consider the grounds and effect of these claims in detail.
- Finally, in certain circumstances shareholders may bring personal claims, where they are able to show that they have suffered loss personally, over and above any loss suffered by the company.
- These claims are costly to bring and uncertain in outcome, as the court has a wide discretion as to remedies.
- In order to protect their position, shareholders are advised to instead enter into Shareholders' Agreements. - 3The development of the law relating to unfair prejudice- Historically, minority shareholders had little recourse when seeking to challenge the conduct of the majority, with the only remedy being to petition the court for the company to be wound up on the grounds that it was just and equitable to do so.
- However, generally, the winding up of the company did not benefit the minority shareholders as the break-up value of the assets of the company may be low, or the only available purchaser may be the majority shareholder whose oppression had caused the minority shareholder to seek a remedy in the first place.
- The introduction of the action for unfair prejudice sought to provide minority shareholders with a better remedy. This remedy was initially set out in s 459 CA 1985, now s 994 CA 2006.
- Section 994 CA 2006 is substantially the same as s 459 CA 1985, so the old case law remains relevant. - 4Unfair prejudice – s 994 – 996 CA 2006Section 994(1) provides that:
"A member of a company may apply to the court by petition for an order … on the ground:
a) that the company’s affairs are being or have been conducted in a manner which is unfairly prejudicial to the interests of its members generally or of some part of its members (including at least himself), or
b) that any actual or proposed act or omission of the company (including an act or omission on its behalf) is or would be so prejudicial." - 5Unfair prejudice – s 994 – 996 CA 2006 (1) Conduct of the company's affairs- In order to succeed with a petition under s 994(1), a petitioner must establish unfairly prejudicial conduct arising from an act or omission of the company, or made on the company's behalf.
- The conduct complained of must be an act or acts done by the company (eg by the directors), not the conduct of an individual shareholder acting in their private capacity.
- The complaint must relate to how the affairs of the company have been managed - personal disputes between shareholders fall outside the scope of s 994. - 6Unfair prejudice – s 994 – 996 CA 2006 (1) Conduct of the company's affairs Re Legal Costs Negotiators Ltd- This company was incorporated by four individuals who were equal shareholders, directors and employees.
- Unfortunately, relations broke down and the fourth individual was dismissed an employee and resigned as a director just before he was to be removed.
- He remained as a shareholder and refused to sell his shares to the other three, who petitioned under s 459 seeking an order that he transfer his shares to them.
- The Court of Appeal rejected this petition on the basis that the other three shareholders, being the majority, could prevent any prejudice from this shareholder.
- It was held that simply remaining as a shareholder was not conduct relating to the company's affairs. - 7Unfair prejudice – s 994 – 996 CA 2006 (1) Conduct of the company's affairs Re Home & Office Fire Extinguishers Ltd- This case illustrates that there may be an overlap between the requirement that the conduct relates to the company's affairs and personal disputes where such disputes make it impossible for the parties to continue working together as directors/shareholders.
In this case two brothers, S and G, were directors and equal shareholders in the company.
S attacked G with a hammer at the company's premises following G's refusal to make a salary advance.
S was charged with grievous bodily harm but acquitted.
The court ordered S to sell his shares to G, holding that S's conduct related to the affairs of the company because it was a breach of the implied understanding that S and G would act properly and in good faith towards each other. - 8Unfair prejudice – s 994 – 996 CA 2006 (1) Conduct of the company's affairs Re City Branch Group Ltd, Gross v RackindThe court in this case held that the conduct of a subsidiary could be regarded as falling within the affairs of a holding company, especially in the situation in this case where the directors of the holding company and subsidiary are the same or substantially the same.
- 9Unfair prejudice – s 994 – 996 CA 2006 (2) Interests of the members- The petitioner must also prove that their interests in their capacity as a member have been unfairly prejudiced as a result of conduct on the part of the company.
- This requirement is construed widely. For example, members have an interest in the value of their shares and will therefore be able to bring a claim if they can show that "the value of their shareholding has been seriously jeopardised by reason of a course of conduct on the part of those persons who have had de facto control of the company, which has been unfair to the member concerned" Re Bovey Hotel Ventures Ltd (1981). - 10Unfair prejudice – s 994 – 996 CA 2006 (2) Interests of the members Gamlestaden Fastigheter AB v Baltic Partner Ltd- In this case a member had provided a loan to the company and the issue was whether the member's petition should be struck out in circumstances where the company was insolvent and the relief sought (payment of compensation by the directors to the company) would confer no financial benefit on this member in his capacity as a member.
- The Privy Council held that "interests" may extend to cover those of a member who is a creditor as in this case where, in the circumstances, the distinction becomes artificial. - 11Unfair prejudice – s 994 – 996 CA 2006 (3) Unfair prejudiceThe leading authority in the interpretation of "unfair prejudice" is the House of Lords case of O'Neill v Phillips
Hoffmann LJ in O'Neill v Phillips stated that fairness for the purposes of s 994 must be viewed in the context of a commercial relationship and that the relationship between the shareholders and the company is set out in the articles, which must be the starting point when determining whether conduct was unfair. - 12Unfair prejudice – s 994 – 996 CA 2006 (3) Unfair prejudice O'Neill v Phillips- The petitioner, O, was employed by the company, whose sole director and shareholder was originally P.
