DERIVATIVE CLAIMS ESSAY

Q. Do the rules that govern derivative claims require reforms,

and if so, how?

Derivative claim (DC) can be argued to be the most disputable

segment of the Company Act (CA) 2006. It is a claim brought on
the company’s behalf brought by an individual shareholder (SH)
against company’s directors. Supposedly an efficacious DC
regime would be one that maintains a balance between
guaranteeing effective remedies to minority SH’s whilst
deterring bothersome SH from hampering business operations.
However, it appears the weight of the new legislation swings
favors managerial autonomy. Whether it could be used as an
instrument that ensures accountability for breach of director
duties is up for debate.

The article below is framed as follows. We shall detail the

synopsis of the scope and the complete procedural framework
of the newly-formed statutory DC enshrined under S.260 of CA.
We shall also asses the statute by examining the fact it
seemingly is devised to favor management and fails in
providing the needed incentives to minority member to claim
respite under DC. Lastly well base our conclusion on the facts
and evidence we gathered.

A longstanding principle was established in Foss v Harbottle

that for a wrong against the company the proper claimant is
the company itself. The decision to actually pursue a claim is
upon a board of directors acting in their scope of powers.
However, under special circumstance wherein the wrong is
being caused by the directors, it would be illogical leave the
decision upon them. In such a situation if company doesn’t
pursue an individual SH can be allowed to bring a DC.

The DC has always been somewhat complex and substandard

under common law. Which resulted lesser use then compared
with other SH remedies. The question now being will the new
regulations bring any changes, will it prove to be an effective
instrument for director accountability. In order to answer these
questions well elucidate upon the changes that came with the
new law regime.

Within common law the circumstances have been limited

where one may initiate DC. The individual may only be able to
impose the claim if the breach of duty evidenced ‘fraud’ and
proved wrongdoers were ‘in control’. The new legislation
extends ground for initiating DC by adding cause of action in
context of an actual or proposed act or omission involving
negligence, default, breach of duty or breach of trust by a
director of the company’. Therefore, in order to bring certainty
to law of DC the law commission proposed significant changes
upon which the parliament vigilantly acted and gave birth to
the Company Act (CA) 2006 wherein S.260(1) expounded the
principle of DC however the reforms are instilled under S.260(3)
which eliminated both ‘fraud’ on minority and wrongdoer ‘in
control’ concepts and placed its emphasis on ‘mere’ negligence,
trust or breach of director duty.

In spite of expanding the cause of action, a precautionary

measure is kept in place to subdue floodgates of baseless
claims against the management. A 2 stage test was set under
S.260(1) of CA.

To establish a DC it shall be subjected to a 2 stage test defined

under S.261 of CA. first test being the paper hearing wherein
application is written to the court through an ex-parte for
focusing on SH’s evidence only. The case would fail to move
forward if the court does not grant permission, the court also
has the ability to dismiss the case the prima facie evidence is
not validated as was witnessed in Wishhart v Castlecroft
Securities the judicial body of Scotland enunciated that a paper
hearing can be used as deterrence to avoid risk of abuse by
applicants.

However, if the one passes the first the second stage is where a
full permission hearing is kept as provided in S.260(2) of CA
which instills mandatory bar factors which if fulfilled, would
amount to the cases dismissal, that states if an individual acts in
accordance to S.172 of CA where he is obligated to promote
company’s success and if the act or omission was permitted by
the company that itself would act as a fence for a minority SH.
Moreover, it cannot all be sanctioned if there’s evidence of
fraud as apparent from Franbar and Burland v Earle.
Additionally, a complaint ascended resulting from an act or
omission that was authorized prior to its occurrence or ratified
after as was witnessed in Re Singh Brothers Contractors (North
West Limited) case.
Thus, we see that mandatory bars given are narrow that clearly
says if an act is approved by majority it cannot be questioned, it
is redundant and can only be used where the shareholders are
unaware of the directors activity, meaning a sleeping partner
otherwise it is next to impossible.
However discretionary bars are set out in Section 260(3) CA
2006 where the courts may refuse for permission if the act was
done in good faith and the person was not motivated by
personal interest (Barrett v Duckett 1995), the importance of
the person complying to Section 172, if authorization or
ratification is likely, if the company has decided to put forward
the claim, and if the companies shareholder could claim using
their right as seen in Franbar Holdings where a claim was
initiated under S994 CA 2006. A test called Hypothetical
Director test was formed by the case of (Mission Capital v
Sinclair 2008) in which it is seen if the claim is beneficial for the
company or not.
We can conclude for discretionary bars that the law given is
very wide and if hypothetical director test is passed a claim will
be against the top management of the company that is the
director because of which a company will be affected.

There were concerns regarding expanding scope of the

legislation which may be abused as a prudent legislative
instrument by activist members and inadvertently lead to a
cascade of DC’s. However, there wasn’t any evidence to
support the till date of the enactment almost no action was
brought. In fact the cases that did try to initiate claim failed in
the early stages. The fact the statute favors management and
fails to provide moderate incentive to minorities to initiate
claim is the sole reason why its seldom used.

