Derivative actions are claims brought by individual shareholders, acting on behalf of a company, against the company’s directors. They are brought in respect of wrongs committed against the company that, for whatever reason, the company is not willing to pursue in its own right.
At present, the circumstances in which such actions may be brought are very limited, due to the general rule (known as the rule in Foss v Harbottle) that the proper person to bring them is the company itself. Specifically, the present law is that a derivative action may only be brought where the wrong complained of:
- amounts to a fraud on the minority and the wrongdoers are in control of the company;
- cannot be ratified by ordinary resolution; or
- is outside the company’s objects and so cannot be ratified in any event.
Part 11 of the Companies Act 2006 (the Act), due to come into force on 1 October 2007, contains a new derivative action procedure (the Part 11 procedure) that will effectively replace these restrictions. The Part 11 procedure broadens the circumstances in which derivative actions may be brought, extending to actions in respect of any ‘actual or proposed act or omission involving negligence, default, breach of duty or breach of trust by a director of the company’. In particular, the procedure will apply to derivative actions for alleged breaches of any of the new statutory duties of directors in Chapter 2 of Part 10 of the Act, including the duty to exercise reasonable care, skill and diligence.
However, despite this general expansion of the circumstances in which derivative actions may be brought, safeguards against unwarranted shareholder activism have been put in place. First, the Part 11 procedure does not change the current rule that it is only the company, not the shareholder, that may obtain damages in a derivative action. Second, the Part 11 procedure contains a requirement that a shareholder will require the court’s consent to sue – and must overcome a number of hurdles before this consent can be obtained.
The Part 11 procedure
The procedure applicable to derivative actions under the Part 11 procedure is governed by the Act and by recent amendments made to the Civil Procedure Rules (the CPR). The combined effect of these rules is as follows.
Stage one – commencement
A derivative action under the Part 11 procedure must be commenced by the issue of both a claim form (as is the case with ordinary proceedings) and an application by the shareholder for the court’s permission to continue the claim. The application must be supported by written evidence.
The company must be made a defendant to the claim, despite the fact that derivative actions, by definition, do not involve claims being made against the company. This is a technical requirement that ensures that the company is bound by any judgment given in the action.
The shareholder must then notify the company of the action by providing the company with a copy of the claim form and the application notice. This ‘notification’ does not constitute formal service of the claim. Consequently, the company is under no obligation, at this stage, to respond in any way (although, as set out below, there might be scope for it to participate if it so chooses).
There is no requirement that the affected directors be notified of the claim as well as the company. It will therefore be important for companies who receive notification to inform promptly all affected directors of the action’s commencement. Companies should also consider whether to give notice under any relevant directors’ and officers’ (D&O) policies.
Stage two, part one – determination ‘on the papers’
After commencement and notification, the court will consider whether the shareholder’s application for permission and the evidence filed in support show that the shareholder has a prima facie case. The shareholder cannot take any steps in the action until the court determines this question.
The court will first consider this question ‘on the papers’ filed by the shareholder. The Act is clear in providing that, where evidence is concerned, the court must determine the question of whether a prima facie case exists by reference to evidence submitted by the shareholder alone (in order to avoid burdening the company and the directors with having to prepare evidence at this early stage).
There may be scope for the company and/or the directors to make submissions to the court. However, the new practice direction to the CPR states that if the company volunteers a submission without invitation from the court, the company will not normally be allowed any costs relating to its submission.
Stage two, part two – possible oral hearing
If the court determines against the shareholder on the papers, the shareholder can request an oral hearing to reconsider the question.
The company must be given notice of any such hearing and the company and/or the directors may be able to appear to present their view of the shareholder’s case.
However, as noted above, if the company attends the hearing without invitation from the court, the company will not normally be allowed any costs relating to its attendance.