= P was impressed with O's work and in 1985 O was awarded 25% of the company's shares and made a director.
- P told O that he would eventually take over the business and would then receive 50% of the profits.
- In December 1985 P retired from the board and O became the sole director.
- The business initially did well but then began to decline and in August 1991 P used his majority voting rights to appoint himself managing director and took over management of the business, telling O that he would no longer receive 50% of the profits, or receive certain share incentives.
- O issued a petition for unfair prejudice based on a legitimate expectation of receiving 50% of the voting shares.
- The House of Lords held that there was no unfair prejudice here as the entitlement to 50% of the profits was never formalised and was conditional on O running the business, which he was no longer doing. - 13Unfair prejudice – s 994 – 996 CA 2006 (3) Unfair prejudice Re Tobian Properties Ltd- “The key phrase in section 994(1), ‘unfairly prejudicial’, comprises two elements, unfairness and prejudice but both of these must be understood in the context of company law.
- The concept of fairness inherent in this phrase is flexible and open-textured but it is not unbounded.
- The courts must act on a principled basis even though the concept is to be approached flexibly.
- They cannot decide whether to grant or refuse relief from unfair prejudice on the basis of palm-tree justice." - 14Unfair prejudice - summary- Following O'Neill v Phillips , in order to establish unfair prejudice, a petitioner must prove:
1. Breach of contract (the articles or a shareholders' agreement), or
2. Breach of some fundamental understanding.
- The court will begin by looking at whether the conduct complained about is in accordance with the articles.
- The court will next consider the scope of any fundamental understandings between the parties.
- Unfairness must be tested by looking at whether the majority had acted or was proposing to act in a manner which equity would regard as contrary to good faith.
- Unlawful conduct will not necessarily be unfairly prejudicial, and trivial or technical infringements of the articles may not give grounds for a s 994 petition. - 15Examples of unfair prejudicial conduct1. Exclusion from management
2. Mismanagement
3. Breach of directors' fiduciary duties
4. Excessive remuneration and refusal to pay dividends - 16Examples of unfairly prejudicial conduct 1. Exclusion from management- This is the most common ground for unfair prejudice petitions.
- In a small quasi-partnership private company, a member may expect to continue to participate in the management of the company on the basis of a fundamental understanding between the parties, despite the fact that any director may be validly removed from office by an ordinary resolution of the members under s 168 CA 2006.
- However, this will not be the case in larger companies with outside investors.
- It is also not the case that in every small quasi-partnership company, the removal from office of a director will automatically give rise to an unfair prejudice claim – there needs to be some conduct which is "unfairly prejudicial" regarding the removal. - 17Examples of unfairly prejudicial conduct 1. Exclusion from management Re Tottenham Hotspur plc- Terry Venables, chief executive of Tottenham Hotspur football club, brought a petition claiming unfair prejudice after he was dismissed from office.
- It was held that he had no legitimate expectation of remaining in control of the company, so the action failed. - 18Examples of unfairly prejudicial conduct 2. Mismanagement- In general, poor management of a company will not give rise to a claim for unfair prejudice, since the courts are very reluctant to find that management decisions amount to unfair conduct.
- It has been held that the risk of poor management is inherent in share ownership and the courts will not interfere with a bona fide business decision made by a company’s board or its majority shareholders except where there is a clear conflict of interests (Re Elgindata Ltd [1991] BCLC 959).
- However, where the directors have abused their powers or exercised them for some ulterior purpose, an allegation of mismanagement may amount to unfair prejudice. - 19Examples of unfairly prejudicial conduct 2. Mismanagement Re Macro (Ipswich) Ltd- In this case an allegation of mismanagement over 40 years resulting in economic loss to the company was found to amount to unfairly prejudicial conduct.
- Here the sole director of the two associated companies neglected his management responsibilities allowing dishonest employees to steal from the company.
- The petitioners successfully argued that substantial financial losses were suffered by the companies as a result, which caused unfair prejudice to them. - 20Examples of unfairly prejudicial conduct Breach of directors' fiduciary dutiesThis is a common ground for petitions for unfair prejudice and there have been a number of successful petitions brought on this ground.
- 21Examples of unfairly prejudicial conduct Breach of directors' fiduciary duties Case Law ExamplesRe London School of Electronics [1986] Ch 211:
- In this case the petition for unfair prejudice succeeded where those in control of the company had misappropriated its assets by diverting them to another business owned by them.
Re Little Olympian Each-Ways Ltd (No 3) [1995] 2 BCLC 420, ChD:
- The directors sold the company's business at a substantial undervalue to another company as part of a wider transaction in which the directors received significant personal benefit.
This was held to be unfairly prejudicial conduct.
Re A Company (No 005287 of 1985) [1986] BCLC 68:
- In this case the petition for unfair prejudice succeeded on the grounds that the directors had made secret profits. - 22Examples of unfairly prejudicial conduct 4. Excessive remuneration and refusal to pay dividends- Although generally companies' articles of association provide that directors' remuneration should be determined by the general meeting, in practice the power to determine directors' remuneration is delegated to the board, and the court will tend not to interfere with the business judgement of the board provided it has honestly determined the level of remuneration.
