graduate student from 01.01.2017 to 01.01.2019
Moskva, Moscow, Russian Federation
VAC 12.00.01 Теория и история права и государства; история учений о праве и государстве
VAC 12.00.10 Международное право; Европейское право
VAC 12.00.12 Криминалистика; судебно-экспертная деятельность; оперативно-розыскная деятельность
VAC 12.00.14 Административное право; административный процесс
UDK 34 Право. Юридические науки
GRNTI 10.23 Предпринимательское право
GRNTI 10.07 Теория государства и права
OKSO 40.06.01 Юриспруденция
BBK 67 Право. Юридические науки
BBK 60 Общественные науки в целом
TBK 75 Право. Юридические науки
BISAC LAW022000 Corporate
This article considers the features of derivative actions under the English and Welsh law and its efficiency depending on certain circumstances. The chronological development and judicial practice outcomes of the question in consideration were analyzed from the 19th century to nowadays including the contemporary provisions of Companies act 2006 such as the two-step filter system for derivative claims. The need for assessing the specific circumstances of the dispute, such as the form of a legal entity, the percentage of participation in the capital of the company, as well as the distribution of the burden of legal expenses, is identified and justified in order to decide on the most effective way to protect the rights of a minority shareholder.
company law, derivative actions, minority protection mechanisms, English and Welsh law
Introduction
The principle of democracy in corporate governance, also known as “rule of the majority”, on the one hand, leads to fairness, because a company action approved by a majority of shareholders will be valid and it represents the will of the most; on the other hand, it may raise the discrimination of minority, who are also members of a company and have invested in it. Arguably, the principle of democracy works properly in case of “the whole country disputes” and other political issues, but it becomes significantly more complicated where the economic interests of individuals are involved[1]. Therefore, one of the purposes of company law is to find the balance between an effective and transparent system of corporate governance, and sufficient protection of interests of minority shareholders from infringement of their rights[2].
Companies Act 2006 defines neither majority nor minority shareholders. It is considered that majoritarian shareholder has 50% + 1 share in a company that allows passing ordinary resolutions, including the appointment of a director. It is logical to assume that a minority shareholder will be such a shareholder who is unable to adopt such resolutions and therefore has less than 50% - 1 share. This is fair for private companies; however, in listed companies, the share capital is dispersed among thousands of investors, and even a person owned just 25% of shares may be considered as a majoritarian shareholder.
Technically the Companies act 2006 gives equal rights to all shareholders in most of the situations: the voting right, the right to receive the proportional number of dividends, to name just a few. For the realization of certain rights, a specific number of shares is required – for example, the shareholder should hold at least more than 5% of voting shares to ask the board to initiate the general meeting – s. 303.
However, the most powerful authority – the ability to appoint the director of a company exclusively belongs to the majority shareholders and requires 50% + 1 share of members participating in general meetings. Moreover, the majority shareholders may approve the actions of directors to prevent them from being challenged later. In other words, control over the directors of a company basically means the control of a company. Mentioned above demonstrates that the minority shareholders are the weak party and certain guarantees and remedies should be provided to them as a counterweight.
Minority shareholders may be protected by various instruments. Some of them are ordinary and may be used by any shareholders: (a) personal claims arising from purchase contracts, torts, or company constitution; (b) shareholders’ agreement including provisions of put- and call-options, fees for breaches, etc. Others are specially designed for minority shareholders: (a) minority shareholder is able to force a bidder to buy the remaining shares on a fair price, if the bidder has acquired or agreed to acquire 90% shares of a company (s. 983); (b) unfair prejudice remedies (s. 994); (c) winding up on the just and equitable ground (s. 122 of Insolvency Act 1986). Derivative action (s. 260) is the most contradictory one, but it also may act as a minority protection mechanism.
This article is aimed to analyze the English and Welsh law and judicial practice on derivative action to identify the efficiency of such mechanism in protection of the minority rights.
Main body
A derivative action is also known as a derivative claim is a type of action brought by a shareholder on behalf of a company against a director or a third party for their negligence, breach of duty, default, or breach of trust. A shareholder must behave in a good faith for a company and shall not use his personal losses as a ground for derivative actions. All benefits will belong to a company, not to a shareholder, and the company will bear the costs associated with this litigation. Consideration of current regulation will be presented after a short background.
As known from Salomon v Salomon & Co Ltd[3], a company is separate from its shareholders and is an independent legal entity. The earlier case – Foss v Harbottle[4] established the rule of the proper claimant which is in line with the finding of Salomon. According to this ambiguous decision, the company is a separate legal entity that has its own governing body (directors) that is entitled to represent the company. And where the wrong has been done to a company, only the company itself is a proper claimant. Therefore, individual shareholders have no power to represent the company and sue on its behalf (Kershaw, 2015[5]).