If the court determines that no prima facie case exists then it will dismiss the shareholder’s application, and the action cannot proceed. If a prima facie case is found to exist the court will adjourn the application and order the parties to prepare for a full hearing of the shareholder’s application. The court will also make orders at this stage for the company and the directors to be served formally with the claim form and the shareholder’s application.
Stage three – full hearing of shareholder’s application
The hearing of the shareholder’s application will proceed in the manner of an ordinary interim application, with both sides being afforded the opportunity to submit evidence and submissions.
At this stage, the court must consider whether to grant permission to the shareholder to continue the claim by reference to a number of factors. First, the court must refuse permission if it concludes that:
- a person acting in accordance with the new section 172 director’s duty (ie to promote the success of the company) would not continue the action;
- the action concerns a future act that has been authorised by the relevant decision-making body in the company (which would either be the shareholders or the directors, depending on the act in question); or
- the action concerns a past act that was authorised by the relevant decision-making body prior to its being carried out, or ratified after it was carried out.
Second, in reaching its decision, the court must also take into account a number of factors including:
- whether the shareholder is acting in good faith in bringing the action;
- whether the act that is the subject of the action will in the future be authorised or ratified by the company’s shareholders; and
- whether the company has decided not to pursue the action.
Finally, the court must have ‘particular regard’ to any evidence regarding the view of shareholders with no personal interest in the action.
If the court ultimately considers that permission should be granted, the action will continue in the same way as ordinary proceedings. In such cases, the company may be ordered by the court to indemnify the shareholder against liability for costs incurred in the permission application or in the derivative claim, or both. On the other hand, if permission is denied, then the action will be unable to proceed and the court will ordinarily order the shareholder to pay the company’s and/or the directors’ costs of defending the application. However, costs incurred in investigating the shareholder’s claim will not ordinarily be recoverable.
General points to consider
What to do?
As already noted, the Part 11 procedure expands the range of circumstances in which derivative actions can be brought against directors. Accordingly, companies and directors should consider taking the following steps:
- reviewing D&O insurance policies to check the extent of cover in respect of shareholders’ litigation, both for individual directors on side A and for the company itself on side B (this is dealt with at greater length below);
- notifying insurers as soon as circumstances arise that may give rise to a derivative action;
- ensuring that effective lines of communication are established with shareholders generally so as to minimise the risk of disputes arising from misunderstandings; establishing relationships with ‘friendly’ shareholders who share the directors’ vision for the company;
- in the case of non-listed companies, considering whether potentially controversial decisions should be authorised by the shareholders or could be ratified after the event. In the case of listed companies, the benefits of such authorisation or ratification would of course have to be more carefully balanced against the substantially increased time and cost of doing so;
- establishing clear reporting lines to the board so that decisions can be made with all necessary information;
- properly investigating allegations of directorial wrongdoing and considering whether the company should take action;
- where possible and appropriate, considering how best to engage with shareholders who do not support a proposed course of action and who may contemplate bringing a derivative action;
- developing plans to manage investor and public relations in the event of a derivative action being brought;
- paying close attention to, and responding appropriately to, any correspondence from shareholders about the activities or decisions of directors – regardless of how ‘friendly’ such correspondence may at first sight appear; and
- responding promptly to any derivative actions brought.
Can the Part 11 procedure be used for tactical purposes?
Concern has been expressed that the Part 11 procedure might be used for tactical reasons. For example:
- in a hostile public takeover situation, as a means of attempting to force the directors of the target to agree to provide information to the shareholder/acquirer – on the basis that the directors would not be acting in the best interests of the company if they refused to do so;
- by special interest groups who acquire shares in order to use the procedure as a means of interrupting or attempting to revisit the directors’ decision-making process on a particular issue – such as whether the new duty to have regard to the interests of employees or the impact of the company’s operations on the environment in making a decision was complied with; and
- by shareholders of a quoted company seeking to force further corporate social responsibility disclosure in the directors’ report under section 417 of the new Act – on the basis that the proposed or actual disclosure is untrue or misleading under section 463.
