Connolly v Seskin Properties Limited, High Court (Commercial) 17 July 2012 [2012] IEHC 332

A recent case from the Irish Commercial Court has considered the rule set down in Foss v Harbottle1, namely that if a company suffers a wrong, it is the company and not its shareholders that must institute proceedings. The rationale for the rule is that a company is an independent legal entity, separate from its members. However, there are four recognised exceptions to the rule in Foss v Harbottle, which can be invoked in situations where the wrong is done by those who control the company. In such cases, a derivative action may be taken where a shareholder, as representative of all the shareholders, institutes proceedings on behalf of the company to redress the wrong. Connolly v Seskin is interesting because, in addition to invoking the fourth exception, the applicant sought to have a fifth exception to the rule in Foss v Harbottle applied.

Background

The applicant, Mr. Connolly, was a 49% shareholder and director of Seskin Properties Limited (Seskin). Mr. Whelan, one of the respondents, originally owned the balance of the shares. His shares were later acquired by Moritz, a company owned and controlled by Mr. Whelan and his son, Mr. Whelan Jr. Mr. Whelan and his son were the other two directors of Seskin and were also shareholders and directors of a company called Maplewood Developments (Maplewood).

Mr. Connolly sought to bring a derivative action, on behalf of Seskin, against Mr. Whelan, Mr. Whelan Jr., and Maplewood. The claim arose from an agreement between Seskin and Maplewood under which Seskin was to construct 82 residential units. Mr. Connolly claimed that the amount due was €5,329,920, pursuant to Clause 4 of the contract. Clause 4 provided that the contractor would be paid €192,000 plus VAT when each unit was completed. It went on to provide that the contract price would be increased in the event that sale prices of the units were higher than the projected sales prices, but it did not provide that a corresponding loss would be absorbed by Seskin if the sales prices were lower than anticipated.

Seskin completed the units and invoiced Maplewood in the total amount of €14,342,400 over a period of three and a half years. The balance was the amount unpaid by Maplewood, which formed the basis of the claim in this case.

The applicant’s claim

Mr Connolly claimed that, as controlling directors of Seskin, Mr. Whelan and Mr. Whelan Jr. allowed Maplewood to accumulate a significant debt, and that they were aware that Maplewood would not be in a position to meet the payments. He claimed that their inaction in relation to the unpaid sums was not in the interests of Seskin and was, in fact, in the interests of Maplewood and the Whelans instead.

He sought to take a derivative action not only against Maplewood but also against Mr. Whelan and Mr. Whelan Jr., on the basis that they should be personally liable for the sum owed by Maplewood due to the breach of their fiduciary duties to Seskin. He claimed that his attempts to raise the issue with Mr. Whelan and Mr. Whelan Jr. at various times, including at directors’ meetings, were unsuccessful. A receiver was appointed to Maplewood in January 2012 which Mr. Connolly felt prejudiced Seskin’s chances of recovering the sums allegedly due.

The Whelans’ arguments

The Whelans argued that the concluded contract did not actually reflect the nature of the agreement between Maplewood and Seskin. According to them, the contract was negotiated by a chartered accountant, Mr. Barrett, who was a director of Seskin and Maplewood at the time of the agreement. Mr. Barrett claimed that it was never the intention that the contract price would be increased in Seskin’s favour in the event that sale prices of the units were higher than the projected sales prices but that there would be no corresponding reduction if the units were sold at a lower price.

Mr. Barrett gave evidence of previous arrangements between Seskin and Maplewood in which the payments were linked to the overall performance of the development, and in which any increase or decrease would be absorbed by Seskin. He claimed that it was intended that this agreement would follow the same pattern. Drafting and other documentation was presented in court to support this claim. Mr. Barrett said that the agreement did not accurately reflect what was envisaged, and that in his view it was a mistake by the solicitors involved in drafting the agreement.

Mr. Whelan stated that the majority of the directors of Seskin did not regard the contract as embodying the actual agreement between Seskin and Maplewood. His position was that if Maplewood were to be sued, it would counterclaim for rectification of the contract. He also pointed out the reality that Maplewood would not be in a position to discharge the amount claimed. The Whelans were adamant that they would not benefit in any way from Seskin not taking action against Maplewood.

Derivative actions - the test and the exceptions to the rule in Foss v Harbottle

Kelly J opened his examination of the law in this area by citing a UK Court of Appeal case, Prudential Assurance Company Limited v. Newman Industries Limited (No 2.)2, where the court held that prior to a minority shareholder being permitted to bring a derivative action on behalf of a company, he must establish a prima facie case (i) that the company is entitled to the relief claimed and (ii) that the action falls within the proper boundaries of the exception to the rule in Foss v. Harbottle.

However, Kelly J clarified that in Ireland, following Fanning v. Murtagh3, the standard of proof required of an intended plaintiff is that he must establish "a realistic prospect of success" rather than a "prima facie case". He then went on to quote Irvine J. in Fanning v. Murtagh on the recognised exceptions to the rule in Foss v Harbottle:

"There are four recognised exceptions to the rule in Foss v. Harbottle, which may permit an individual shareholder as a minority to sue on behalf of the other shareholders. These exceptions, briefly stated, comprise the following categories of wrongdoing namely:-

  1. an act which is illegal or ultra vires to (sic) the company;
  2. an irregularity in the passing of a resolution which requires a qualified majority;
  3. an act purporting to abridge or abolish the individual rights of a member;
  4. an act which constitutes a fraud against the minority and the wrongdoers are themselves in control of the company."