The industrial bodies have been nervous that the new DC

makes its apparently easier for individual SH to initiate claim
against directors. The key concern being widening the cause of
actions in the new statute mixed with codification of director
duties in Chapter 2 of Part 10 of CA i.e., General Duties of
Directors will open sluicegate of DCs.

Firstly the new legislation does not override the principle of

Foss v Harbottle, in fact the parliament never intended to
change courts tradition and their reluctance to intervene
business operations, the Law commission clarified this in their
report.

We view that the rudimentary approach for the right to initiate

DC is sound, and individual SH should be granted to bring action
under extraordinary circumstances. S.260 of CA espoused
maximum no of recommendations by Law commission.
Essentially its not substantive rule intended to replace the Foss
principle rather improved procedure for bringing claims based
on existing rules.

Its becoming apparent that director may be too protected by

this procedure if the courts do not change their attitude
towards DC. The directors have concerns primarily on the
insertion of negligence as a cause of action. Whereas the a
breach of duty shall not be addressed unless a minority SH
claim the two stage test as mentioned above. This test was
purposely created to act as a barrier to protect the company
and the directors from SH harassment. However, it may offer
too much protection as directors may deny minority members
an improved prospect of procuring authorization to continue.

Except for two instances under which judicial body is mandate

to repudiate permission to pursue a DC, judges have wide array
of discretional powers on the matter with allusion to the
criterion set under S.263(3) and (4). And supposedly its
believed that the directors are open the risk of swelling lawsuits
and whether the new DC could be an efficacious governing
instrument would entirely depend upon how judiciaries
capability to discharge their discretion.

It’s doubted whether the English courts traditional suspicion

towards DC could change. Though its early to draw assumptions
before a pile of case law has settled under the new statute., 2
cases Mission Capital Plc v Sinclair and Franbar Holdings Ltd v
Patel can provide some assistance on the matter.

We must note that two abovementioned cases have not been

granted permission to continue. The courts failed to find
evidence of circumstances of mandatory refusal in both cases.
So, they went onto contemplate discretional factors, amongst
them these two-hold utmost importance.

One being a person acting to promote company’s success

would ascribe to continuing the claim. Court in both cases used
the hypothetical director test set in S.263(3)(b) and concluded
in the eyes of the hypothetical director acting for the
company’s benefit, the claim holds little importance. Courts
also espoused a restrictive approach when applying this test as
viewed by William J in Franbar case.

In my opinion, the hypothetical director acting under S.172

would assimilate a wide array of consideration when
determining whether a claim should continue. This would
include prospects of a successful claim, companies ability to
make recovery on any award of compensation, the commotion
caused to companies business development by focusing its
resources to proceedings, the cost of proceeding and harm to
company’s reputation and business if the proceeding fails.

Another factor being if theirs any alternate remedy available for

claimants. In particular under S.994 to form a claim for
prejudicial conduct which became the key reason to deny
permission in Franbar case. This shows the English courts
approach of leaving DC as a last resort.

However, its early to write up conclusions that the courts will

continue their stance against DC, we may reasonably expect
them to continue a stringent control of cases brought under
this procedure. This stance of the courts still suggests us to
believe that the high procedural threshold still favors the
directors.

We note that few DC cases that came within the new regime
cannot fully be used as base to illustrate the question.
However, we may be able to devise an answer by
reconnoitering incentives and disincentives of the new law in
respect of minority members

The new statutes strike a balance in favor of managerial

freedom is itself disincentive to potential claimant as was
observed by Reisberg. If courts are successful in clearing out
past precedents where the DC was brought to supplement self
interest of individual members, one could wonder what are the
incentive for the members to claim in court besides self
interest.

The new procedure fails to redress the subject of cost and free-
riders which in turn discourages individual members for
initiating claim. A DC is brought by an individual member;
however, the expense is solely carried by that individual unless
the judicial body issue a Wallersteiner order. And since many of
the possible claimants are minority members, they are
burdened financing this claim, and also if they are willing to
take such a step would they even be indemnified by the
company. Moving on, there is the free-riding issue. If the DC
does get courts support the remedy is not awarded to that
individual rather to the entire members and the company
claims the benefit. hence it becomes harder for us to see what
incentive lies for individual members to use this route.
Regretfully, CA does host any precise provision regarding these
problems.

The new procedure fails in achieving the needed clarity making

the law less complicated. And in order to procure courts
permission to pursue the claim, the 2-stage test is kept in front
of the claimant. And as for potential claimant it infers
prolonged hearings and let’s not forget the difficulty in
matching the criteria set under s.263 (2) and (3).

Last but not least, comes the problem of accessing information.

Minority members have restricted access to corporate data
making it problematic to provide sufficient evidence to support
the claim of breach of director duties and the new procedure
does not ascribe any significance to the problem, however it
does include related provisions under S.261(3), suggesting the
court would ask for evidence to be given by the company if
claimant succeeds to form a prima facie case for granting
consent. However, the powers granted to court would be
sufficient to curbing this problem is unknown.

We sum up, the new legislation lacks incentives adding on to

court traditional approach of reluctance this suggests that an
exploitation of DC is improbable. Instead this new procedures
equilibrium favors management which might be a symbol that
lesser people would claim under DC. Individual members who
seeking corporate remedy would hardly regard the new DC law
as an ideal instrument where the system itself favors the
directors over minority members.