Foss v Harbottle brought some uncertainty in company law and left minority shareholders unprotected for a certain time. Followers of findings argued that internal company management is not a court’s business and the court has no power to challenge such actions if they were approved by the majority. Moreover, if the court had made the opposite decision, it would have led to massive claims by minority shareholders and corporate governance would be paralyzed. Critics of Foss v Harbottle findings noticed that minority shareholders have no real instruments to prevent abuse of rights committed by directors and majority shareholders. It seems that both parties were right. On the one hand, company management should have the opportunity to make risky but balanced decisions to ensure business development in a market economy. On the other hand, minority shareholders have also invested some funds in company equity and should have a mechanism to prevent assets tunneling or other wrongful conducts.
Aforesaid was implemented through the exceptions of Foss v Harbottle. From which the 4th exception, known as “a fraud on minority” is the most important and unique. It was detailly explained by Jenkins LJ in Edwards v Halliwell[6]. This exception allowed minority shareholders to sue on behalf of a company in case the wrong has been done to a company and the wrongdoers were in control. This mechanism was designed to challenge actions committed by directors of a company, even if the affiliated majority approved their actions. The claimant had to prove that challenging action was a fraud, that directors held the majority of shares of exercised sufficient control in another manner[7], and that other minority shareholders are supporting this action (the majority inside the minority[8]). The court also tried to provide protection only for shareholders behaving in a good faith and only if other opportunities to protect the company do not exist. “Fraud on minority” exception was a huge improvement to Foss v Harbottle rule, but it was too narrow, hard to prove “fraud” and “control of wrongdoers” for a minority shareholder who may experience difficulties in obtaining information from the company.
Former common law rules on derivative actions were replaced by s. 260 – 264 Companies act 2006. On the one hand, current regulation is more flexible and shareholder-friendly. It does not limit grounds for derivative actions, not require to demonstrate fraud, lack of good faith, or wrongdoers’ control. Actions that had been committed before a certain person became a member of a company may be challenged by this new shareholder. On the other hand, the two-step permission process is a serious hurdle for claimants.
The first step is a paper-based hearing and is designed to figure out does the member-claimant has the prima facie case. The company does not participate at this stage. If the case was dismissed, the claimant may ask for reconsideration at an oral hearing. The second stage is full permission hearing where the company may be involved and ordered to provide some documents. There are some undisputed grounds for refusal of approval: (a) a person acting in accordance with section 172 would not continue the action; (b) the challenging action had been authorized or ratified; (c) the challenging proposed act has been authorized.
The last two grounds are interesting. It may seem that majoritarian shareholders may authorize any act or omission made by directors to prevent future challenging, but it is not true. Shareholders cannot authorize breach of directors’ duties, breach of company constitution, or any other actions that are illegal or ultra vires (Hannigan B, 2016[9]). Therefore, a potential claimant should not be afraid even if obviously illegal action was ratified by the general meeting or the board.
Current regulation allows a parent company shareholder to challenge the actions of the subsidiary company[10], this mechanism called “multiple derivative claims” and it is quite effective to protect members from violations committed in complexly structured groups of companies. During the permission process court also should discover and take into account facts listed in s. 263(3), such as whether the company has decided not to pursue the claim, whether the member is acting in good faith in seeking to continue the claim, and some other facts.
Provision canceling derivative claims in liquidations should be considered from two points of view. On the one hand, liquidation provision is straightforward – if the company goes into liquidation, the liquidator has all the power and is acting on behalf of creditors; internal corporate conflicts are no longer paramount. A liquidator has the power to challenge company actions on insolvency grounds. Moreover, liquidator concerns about total balance and may decide not to challenge a particular action if the litigation will cost more than will be finally benefitted. On the other hand, this bar for derivative action may be used by unscrupulous majoritarian to interrupt the ongoing derivative claim. In accordance with s. 84 of Insolvency act 1986 company may be voluntary liquidated if the special resolution (75%+) was agreed. Therefore, the majority may terminate the potentially successful derivative action by voting for liquidation. Unfortunately, there are no ways to effectively counteract with such a tactic.
There is one more bar against shareholders going to initiate a derivative action (Frank Wooldridge and Liam Davies, 2012)[11]. If directors or majoritarian shareholders have suspicions that the minority may initiate a successful derivative action, it is wise to initiate the same action by the affiliated shareholder, but do it without sufficient pieces of evidence or with other procedural weaknesses. The purpose of such behavior is to compel a court to dismiss the application for permission. Thankfully, s. 262 (2) allow other shareholders to continue the derivative claim on special grounds. This provision makes the majority shareholder’s attempt to disrupt the litigation useless (Davies, Gower and Worthington, 2016[12]).