Things to keep in mind
Companies and directors should bear the following general points about the Part 11 procedure in mind.
- It is likely that, except in urgent cases, the first notice the company and the directors will receive of an action will be a ‘letter before action’ setting out the details of the shareholder’s claim and requiring the company to respond. From this point, depending on the nature of the claim, the shareholder will ordinarily have to wait for a period of approximately one month before proceedings can be commenced under the terms of the practice direction on pre-action protocols contained in the CPR. The procedure set out above will then apply. The action can be brought earlier, but doing so may put the shareholder at a risk of an adverse cost order being made against him or her.
- As set out above, the Part 11 procedure applies to both actual or proposed acts or omissions that may constitute breaches of duty. It was the government’s intention that this extension of the procedure to ‘proposed’ conduct will enable relief in the form of an injunction or a declaration to be obtained, prior to any wrong having been committed or loss having been suffered. This would mean that if, for example, the act in question was the passing of a particular board resolution, a shareholder could utilise the Part 11 procedure to seek an injunction to restrain the directors in advance from proceeding along that course. However, the extent to which the procedure can be used in this manner will be a matter for judicial determination.
- The Part 11 procedure does not limit the scope of the wrongs in respect of which derivative actions can be brought to wrongs committed within the UK. There is consequently a risk that directors of multinational companies may face derivative actions in England regarding conduct taking place in other countries.
- If a letter before action (or other correspondence indicating that a derivative action may be brought) is received by the company and the directors, the issue of separate representation will need to be considered. Whether separate representation should be obtained will be a matter for consideration on a case-by-case basis, having regard to the nature of the action, the extent to which the interests of directors and the company diverge (or are likely to diverge), and, importantly, the views of any D&O insurer. At this early stage, unless the interests of the company and the directors are clearly at odds, it may well be the case that the insurer will be unwilling to fund separate representation.
- More generally on insurance, it will be important for companies to review the scope of their D&O cover taking account of the Part 11 procedure. In particular, it will be important to determine whether the ‘wrongful acts’ covered include future wrongful acts, given the ability for derivative actions to be commenced in respect of ‘proposed’ acts or omissions by directors. Additionally, any exclusions should be reviewed carefully to ensure that derivative actions fall within the scope of the claims to which the insurance will respond. Companies should also consider whether they have any coverage for liabilities incurred under a court order that the company fund the costs of a derivative action.
- The Part 11 procedure principally applies to derivative actions brought in respect of breaches by directors of their various duties. However, it also extends to actions against persons involved in such breaches. So, for example, in a claim in respect of money transferred by a director in breach of trust, it is envisaged that the procedure would allow a derivative action to be brought against both the director and any other person or entity who received the funds with knowledge of their source and nature.
- The Part 11 procedure is subject to transitional provisions that restrict its application in cases in which the conduct complained of took place before 1 October 2007. The present law will continue to apply to all derivative actions that are commenced before that date, save for one exception for derivative actions that are commenced before 1 October 2007, but in which, as at that date, no application for permission to continue them has been made. The new procedure will apply to these actions. Additionally, the transitional provisions affect derivative actions commenced after 1 October 2007, but which concern conduct that occurred wholly or partly before that date. In this case, the action will only be allowed to proceed to the extent that it could have done so under the present law, but the new court procedure will nonetheless apply. So, for example, a derivative claim commenced on 10 October 2007 that alleges directorial negligence in October 2006 would not be allowed to proceed, on the basis that the current law does not permit a derivative action to be brought by a shareholder on this basis.
Companies and directors can take comfort in the fact that the Part 11 procedure contains a specific ‘anti-greenmail’ provision. If the court gives permission to continue a derivative action, then it may order at the same time that the action not be discontinued, settled or compromised without the court’s further permission. The court is likely to impose this condition where it is concerned that a proposed discontinuance or settlement might not come to the attention of shareholders who might have an interest in taking over the claim.