- However, it is clear that there is ample scope here for abuse of this power, and in these cases the court will be prepared to hold that failure to pay dividends and/or directors' awarding themselves excessive remuneration will be unfairly prejudicial conduct. - 23Examples of unfairly prejudicial conduct 4. Excessive remuneration and refusal to pay dividends Re a Company (No. 004415 of 1996)Here the court held that if remuneration and dividend levels cannot be justified by "objective commercial criteria" then it would follow that the affairs of the company have been managed in a way which is unfairly prejudicial to the interests of shareholders who are not directors.
- 24Who may bring a claim for unfair prejudice?- Under s 994(1) the petition for unfair prejudice may be brought by a "member" of the company.
- Section 112 defines a "member" as a subscriber to the company's memorandum and "every other person who agrees to become a member of the company and whose name is entered into the register of members". However, the case law indicates that the court will be prepared to interpret this broadly in appropriate circumstances. - 25Who may bring a claim for unfair prejudice? Harris v JonesThe court held that a person to whom shares had been transferred but had not been registered as a member had the right to bring a s 994 petition.
- 26Who may bring a claim for unfair prejudice? Blunt v JacksonThe judge in this case noted that the court had the power to retrospectively amend the register of members, and so allowed a person who had agreed to become a 50% shareholder and had worked for the company on low wages in the belief that he was a shareholder, but was not registered as such, to succeed in a petition for unfair prejudice based on his exclusion from management.
- 27Remedies – s 996- The court has a wide discretion in determining the appropriate remedy.
- Section 996(1) states that the court may "make such order as it thinks fit for giving relief in respect of the matters complained of”.
- Section 996(2) lists possible orders that the court may make"
1. ”regulate the conduct of the company's affairs in the future;
2. require the company (i) to refrain from doing or continuing an act complained of, or (ii) to do an act which the petitioner has complained it has omitted to do;
3. authorise civil proceedings to be brought in the name and on behalf of the company by such person or persons and on such terms as the court may direct;
4. require the company not to make any, or specified, alterations in its articles without the leave of the court;
5. provide for the purchase of the shares by any members of the company by other members of the company or by the company itself…" - 28Remedies – Share purchase order- There is a presumption that the court will grant an order for the purchase of the petitioner's shares by the company or another shareholder under s 996(2)(e) (Grace v Bigioli [2005] EWCA Civ 1222).
- This is the most common remedy and is usually sought by shareholders in small private companies who have limited options to sell their shares (remember that private companies are prohibited from offering shares to the public under s 755 CA 2006).
- The court must then determine the valuation of the petitioner's shares. The key issue is for the court to determine a price that is fair in all the circumstances. - 29Remedies – Share purchase order Re Bird Precision Bellows LtdIn this case Nourse J looked at the valuation process in detail, noting that for quasi-partnership companies at least, it would normally be unfair to impose a discount on the shares to represent the limited voting power and control of a minority shareholder, since for these companies generally the minority shareholder is being forced to sell their shares as a result of the unfairly prejudicial conduct.
- 30Valuation of the shares- One critical issue is the date on which the shares should be valued, since the value of the shares may have changed considerably between the date on which the petition to court was made and the date of judgment.
- Abbington Hotel Ltd [2011] EWHC 635: The starting point for the date of valuation of shares for a buy-out order under s 996 is the date of judgment, but the court is free to choose a date that is most appropriate in the circumstances of the case. The date should be "that which best remedies the unfair prejudice held to be established”.
- Note that in O'Neill v Phillips [1999] 1 WLR 1092 HL, Hoffmann LJ noted that if the respondent (the company or majority shareholder) has made a reasonable offer to buy out the petitioner, based on an expert valuation, then the respondent may be entitled to have the petition for unfair prejudice struck out. - 31Valuation of the shares McCallum-ToppinThe estate of a deceased director in a successful closely held family company (AMT Coffee Limited) succeeded with a claim under s 994 CA 2006 that the affairs of the company had been carried out in an unfairly prejudicial manner.
The majority:
1. Deprived the minority of dividends where there would have been sufficient reserves to pay them, but for the majority paying themselves salaries which were largely unjustified.
2, Used the company as a “personal piggy bank”, borrowing in excess of £1 m from the company for personal expenses.
- Under s 996 CA, the majority were ordered to buy the minority’s shares at a “fair value” at an undiscounted valuation. - 32Valuation of the shares Re Sprintroom- It was held that a breach of duty by a director who incorrectly claimed that the intellectual property to a piece of software vested with him personally, not the software development company, did not preclude his entitlement to a remedy as a (40%) shareholder under s 994 CA 2006.
- The court found that the majority 60% shareholder unfairly prejudiced the minority 40% shareholder by:
1. Exclusion from management. As a director, although the minority had breached s 172 and s 175 CA 2006, this was not sufficient to justify his exclusion as the dispute as to IP rights was conducted openly; whereas a more egregious breach in bad faith such as secret negotiation from competitors would justify his exclusion.
2. Making an offer to buy the minority’s shares which did not reflect his 40% interest (so a balancing payment was ordered). - 33Just and equitable winding up- Historically, this was the only remedy available to an aggrieved minority shareholder.
- This remedy is set out in s 122(1)(g) Insolvency Act 1986 (IA 1986):
"A company may be wound up by the court if the court is of the opinion that it is just and equitable that the company should be wound up.”
