The UK Derivative actions regime is an effective corporate governance tool

Introduction

Derivative claims are claims that are filed in the name of the company for some wrong that is committed against the company. As such, derivative claim is not filed by the company itself because the majority shareholders may have ratified the wrongful act, or they may have decided not to take legal action under the situation. This means that the company is not able to file a claim itself. In such as situation, derivative claim allows an individual or minority shareholder to pursue the action in the name of the company. This also leads to better corporate governance mechanisms as accountability of the directors or the executives or even the majority shareholders can be enforced. Therefore, there is a relationship between corporate governance and derivative claim, which is discussed in this essay.

Corporate governance: Need and scope

Corporate governance refers to the structure that contains rights and responsibilities of all the stakeholders that are involved in the company and who are affected by the decisions in the company. Effective corporate governance is aimed at ensuring that the executives in the company respect the rights and interests of all the stakeholders and the stakeholders also behave responsibly with respect to the generation of wealth in the company. As such, effective corporate governance is necessary for ensuring the fair dealings in the company as far as the executives and stakeholders are concerned.

The UK has a strong tradition of corporate governance laws both in the common law as well as in statute. The Companies Act 2006 (CA 2006) makes certain provisions, including the statutory derivative actions, which have impact for corporate governance laws. These provisions are grounded in the need for accountability within the corporate structure as well as ensuring corporate governance. It is pertinent to discuss the reasons for corporate governance and how this relates to derivative actions at this point. These reasons are situated in the need to ensure the protection of interests of minority shareholders, responsible and ethical conduct of the directors and executives in the company and for increasing investor confidence in the stock market.

global economies. In other words, the conduct of a corporation or its directors may have ramifications, not only for the company and its immediate stakeholders, but also the national or global economy. Ultimately, lack of corporate governance also impacts investor protection and the perceptions of prospective investors with respect to the potential protection that they may get from the regulatory mechanism.

Derivative actions have a strong interrelation with corporate governance. These actions allow the minority shareholders or individual shareholders in the company to take action against persons who commit a wrong against the company. The significance of the action is that it is an exception to the otherwise majoritarian rule that is applicable to the company. Derivative actions allow actions that are breaches of the general directors’ duties, as well as other corporate conduct potentially damaging to the community, to be examined by the courts and remedied where necessary.

The Companies Act 2006, ss. 171-177, provides the general duties of the directors towards the company. In general, the enforcement of such duties is done on behalf of the company, under the principle of majority rule, which requires the majority of directors or shareholders must support the decision to bring an action against the errant director. However, a derivative claim under Companies Act 2006, ss. 260-264 can be brought by individual or minority groups of shareholders, although permission must be sought from the court to continue the claim on behalf of the company. Such derivative claims were evolved first under the common law by the courts. Since 2006, statutory derivative claim is also available. These are discussed in the following section.

Derivative actions for effective corporate governance

Traditionally derivative actions were very difficult to pursue for minority shareholders because the principle of majority rule and the ‘proper plaintiff’ principle was applied strictly. This was as per the rule in Foss v Harbottle, as per which, company is a legal entity in itself and the proper plaintiff in actions in its own name. As per the Foss principle, it was difficult for minority shareholders to bring a lawsuit in the name of the company. The Foss principle prevented the shareholders from successfully pursuing derivative actions. In Johnson v Gorewood & Co, the House of Lords did not allow shareholder to take derivate action where the company was shown to have suffered loss due to breach of duty by directors. In Gray v Lewis, James LJ held that “where there is a body corporate capable of filing a bill for itself to recover property either from its directors or officers, or from any other person, that corporate body is the proper plaintiff and the only proper plaintiff.” In Prudential Assurance Company Ltd v Newman, the plaintiff shareholder was not allowed to recover damages merely because the company in which he has an interest has suffered damage as his loss was merely a reflection of the loss suffered by the company. In all these cases, it is clear that corporate governance lost because the principle of Foss was applied

