In the January edition of Dispute Resolution Matters we discussed the duties directors’ owe to a company and the codification of these duties in the Companies Act 2006 (“the Act”).
In this edition we show how the Act seeks to make it easier for shareholders to hold directors to account by broadening the circumstances when a shareholder can effectively step into the shoes of the company and bring a claim against a director. We will also consider how shareholders may challenge directors’ decisions under the new law and the key message for, and actions required by, directors making major decisions.
What is a derivative claim?
In short, it is a claim made by a company but brought on behalf of it by a company member (shareholder). Prior to the Act, a member of a company could make a derivative claim only in relatively few circumstances, usually where there had been a fraud on minority shareholders. The new regime The new regime is wider in scope than the old law. A claim may be brought against a director or a third party following an actual or proposed act or omission involving negligence, default, breach of duty or breach of trust by a director or former director. A director includes a shadow or de facto director. The director need not be a majority shareholder and need not have benefited personally. Claims against third parties are permitted only where the company suffers damage arising from an act or omission involving breach of duty etc, by a director and the third party knowingly benefited or knowingly assisted the director in the breach. The Courts are construing this provision narrowly.
A new procedure is introduced to accompany the new regime. The member commencing a claim must first obtain permission to continue the action. This is a two stage process:
- The initial vetting
This stage is intended to weed out spurious claims and avoid companies becoming bogged down dealing with meritless claims from shareholders. The onus is on the shareholder to establish a case and there is no requirement on the company to provide evidence.
At present this test is not particularly strict. However, Judges may become stricter as they get a feel for the type of cases which will succeed or fail.
- If the application gets through the initial vetting stage, the next hearing involves the company.
The Act provides guidance to the Court and the parties on when permission is to be given. Permission must be refused if:
- A person acting in accordance with the duty to promote the success of the company (discussed in our last edition) would not pursue a claim. In other words, would a director performing his duties properly and objectively decide to continue the claim?
- The act or omission was not authorised or has not been ratified subsequently. This potentially raises the issue of whether the act or omission could be authorised or ratified, e.g. an unlawful return of capital, or certain acts in the face of insolvency could not be.
In addition the following discretionary considerations must be considered:
- Whether a member is acting in good faith.
- The importance that the person acting in accordance with the duty to promote the success of the company would attach to continuing the claim.
- The possibility and likelihood of the act or omission being authorised or ratified.
- Whether the company has decided not to pursue the claim.
- Whether there is a claim that the member could pursue in his own right.
What of unfair prejudice and protection of minority shareholders?
The legal protection for minority shareholders is unchanged (section 994 of the Act replaces the old section 459).
In the recent case of Franbar Holdings Limited -v- Patel (2009), the Court considered a derivative claim and a petition brought by a minority shareholder and having worked carefully through the criteria in the Act, refused to grant permission for the derivative claim to continue. One of the key reasons for the Court refusing to grant permission was the ability of shareholders to obtain a satisfactory remedy through the unfair prejudice petition. Therefore, it seems that where there is scope for a section 994 petition, a derivative claim may be inappropriate.
Any real change?
In light of this decision, it may well be that most aggrieved shareholders will issue a section 994 petition rather than seeking permission to bring a derivative claim. That is particularly likely when the company involved is effectively an incorporated partnership with just a few key directors and shareholders who all participate in the management and running of the company.
However, the codification of directors’ duties, the introduction of specific factors which directors ought to consider when making decisions and the extension of the circumstances when a claim can be brought on behalf of a company to include negligence (without the need to establish bad faith or any benefit to the wrongdoer) potentially opens directors to challenges which would have been difficult for shareholders to bring under the old law.
As is always the case with such changes, it will take some time for the full extent of the changes to filter through to case law and for potential claimants to recognise the true scope of the Act. However, in the light of the current downturn in the economy and the increasing scrutiny of directors’ conduct by shareholders, it is not difficult to envisage that the new regime may well become the preferred route for aggrieved shareholders to challenge the actions of the board.
The key message for any director is to fully understand and comply with the duties which accompany the role and as set out in the Act. Furthermore:
- When making major decisions it is important that a proper paper trail demonstrates that the relevant factors have been considered, and puts the decision in its proper context by setting out the key facts which exist when the decision is made. It is very easy for a third party to be wise after the event and criticise a decision with the benefit of hindsight. The existence of a contemporaneous note setting out the position as it was then perceived can be extremely useful in steering the Court away from applying hindsight.
- If the company is facing financial difficulties or is forced to take decisions involving legal or accountancy issues (or indeed any other technical issues outside of the experience of the directors), obtain and act on professional advice and again create the paper trail to demonstrate that such advice has been obtained and acted upon.
- Check that appropriate officers and directors insurance is in place which is sufficient to fully cover any derivative claims.