- A minority shareholder may apply to the court ("petition") under s 122(1)(g) IA 1986 for the company to be wound up and the assets distributed amongst the shareholders.
- This remedy comes from the law of partnership, where the courts of equity had jurisdiction to dissolve a partnership where the relationship between its members had broken down.
- Just and equitable winding up is a draconian remedy of last resort, resulting in the end of the life of the company.
The courts will therefore attempt to find alternative remedies where possible.
- The Companies Act 1980 introduced the remedy of unfair prejudice (now set out in s 994 CA 2006) and this is now used far more commonly in the resolution of shareholder disputes than just and equitable winding up. - 34Consequences of a just and equitable winding up petition- Where a shareholder petitions the court under s 122(1)(g) IA 1986 for just & equitable winding up, this can have dire consequences for a prosperous company.
- Section 127 IA1986 provides that:
- "…any disposition of the company’s property, and any transfer of shares, or alteration in the status of the company’s members, made after the commencement of the winding up is, unless the court otherwise orders, void”.
- Banks will freeze company bank accounts as soon as they receive notice of such a petition, since any payments made out of the company's bank account after presentation of the petition can be set aside by the liquidator when the company has been wound up.
- This means that the company is in effect paralysed pending the outcome of the petition. - 35Just & equitable winding up: grounds for petitionKey case: Ebrahimi v Westbourne Galleries Ltd
- Lord Wilberforce said that the remedy gave the court a wide discretionary jurisdiction.
- He considered it important not to create categories or particular grounds on which a claim for just and equitable winding up can be brought.
- Cases should be considered individually.
- Generally speaking, successful petitions for just and equitable winding up usually result where the relationship between directors and/or shareholders has broken down to the extent that it is not possible for the company to be run effectively.
- Examples of this include the final three grounds discussed below: deadlock (where the parties are not able to reach a decision), justifiable loss of confidence in the company’s management and exclusion from management.
- This is a draconian remedy and therefore will only be ordered on compelling grounds.
- There are a number of cases in which the court has ordered a company to be wound up, which illustrate the circumstances in which this remedy may be appropriate. - 36Just & equitable winding up: grounds for petition Ebrahimi v Westbourne Galleries Ltd- This case concerned a rug business which had been run by E and N as a partnership for over a decade.
In 1958 a company was established to take over the business and initially E and N were the only directors and equal shareholders.
N's son then joined the company as a director and shareholder, meaning that E became a minority at both board and shareholder level.
The parties fell out and E was voted off the board but retained his shares.
No dividends were paid to him, as all the profits were distributed by way of directors' remuneration.
E petitioned the court for a winding up order and alternatively for relief under the "oppression remedy" in the Companies Act 1948, which was the precursor to the unfair prejudice remedy.
The House of Lords concluded that although E had been validly removed as a director under the Companies Act, as the company had been formed on the understanding that E would remain in management, his exclusion was in breach of that understanding and therefore it was just and equitable to wind up the company.
This company was held to be a "quasi-partnership". - 37Grounds for petition1. Substratum has failed
2. Fraud
3. Deadlock
4. Justifiable loss of confidence in the company's management
5. Exclusion from participation in a small private company where there was a relationship based on mutual confidence - 38Grounds for petition 1. Substratum has failed- Where the petitioner establishes that the commercial object for which the company was formed has failed or been fulfilled, this will be a ground for just and equitable winding up.
- Note that this ground is of much less importance now as s 31(1) CA 2006 provides that a company's objects will generally be unrestricted.
- Re German Date Coffee Co
The company had been established not for the general purpose of making coffee from dates but to work a particular patent, and as that patent did not exist, the company could be wound up. - 39Grounds for petition 2. Fraud- Where a company has been formed to perpetrate a fraud and winding up represents the best way for its shareholders to recover the money they invested, the court may grant a winding-up order.
Re Thomas Edward Brinsmead & Sons
- In this case three men who were named Brinsmead were former employees of John Brinsmead & Sons, a renowned piano manufacturing company.
- They formed Thomas Brinsmead & Sons to make pianos which they passed off as manufactured by John Brinsmead & Sons.
- The court held it to be just and equitable to wind up the company and return the money to the shareholders since the purpose of the company was fraudulent. - 40Grounds for petition 3. Deadlock- It is rare for there to be total deadlock in the management of a company since the chairman generally has a casting vote at board meetings.
- However, where deadlock does occur the court may order the company to be wound up.
Re Yenidje Tobacco Ltd
- Here two tobacco manufacturers formed the company to merge their businesses.
- They were equal shareholders and the only two directors.
- The relationship between the two became acrimonious to the point that they refused to speak to each other and would only communicate through the company secretary.
- Despite the fact that the company was profitable, the court ordered it to be wound up. - 41Grounds for petition 4. Justifiable loss of confidence in the company's management- This ground overlaps with the deadlock ground above.
- Where a company is in effect a quasi-partnership, the court may order it to be wound up where there is a lack of confidence in the management.
- For this ground to apply there needs to be a lack of probity in the way the company is being run by the majority, effectively driving the minority out so that it is unjust and inequitable to require the minority to remain shareholders, therefore justifying the winding up.