strictly. However, the courts did evolve exceptions to allow derivative actions over a period of time and this has worked in favour of better corporate governance. The principle landmark case on this issue is Edwards v Halliwell, in which the court laid down some exceptions to the Foss rule. In context of derivative actions, the court laid down the ‘fraud on minority’ principle, as per which, if fraud is being committed by the majority, then a derivative action could filed by the minority shareholders. The principle of ‘fraud on minority’, which is the relevant exception in Edwards case for allowing derivative actions, depends on the actions that are capable of ratification. Where the actions of the directors, majority shareholders or others can be ratified, the courts will not allow actions by the minority shareholders. This was seen in Bamford v Bamford where the bona fide exercise of power, led the court to hold that the action could be ratified by the majority shareholders and therefore derivative claim could not be taken. In Pavlides v Jensen case, the directors of the company had not conducted mala fide actions, but there had been a negligence on their part, however, it was without any benefit, and so the court held that action would not lie. There were obvious problems in the application of corporate governance principles due to the rigid application of proper plaintiff principle and so the Law Commission in its report on minority shareholders’ rights recommended the abolition of the common law ‘fraud on minority’ exception, and instead make a statutory derivative claim procedure. Ultimately, the statutory derivative claim has been adopted in the Companies Act 2006. However, as the next section discusses, it is still not easy to bring such a derivative claim in the name of the company as such a claim has to be first allowed by the court on merits.

The Companies Act 2006 part 11 provides for statutory derivative actions and section 260 (1), allow derivative claims in respect of a cause of action vested in the company, and seeking relief on behalf of the company. Such derivative actions only lie where the cause of action arises from an actual or proposed act or omission involving negligence, default, breach of duty or breach of trust by a director of the company. The new statutory procedure requires the applicant to first make a prima facie case before the court so that the court may see whether there is a merit in the continuance of the derivative action. Once the court is satisfied as to the cause of action, it may allow the action to proceed. Statutory derivative action is taken where the act involves a director of the company only. It is also important to remember that the ‘proper plaintiff principle’ is not completely negated by the new statutory derivative action process and that is the reason why the court has to be satisfied as to the cause of action because it is important for the court to see a reason why the time honoured principles of majoritarian rule and proper plaintiff should be disregarded. It is noteworthy that the derivative action structure is somewhat different from the one that is available under the common law structure, as embodied in Foss v Harbottle rule and the exceptions. These differences are summarized by Kershaw when he say that “while in the common law, the shareholder would have to demonstrate that the action fell within one of the exceptions to the Foss rule, under the statutory provisions, the shareholder needs permission

from the court to continue with the action after showing that the action relates to an act of the company’s director.” Even after the statutory derivative action has come into existence, there have been cases where such derivative claims have been rejected. One such situation is where an unfair prejudice petition is also available to the claimant who has filed for a derivative claim, where the courts have actually held that if an unfair prejudice petition lies, then derivative claim will not lie. The best interests test is applied by the courts in deciding whether the derivative claim will be allowed to proceed or not. For instance, in Franbar Holdings v Patel case, the court applied this test to hold that the claimants under derivative actions have to prove that such action would be in the best interest of the company. Again, where the director is alleged to have breached some duty owed to the company, but the majority of the shareholders have ratified the actions of the director, or where there is a possibility of an action that is a potential breach of duty but has been ratified by the shareholders, then the court may not allow the derivative claim. Finally, in cases where the court is shown that a person who is acting in the best interests of the company would not continue with the claim, the court may reject the continuance of the derivative claim altogether. Thus, it is seen that obtaining the permission from courts for the filing of a derivative claim is not an easy task. In fact, in the bigger listed companies, there are too many seemingly unsurmountable challenges and difficulties for the minority shareholders and these derivative claims involve a lot of expense and time and many a time it is seen that the minority shareholders find that it is not worth the effort and expense for them to continue with the derivative actions. Therefore, despite the availability of the corporate governance mechanism under the Companies Act 2006, this mechanism may not really be effective in bringing greater corporate governance, which is unfortunate because derivative claims are useful mechanisms in ensuring stricter norms of accountability. It is also seen that the availability of derivative claims in the corporate governance mechanisms lead to a higher stock market capitalisation and therefore, there is a positive relationship between derivative claims and stock market capitalisation.

Conclusion

Derivative action is an effective corporate governance tool because it leads to the creation of a greater accountability of the directors and executives of the company. Derivative action allows minority shareholders to take action in the name of the company when the company itself is disabled from taking such an action by the majority voting against it or even ratifying the wrongful act.

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