- Statutory derivative actions come into force on 1 October 2007
- Potential increase in scope for shareholders to bring actions against directors of a company
- The courts' attitude to claims, and the effect on D&O cover, is as yet unclear
Part 11 (sections 260 to 269) of the Companies Act 2006 relates to derivative actions by members of a company. It replaces the common law regime based on the rule in Foss v Harbottle implementing the Law Commission’s recommendation that a “new derivative procedure with more modern, flexible and accessible criteria for determining whether a shareholder can pursue an action” be created.
The statute entitles shareholders, subject to the court’s permission, to bring claims on behalf of a company against an existing or former director of that company, for causes of action arising from an actual or proposed act or omission involving negligence, default, breach of duty or breach of trust by that director.
Following issue, the shareholder must obtain the court’s permission to continue the claim. Part 11 will be supplemented by amendments to the Civil Procedure Rules, and the court will apply a two-stage test.
Stage 1: the shareholder must make a prima facie case for the court to grant permission to continue the claim. The court considers evidence filed by the applicant only, and must dismiss the application if the applicant cannot establish a prima facie case.
Stage 2: the court has a discretion to refuse permission, and may require evidence from the company. The court considers several factors in determining whether an action should continue, including the applicant’s conduct, whether the relevant act or omission was authorised in advance or ratified subsequently and whether a separate cause of action also exists for the applicant’s own benefit.
Proliferation or protection?
There is a wider range of circumstances in which a derivative action may be brought under the new statutory provisions than at existing common law and there are concerns that this will lead to a proliferation of derivative actions. The fear that Part 11 makes it easier for shareholders to commence actions is heightened by the widening of directors' duties in Part 10 of the Act. But will it actually be easier to commence such actions?
Aside from the semantics of determining when an action is commenced (when issued or when permitted by the courts to continue?) the provisions introduce a significant measure of judicial control at the very outset of proceedings, immediately weeding out obviously frivolous and vexatious claims. That the legislation gears itself towards outlining circumstances in which the courts must refuse rather than must grant permission, arguably reinforces a whiff of negativity.
Further, permitting the company to adduce evidence rebutting an application for permission to continue, formalising potential costs liabilities on a failed applicant and the fact that a shareholder would not benefit directly from a successful claim also act as pre-issue checks to would-be litigants.
But does the attitude to derivative claims even matter, in certain practical aspects, for perception is arguably more fear-inducing than reality? Concerned directors may well increase their D&O cover against an increased risk of derivative claims, whether theoretical or actual, particularly where companies operate in litigious jurisdictions or sensitive sectors. Insurers offering such cover may also increase the cost of premiums in anticipation of a flood of claims, certainly in the short term until the courts determine how they will treat such actions.
So far as their own protection is concerned, directors may also choose to avail themselves of powers introduced in 2005 permitting the company to indemnify them against damages and defence costs arising out of claims by third parties (including shareholders). The Commission’s aim of protecting well-run companies also offers incentives of protection (as well as profit) to directors.
Until the courts have occasion to apply the two-stage test, it is unclear whether they will choose to fetter anxious shareholders or unleash a demon horde of frenzied applicants. In the meantime, directors, insurers and their advisers face a potentially lengthy wait to understand how the new regime will operate.