Loch v John Blackwood Ltd
- The majority shareholder in this company dominated the board of directors, refused to declare dividends, call general meetings or publish accounts, aiming to induce the minority shareholders to sell their shares at an undervalue.
- The Privy Council ordered the company to be wound up. - 42Grounds for petition Exclusion from participation in a small private company where there was a relationship based on mutual confidence- This was the situation in Ebrahimi v Westbourne Galleries.
- Lord Wilberforce listed the typical elements in petitions brought under this ground as:
i) the basis of the business association was a personal relationship and mutual confidence (often where a pre-existing partnership converts into a limited company);
ii) an understanding that all shareholders will participate in management;
iii) a restriction on the transfer of members' interests preventing the petitioner leaving.
- He concluded that just and equitable winding up would be appropriate where the petitioner:
"can point to, and prove, some special underlying obligation of his fellow member(s) in good faith, or confidence, that so long as the business continues, he shall be entitled to management participation, an obligation so basic that, if broken, the conclusion must be that the association must be dissolved." - 43Who can bring a petition?- Section 124(1) IA 1986: application to the court for a winding-up order may be made by a “contributory".
- "Contributory" means any person liable to contribute to the assets of a company in the event of it being wound up, which includes every past and present member.
- For a fully paid up shareholder to bring a petition, they must show a "tangible interest in the company”.
i.e shareholder must prove (on the balance of probabilities) that there will be a surplus among the shareholders after payment of the company's debts, liabilities and the expenses of the liquidation (Re Rica Gold Washing Co).
- If the shareholder cannot prove surplus assets, they may also establish a tangible interest by showing that they would achieve some advantage or avoid or minimise some disadvantage which would accrue to them as a member if the company was wound up (Re Chesterfield Catering Co [1977] Ch 373).
The petitioner's own conduct is relevant, as this is an equitable remedy. - 44Derivative claims intro- doctrine of separate legal personality (Salomon) means that the company can sue and be sued in its own name.
- Where the company has suffered loss, it is therefore the company that is the proper claimant.
- However, companies are inanimate and therefore can only act through their directors, or in certain circumstances, through the members by majority vote in general meeting.
- Where the loss has been caused by the action of an internal stakeholder, for example one or more directors, or the majority of the members, clearly vested interests may prevent the company from bringing an action.
- Can an individual member bring a claim in this situation where the board refuse to do so?
- The courts have been reluctant to interfere in the internal management of companies
- Carlen v Drury: "This Court is not required on every Occasion to take the management of every Playhouse and Brewhouse in the Kingdom." - 45Types of shareholder actions relating to internal disputes1. Claims brought by members in relation to wrongs done to them personally (not in relation to wrongs done to the company) ("Personal claims")
2. Claims brought by members to vindicate a wrong done to the company ("Derivative claims") - 46Types of shareholder actions relating to internal disputes Personal claims- Here the member may bring a personal or representative action, or one of the statutory remedies (unfair prejudice under s 994 CA 2006 or just and equitable winding up under s 122 Insolvency Act 1986).
- Shareholders may also bring a personal claim to enforce their rights as shareholders in the articles under s 33 CA 2006.
- You have already considered the statutory claims for unfair prejudice and just and equitable winding up.
- These types of claims are not affected by the rule in Foss v Harbottle or the statutory procedure in CA 2006. - 47Types of shareholder actions relating to internal disputes Derivative claims- These types of claims are known as derivative claims and originally were dealt with by the courts in accordance with the rule in Foss v Harbottle.
- However, since CA 2006 came into force, there is now a statutory procedure for a shareholder to bring a derivative claim on behalf of the company, which replaces the common law in so far as it applies.
- These are the types of claims that we are focussing on in this element.
- We will consider briefly the rule in Foss v Harbottle and the common law exceptions to this rule. We will then focus on the statutory derivative claims procedure under CA 2006 in detail. - 48The historical development of the law on derivative claims- Historically, the "rule in Foss v Harbottle " guided the approach of the courts to derivative claims.
- This rule provided that the "proper claimant" was the company in a situation where the company itself was the victim of a "wrong" (eg a director had breached his duty to the company) and made it very difficult for an individual member to bring a claim, either on their own behalf or on behalf of the company.
- The case law in this area is difficult to interpret and the distinction between different types of action is sometimes blurred.
- CA 2006 introduced a new statutory procedure for derivative claims, which is set out in ss 260 – 263. The statutory procedure introduced in CA 2006 was an attempt to clarify (and codify) this area.
- The old common law rules are still relevant in certain very limited situations.
- The statutory rules only affect claims for wrongs done to the company, and even then, only claims for wrongs done by directors (s 260(3)). - 49he rule in Foss v Harbottle- The rule in Foss v Harbottle is clearly summarised in the case of Edwards v Halliwell
i) The proper claimant in an action in respect of a wrong done to a company is prima facie the company itself (the "proper claimant principle”).
ii) Where the alleged wrong is a transaction which might be made binding on the company and all its members by a simple majority of the members, no individual member of the company is allowed to maintain an action in respect of that matter "for the simple reason that, if a mere majority of the members of the company … is in favour of what has been done, then cadit quaestio" (in other words, the majority rule). This is known as the "internal management principle").