Arguably, the biggest disadvantage of the derivative action is its cost. It has two aspects. Firstly, a claimant may be liable for part of litigation costs. In accordance with the latest cases[13], the court may place a ceiling for the number of costs that the claimant may be indemnified. This means, that even if the claimant wins the case, he will pay part of fees despite the fact that all recovery will go to the company. Secondly, the company may be ordered to cover the costs of both parties: the claimant and the plaintiff (Hannigan, 2016). Litigation costs may be significant and even after a successful derivative action company may become insolvent.
The last one, but not the least important feature of the derivative action is that the claimant-shareholder will not receive any direct benefits from the judgment. It is directly prohibited to bring a derivative action based on personal interest. Moreover, when litigation ends, the corporate conflict between the minority and the majority will be hardly ended. The majority is still in control and able to appoint a director that may act in their favor.
To sum up, derivative action is an extraordinary instrument of corporate law, but there are a lot of hurdles that make it not very effective. It is difficult to go through a two-step procedure; it is economically dangerous for both a claimant and a company; it may not stop the conflict between parties; it should be proven that there are no any other tools to solve a conflict, etc. Considering that the claimant is acting on behalf of a company and that all benefits will be received by a company, it is unlikely the proper minority protection mechanism.
Conclusion
English and Welsh law provides a complete set of legal remedies for minority protection that cover almost all possible disagreements. Fundamental conflicts, depending on the circumstances, may be solved by three different mechanisms. One of them is derivative action which provides indirect minority protection where the company’s interests were violated.
Derivative action works in both PLC and LLC. In PLC the effectiveness of derivative action depends on the percentage of holding. If the minority has only several shares, the only rational decision is to sell shares on a stock exchange because the minority will barely have sufficient documents and litigation costs are significant. If the minority has about five or ten percent of shares (which anyway means millions of pounds as it is a public company), it will make sense to initiate this procedure. Unfortunately, it is more dramatic for private companies, because shares are not freely tradable and articles of association may have the direct prohibition against sell of shares to third parties. Which means that the minority shareholder is stuck in a company with a corporate conflict in it. Some other legal mechanisms of English and Welsh law are designed to protect minority shareholders in private companies. Some of them will be analyzed in further articles.
[1] Henry G. Manne, “The 'Corporate Democracy' Oxymoron”, [2007], The Wall Street Journal, January 2, 2007;
[4] [1843] 67 ER 189;
[5] David Kershaw, The rule in Foss v Harbottle is dead: ling live the rule in Foss v Harbottle, J.B.L. 2015, 3, 274-302;
[6] [1950] 2 All ER 1064;
[7] Prudential Assurance Co Ltd v Newman Industries Co Ltd (No 2): CA 1982;
[8] Smith v Croft (No 2) [1988] Ch 114;
[9] Brenda Hannigan, Company law (4th edn, Oxford University Press 2016);
[10] Universal Project Management Service Ltd v Fort Gilkicker Ltd & Ors [2013] Ch. 551;
[11] Frank Wooldridge and Liam Davies, Derivative claims under UK company law and some related provisions of German law, Amicus Curiae, Issue 90, Summer 2012;
[12] Davies, P. L., Gower L.C. and Sarah Worthington. 'Gower's Principles of Modern Company Law', (10th edn, London, Sweet & Maxwell, 2016);
[13] Kiani v Cooper [2010] EWHC 577 (Ch) see also Stainer v Lee [2010] EWHC 1539 (Ch);
1. Companies Act 2006
2. Insolvency Act 1986
3. Edwards v Halliwell [1950] 2 All ER 1064;
4. Foss v Harbottle [1843] 67 ER 189;
5. Kiani v Cooper [2010] EWHC 577 (Ch);
6. Prudential Assurance Co Ltd v Newman Industries Co Ltd (No 2): CA 1982;
7. Salomon v Salomon & Co Ltd [1897] AC 22;
8. Smith v Croft (No 2) [1988] Ch 114;
9. Stainer v Lee [2010] EWHC 1539 (Ch);
10. Universal Project Management Service Ltd v Fort Gilkicker Ltd & Ors [2013] Ch. 551;
11. Alan Dignam and John Lowry, Company law (10th edn, Oxford University Press, 2018), 29;
12. Brenda Hannigan, Company law (4th edn, Oxford University Press 2016);
13. David Kershaw, The rule in Foss v Harbottle is dead: ling live the rule in Foss v Harbottle, J.B.L. 2015, 3, 274-302;
14. Davies, P. L., Gower L.C. and Sarah Worthington. 'Gower's Principles of Modern Company Law', (10th edn, London, Sweet & Maxwell, 2016);
15. Frank Wooldridge and Liam Davies, Derivative claims under UK company law and some related provisions of German law, Amicus Curiae, Issue 90, Summer 2012;
16. Henry G. Manne, “The 'Corporate Democracy' Oxymoron”, [2007], The Wall Street Journal, January 2, 20