Mr. Connolly claimed that he fell within two of the exceptions to the rule in Foss and Harbottle. In the first instance, he claimed that the failure of the Whelans’ to pursue Maplewood for the alleged debt constituted a fraud against the minority and that the wrongdoers were themselves in control of the company.

Alternatively, he claimed that the so-called fifth exception applied and that the justice of the case demanded that a derivative action should be allowed to proceed.

The fifth exception

The fifth exception was originally set out in a decision of the Supreme Court of Western Australia and later cited in an Irish judgment of Finlay Geoghegan J. in Glynn v. Owen4.

In the Australian case, Biala Pty Limited v. Mallina Holdings Limited5, the court debated the issue of whether or not a fifth exception to the rule in Foss and Harbottle existed. The judge (Ipp J.) cited comments from Foss v. Harbottle by Sir James Wigram V.C. to the effect that there should be a general power of interference by the courts where justice demands that such a power be exercised.

Ipp J in the Supreme Court of Western Australia approved these comments, saying: "…it seems to me to be contrary to principle to require wronged minority shareholders to bring themselves within the boundaries of the well recognised exceptions and to deny jurisdiction to a court of equity even where an unjust or unconscionable result may otherwise ensue . . . accordingly, I uphold the argument of the plaintiffs that the court may allow a derivative action by shareholders in circumstances where the justice of the case so requires."

The debate on a possible fifth exception was considered further by Finlay Geoghegan J. in Glynn v. Owen where she noted that the rule in Foss v Harbottle may be relaxed where the interests of justice so require it.

Finally Kelly J cited with approval, Keane C.J. at paragraph 26.20 of his text "Company Law"6 where he states:

"I respectfully agree that the formulation of the rule in the earlier cases makes clear that it should not be applied in such a way as to lead to injustice. Nevertheless, the entitlement of a shareholder to pursue by way of derivative action a claim for and on behalf of a company is an exception to an ‘elementary principle’ as referred to above. As such, it should not be broadly or liberally applied. A very strong case would have to be made out. It would also have to be consistent with the principles underlying the rule in Foss v. Harbottle and the exceptions to it. These include the reluctance of the courts to interfere in the internal management of a company."

The Judge’s findings – prospect of success

Kelly J concluded that, overall, the prospects of success against Maplewood were poor and that it had a good prospect of succeeding in a counterclaim for rectification of the contract. He pointed to Mr. Connolly’s delay in raising the issue of the build-up of the alleged debt, and he pointed to Maplewood’s inability to meet the debt in any event. He was of the opinion that the Whelans’ decision not to sue Maplewood was not a breach of duties owed to Seskin.

The Judge’s findings– the fourth exception

Kelly J considered Mr. Connolly’s claim under the fourth exception, where an act which constitutes a fraud against the minority has been done to the company and the wrongdoers are themselves in control of the company. Kelly J cautioned against attempting to identify what might or might not constitute a fraud on a minority in the ever-changing circumstances of modern commercial life. He said however that it involves some element of "moral turpitude".

He said that the decision not to sue Maplewood did not amount to a wrong on Seskin. He went on to question what benefit either of the Whelans could derive from the decision not to sue Maplewood. There were no personal guarantees in place by the Whelans, which, if they had existed, would have been an understandable benefit which they might have had for not wanting to sue Maplewood.

In rejecting the claim under the fourth exception, Kelly J concluded that there were no acts of a fraudulent character or of moral turpitude on the part of the Whelans.

The Judge’s findings – the fifth exception

On the fifth exception, that there should be a general power of interference by the courts where justice demands that such a power be exercised, Kelly J stated that Mr. Connolly had failed to demonstrate a reason for intervention by the court. He repeated that the fifth exception should not be broadly or liberally applied, and that a very strong case must be made out. He concluded that the principles underlying the rule in Foss v Harbottle include a reluctance on the part of the court to interfere in the internal management of a company.

Comment

This case provides a useful analysis of the law in Ireland on derivative actions and the exceptions to the rule in Foss v Harbottle. It is interesting to observe the reluctance of the Commercial Court to look beyond the internal management decisions of a company in such cases.

The invitation to the Commercial Court to consider a possible fifth exception, whilst unsuccessful in this case, appeared to have been broadly accepted in principle by Kelly J, and it may be invoked in Irish Courts in the future as a result.

It is also interesting to note the divergence between Irish and English law in relation to the strength of the case which the applicant in such actions must establish, with the Irish courts requiring a somewhat higher standard then their English counterparts, namely a reasonable prospect of success. In the UK, derivative actions have been governed by statute since 2006. Under the legislation, the applicant is required to establish a prima facie case for permission to pursue a derivative claim7.

For a link to the judgment, please click here.