- In addition, if the matter relates to an irregularity that the company is able to ratify or condone by its own internal procedure then no individual member may bring an action (the "irregularity principle”). - 50Exceptions to the rule in Foss v Harbottle1. Where the act complained of is ultra vires or illegal;
2. Where the matter is one which could validly be done or sanctioned only by some special majority of members, or there has been non-compliance with a special procedure;
3. Where the personal and individual rights of the member have been infringed; or
4. Where what has been done amounts to a "fraud on the minority" and the wrongdoers are themselves in control of the company.
- The generally accepted view is that only the fourth exception set out above is a true exception to the rule in Foss v Harbottle , since the other exceptions can be explained on the basis of the member being allowed to sue for breach of their personal rights. - 51Derivative actions under CA 2006 Part 11- A "derivative claim" is a claim brought by a member in respect of a cause of action vested in the company seeking relief on behalf of the company.
- The disadvantage of derivative claims is that the relief gained is only awarded to the company, not the individual member bringing proceedings.
- The advantage of derivative claims are that they allow individual members to "right a wrong" on behalf of the company in circumstances where the company itself does not bring a claim. - 52Derivative actions under CA 2006 Part 111. A claim may be brought by any member - s260(1).
2. A claim may be brought against any director and/or another person, including former directors - s260(3)/(5)
3. The grounds for bringing a claim: any act or omission, actual or proposed, involving negligence, default, breach of duty or breach of trust by a director - s260(3). Note that it is immaterial whether the cause of action arose before or after the claimant became a shareholder – s260(4) - 53Application for permission to continue a derivative claim: the two-stage process- Section 261- 263 require a member bringing a derivative claim under s 260 to apply to court for permission to continue the claim.
- This is a two-step process, involving two hearings:
1. The court will consider whether the applicant has a prima facie case for permission to continue the derivative claim . If the application is not dismissed at this first stage (because the applicant provides evidence of a good cause of action) then it moves to the second stage.
2. If the application shows a prima facie case for permission under stage 1, it then proceeds to the second stage under s 263, which is the full permission hearing . The court may order the company, as well as the applicant, to provide evidence at this stage. - 54Application for permission to continue a derivative claim: Stage 1Stage 1
- The purpose of the first stage is to enable the court to quickly dismiss cases that stand little or no chance of success.
- In practice, the parties may be able to bypass this stage where the defendant company concedes that there is a prima facie case (eg Franbar Holdings Ltd v Patel) or where the court may be prepared to hear the first and second stages for permission together (eg Stimpson v Southern Landlords Association).
- However, this practice has been criticised because bypassing the filtering mechanism of stage 1 may lead to unmeritorious cases proceeding to a full permission hearing (Re Severn Holdings). - 55Application for permission to continue a derivative claim: Stage 2For the second stage, the full permission hearing, s 263 sets out absolute and discretionary bars to granting permission to a member to continue a derivative claim.
- 56Application for permission to continue a derivative claim: Stage 2 Absolute bars- Section 263(2) states that permission must be refused if the court is satisfied -
a) ” that a person acting in accordance with section 172 (duty to promote the success of the company) would not seek to continue the claim, or
b) where the cause of action arises from an act or omission that is yet to occur, that the act or omission has been authorised by the company, or
c) where the cause of action arises from an act or omission that has already occurred, that the act or omission -
i) was authorised by the company before it occurred, or
ii) has been ratified by the company since it occurred." - 57Application for permission to continue a derivative claim: Stage 2 Discretionary barsSection 263(3) - factors court must take into account when exercising its discretion to grant permission to continue a derivative claim:
a) ”whether the member is acting in good faith in seeking to continue the claim;
b) importance of acting in accordance with section 172 (duty to promote the success of the company) ;
c) where the cause of action results from an act or omission that is yet to occur, d) whether the act or omission could be, and in the circumstances would be likely to be
i) authorised by the company before it occurs, or
ii) ratified by the company after it occurs;
d) where the cause of action arises from an act or omission that has already occurred, whether the act or omission could be, and in the circumstances would be likely to be, ratified by the company;
e) whether the company has decided not to pursue the claim;
f) whether the act or omission in respect of which the claim is brought gives rise to a cause of action that the member could pursue in his own right rather than on behalf of the company." - 58Other considerations to be taken into account when the court is considering whether to grant permission to continue the claimSection 263(4) also states that the court must 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. This follows the earlier-mentioned case of Smith v Croft (No 2).
- 59Approach of the courts- The statutory procedure is similar to the rule in Foss v Harbottle in that the court will presume to dismiss a derivative claim unless one of the exceptions applies.
- During the course of parliamentary debate on the new statutory procedure there was concern that this new procedure would open the floodgates of litigation, given that the s 260 action allows a member to bring a claim on behalf of the company against a director for negligence, which is much wider than the old common law exceptions to Foss v Harbottle.
- However, this has not been the case.
- The courts robustly case manage such claims at the permission stage and successful claims remain rare.
- There are substantial disincentives to bringing such a claim since members themselves do not recover the damages (these are paid to the company where the claim is successful) and the costs of these claims are substantial. - 60Case law under s 260 Mission Capital v Sinclair- In this case two directors, who were also shareholders, were dismissed from the board of the company and their service contracts were terminated.
- The company later brought a claim against these two directors, who counterclaimed seeking reinstatement and bringing a derivative claim against the continuing directors.
