A new regime for shareholder remedies

On 1 October 2007 the Act introduces a new statutory procedure enabling a shareholder to bring a claim on the company’s behalf against its directors for negligence, default, breach of duty or breach of trust. Claims for actual or proposed acts or omissions will be allowed.

The new court procedure will be used for all derivative claims commenced on or after 1 October 2007 but, where the director’s act or omission in question occurred before this date, the court will determine the outcome on the basis of the common law applicable at the time of the act or omission.

This new derivative claims regime has, together with the proposed codification of directors’ duties, been the subject of enormous scrutiny and debate both in Parliament and in the press. But is there really an increased risk of litigation?

The current position

Currently a shareholder can only bring proceedings against the directors for breach of the duties owed to their company in extremely limited circumstances. The general principle is that it is for the company (not a shareholder) to bring proceedings where it is the injured party.

The new procedure

The Act sets out a new statutory right for shareholders to bring a derivative claim against a director (or other person) on the company’s behalf. The person bringing the claim does not need to have been a shareholder at the time the cause of action arose.

There is a two stage test requiring the shareholder to obtain the court’s permission to continue a claim. This safeguard was introduced by the government to address concerns that the new derivative claim procedure could open the floodgates to US-style class actions by aggrieved or activist shareholders.

• First the court must bring proceedings to an end if there is no prima facie case; and

• Second the court has a discretion to refuse or grant leave to continue a claim, taking account of specified matters.

Factors to be considered by the court

The court has to refuse permission for the claim if:

  • directors acting in accordance with their new duty to promote the success of the company would not seek to continue the claim; or
  • the matter complained of has been authorised in advance or has been ratified subsequently.

In considering whether to give permission the court must take into account the views of any independent shareholders, the importance a director promoting the success of the company would attach to continuing the claim, plus whether:

  • the shareholder is acting in good faith;
  • the company is likely to authorise or ratify the matter;
  • the company has decided not to bring a claim; and
  • the case could be brought by the shareholder in his own right rather than on behalf of the company.

The “double whammy” - is there a greater risk of litigation against directors?

“To put it in vulgar, non-legal terms, people who have spoken to us fear a double whammy. In Part 10, directors’ duties are widened, while Part 11 makes it easier for shareholders to commence actions against directors. There is concern. Is it justified? That is what we are trying to find out in Committee …” - Lord Hodgson, Grand Committee, 27 February 2006.

There is genuine concern that the codified directors’ duties coupled with the enhanced right to bring derivative claims has increased the exposure of directors to claims. Despite the ‘think small first’ approach (one of the stated aims of the Act) this might actually hurt many SMEs more than the better organised and resourced PLCs.

The safeguards should go some way towards ensuring that vexatious or frivolous claims are thrown out at the earliest opportunity. But of course the fear is that, until the new duties are better-understood and the claims procedure tested, the courts might be tempted to allow cases to run.

That said, it should be remembered that the financial risk of bringing an action will be borne by the shareholder and that any damages awarded will be payable to the company not to the shareholder actually bringing the claim. So the new derivative claim is not a US-style class action and some of the hysteria has been unfounded.

It is also not yet clear how easy it will be for shareholders in a holding company to establish claims relating to the actions of subsidiaries and their boards.

What can directors do to protect their position?

Directors would be advised to check whether their D&O cover will cover the cost of dealing with derivative claims. They should also review any indemnity that the company may have granted them against defence costs and damages arising out of claims by third parties (BUT note that a successful derivative claim will NOT be caught as the company is the beneficiary). Finally, for companies that operate in particularly litigious jurisdictions or in sectors which are sensitive or which frequently attract criticism, it may be appropriate to look at other ways of minimising exposure of directors. There are already examples of companies delisting from US stock exchanges.

Is it in force?

The Companies Act 2006 received Royal Assent on 8 November 2006. Some provisions were introduced in January and April 2007. A substantial part of the Act comes into force on 1 October 2007, more on 6 April 2008, with the remainder going live on 1 October 2008. BERR (formerly DTI) has published a detailed table of commencement dates.

Link to more briefings on the Act

More briefings are available on the Companies Act 2006 page on our website.