- The court refused to give permission to continue the derivative claim under the discretionary grounds, deciding that a notional director acting in accordance with their duty under s 172 to promote the success of the company would give little weight to continuing the claim.
- The court were also influenced by their finding that the claimants could alternatively bring a claim for unfair prejudice under s 994. - 61Case law under s 260 Franbar Holdings v Patel- A disagreement arose about the way in which the company was managed and the operation of a shareholders' agreement.
- The claimant was a shareholder in the company who brought a claim against the company and the directors for breach of the shareholders' agreement, a petition for unfair prejudice and a derivative claim against the directors.
- The court refused permission to continue the derivative claim under the discretionary factors, considering that a notional director would not attach importance to the claim because the matters complained of were also covered by the actions for breach of the shareholders' agreement and the petition for unfair prejudice under s 994. - 62Case law under s 260 Iesini v Westrip Holdings Ltd- In this case the court found that the directors had not breached their duties so there were no grounds for launching a derivative claim.
- Lewinson J in this case reviewed the statutory procedure, noting that the first stage is considered on the basis of the evidence filed by the applicant only, without requiring evidence from the defendant or the company, and at the second stage, something more than a prima facie case must be needed but the court cannot embark on a mini trial of the action. - 63Case law under s 260 Stainer v Lee- In this case the court granted limited permission to continue a derivative action to the end of the disclosure stage of proceedings, subject to various conditions, including a condition as to costs.
- The court considered that the strength of the case would be clearer after the conclusion of the disclosure stage. - 64Case law under s 260 Cullen Investments Ltd v Brown-In this case the court granted permission to continue the claim to trial.
- The claimant alleged that a director had exploited a corporate opportunity for his own benefit.
- The shareholder had assumed all the financial risks of the litigation and the court rejected the argument that no director acting in accordance with their duty under s 172 would have supported the claim. - 65Case law under s 260 Bridge v Daley- Here the court refused permission to continue the derivative claim.
- The judge accepted that the claimant shareholder was acting in good faith but since most of the allegations were unsubstantiated and the overwhelming majority of shareholders and the independent board members did not support the claim, permission was refused.
- The judge concluded that the complaint would be better brought as a petition for unfair prejudice under s 994. - 66Costs of derivative claims- A member brings a derivative claim on behalf of the company, and it is the company and not the member claimant who will benefit from any remedies awarded.
- A major disincentive to bringing proceedings is therefore the cost involved.
- Rule 19.9E of The Civil Procedure Rules allows the court to order the company to indemnify the claimant against any liability in respect of costs incurred in the claim or the permission application, or both.
- An application for costs may be made at the same time of the permission application.
-This is called a pre-emptive costs order.
- Pre-emptive costs orders were first awarded in the case of Wallersteiner v Moir (No 2) where Buckley LJ concluded that a member who brings a derivative claim may be entitled to be indemnified by the company at the end of the trial for their costs, provided they acted reasonably in bringing the action. Such orders are therefore sometimes referred to as "Wallersteiner orders". - 67Derivative claims – overlap with s 994- It is clear from the case law that if the facts giving rise to a derivative action under s 260 also give rise to a claim for unfair prejudice under s 994, the court will be reluctant to grant permission to continue the derivative claim (Mission Capital plc v Sinclair, Franbar Holdings v Patel).
- However, this is not an absolute bar. In appropriate circumstances the discretion may be exercised the other way, and the court may hear the proceedings under s 994 and s 260 together, as was the case in Phillips v Fryer [2011] EWHC 1611 (Ch). - 68Derivative claims vs s 994 - advantages and disadvantages- The advantages of bringing a claim for unfair prejudice under s 994 rather than a derivative claim under s 260 are that such a claim is easier to proceed (as there is no permission requirement) and also that the remedy obtained is for the member, not the company.
- However, a derivative action may be preferable to a claim for unfair prejudice where the aim of the claimant is not to be bought out (which is the most common remedy in unfair prejudice claims), but for the company to benefit Clark v Cutland [2004] 1 WLR 783.
- Note that where a shareholder brings a claim for unfair prejudice under s 994, s 996(2)(c) gives the court the power to direct the claimant to bring a derivative claim, however it seems that it would be in very rare circumstance that this would be used. - 69Derivative claims vs s 994 - advantages and disadvantages Paramount Powders (Badyal v Badyal)- eldest brother (B1) who held 25% shares in a family company failed with three claims:
Unfair prejudice – s 994 CA 2006
B1’s exclusion from management and dismissal as a director was justified and not unfair because B1 was in breach of s172 and s 175 CA 2006 by directly competing against the company through his son’s company without consent of his fellow directors. There was no unfair prejudice remedy.
Just and equitable winding up – s 122(1)(g) IA 1986
The petition to wind up on ground of failure of mutual trust and confidence between B1 and the other directors failed because B1 competed with the company in breach of his duties - winding up (an exceptional remedy in any event) was not available. The petition was also refused as it would “leave the field clear for Trident”.
Derivative claim – s 260 CA 2006
B1 claimed that brother 2 had breached his duty as a director to the company by setting up a competitor company but the claim failed as B1 had consented. - 70Personal claims and specific statutory rights Introduction- Where a personal right of a shareholder has been infringed by the majority, the board or an outsider, the individual shareholder may be able to bring a claim to recover loss suffered under the general principles of contract or tort law.
- These claims often arise from breaches of the company's constitution (the articles) or a shareholders' agreement.
- In the situation where a shareholder has suffered loss remediable by way of an action in contract or tort, it is possible that the shareholder could also have a claim for unfair prejudice or even just and equitable winding up. Those specific statutory remedies arise in addition to shareholders' general rights in contract or tort.
- The key issue is to look at the loss suffered and whether it is “reflective loss” or whether the shareholder has suffered loss to them personally in addition to the loss suffered by the company. - 71Personal claims for reflective loss- Where the alleged wrong results in a loss to the company as well as the shareholder and the ONLY loss alleged to have been suffered by the shareholder is in fact a reflection of the loss sustained by the company (eg the shareholder's shares have decreased in value due to the wrong suffered by the company), the courts will not allow the shareholder to bring a personal claim.
- This is a result of the rule in Foss v Harbottle. - 72Personal claims for reflective loss Prudential Assurance Co Ltd v Newman Industries Ltd (No 2)- The Court of Appeal summarised this principle as follows: "But what [a shareholder] cannot do is to recover damages merely because the company in which he is interested has suffered damage.
He cannot recover a sum equal to the diminution in the market value of his shares, or equal to the likely diminution in dividend, because such a "loss" is merely a reflection of the loss suffered by the company.
The shareholder does not suffer any personal loss. His only "loss" is through the company, in the diminution of the net assets of the company. - 73Personal claims where the shareholder has suffered reflective loss but also further personal loss- However, where the shareholder can establish that the defendant's conduct constituted a breach of a legal duty owed to them personally (eg in contract or tort) and that the breach of duty caused them personal loss, separate and distinct from the loss caused to the company, they will be permitted to bring a personal action.
- There is much case law on the reflective loss principle. In Johnson v Gore Wood, the House of Lords emphasised that the policy reason underlying the bar on personal claims for reflective loss is the need to protect creditors. It is therefore rare that the shareholder is able to show additional loss on which to claim. However, in Giles v Rhind, the shareholder was able to show this. - 74Personal claims where the shareholder has suffered reflective loss but also further personal loss Johnson v Gore Wood & CoIn this case the claimant was a majority shareholder in a company who sued a firm of solicitors for negligence on the ground that their negligence had caused him personal loss. Proceedings for negligence brought by the company had settled. The defendants argued that the claim was a claim for reflective loss and was an abuse of process. This case came before the House of Lords who analysed the situation in detail.
- 75Personal claims where the shareholder has suffered reflective loss but also further personal loss Johnson v Gore Wood & Co authorities supporting the three propositions‘- Where a company suffers loss caused by a breach of duty owed to it, only the company may sue in respect of that loss. No action lies at the suit of a shareholder suing in that capacity and no other to make good a diminution in the value of the shareholder's shareholding where that merely reflects the loss suffered by the company.
2. Where a company suffers loss but has no cause of action to sue to recover that loss, the shareholder in the company may sue in respect of it , even though the loss is a diminution in the value of the shareholding…
3. Where a company suffers loss caused by a breach of duty to it, and a shareholder suffers a loss separate and distinct from that suffered by the company caused by breach of a duty independently owed to the shareholder, each may sue to recover the loss caused to it by breach of the duty owed to it but neither may recover loss caused to the other by breach of the duty owed to that other." - 76Personal claims where the shareholder has suffered reflective loss but also further personal loss Giles v Rhind- company was insolvent due to a former director’s breach of directors' duties not to compete or misuse confidential information.
- These duties were also express terms in a shareholders’ agreement to which the defendant and claimant were parties.
- The company had initiated an action against the former director, but the administrative receivers discontinued it when the defendant director applied for a security of costs order.
- In effect, the defendant had, by his breach of duty, rendered the company incapable of seeking legal redress against him.
- The claimant sought to recover losses to the value of his shareholding, loss of remuneration and loss of the value of loan stock.
- The Court of Appeal held that the claimant could pursue his claim for breach of the shareholders' agreement including his losses in respect of the value of his shareholding.
- The claims for loss of remuneration and losses of capital and interest in respect of loans made by him to the company did not, in any case, fall within reflective losses.
- A substantial sum was awarded by way of damages. - 77Personal claims where the shareholder has suffered reflective loss but also further personal loss Sevilleja v Marex Financial LtdSupreme Court held that the Court of Appeal case of Giles v Rhind was wrongly decided.
This was because it contradicted the rule in Prudential and Johnson (and ultimately the rule in Foss v Harbottle) that a shareholder, whose shares fall in value due to loss suffered by the company does not suffer a recoverable loss where the company has a cause of action.
This is regardless of why the company has not brought the claim or whether the company is financially able to bring a claim.
In Sevilleja v Marex Financial Ltd , the Supreme Court considered the extent to which the reflective loss principle applied to creditors.
Sevilleja argued that the rule against reflective loss applied to creditors (not just shareholders) and that this defeated the claim.
The Court of Appeal agreed and held that the rule applied to defeat claims of unsecured creditors because the creditor had their own claim against the wrongdoer. - 78—
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- Managing companies: Minority shareholder remedies
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- Isla Duguid
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