Our legal advice service focuses on Commercial law. We try and focus on many areas of concern which affect everyday individuals who have an interest in a business or financial institution here in the UK. In the article below Bobby Madan focuses on the nature of the Derivative Claim under the Companies Act 2006. For this article I have referred to the text  Gower Principles of Modern Company Law.

Scope of the Law

The Derivative claim is one which still requires much clarification in the area of Corporation Law. It is still a very grey area in Commercial Law.  I hope this article brings you more clarification on this area.

 The typical scenario you will probably experience as a shareholder is where the shareholder invests his money into a company it could be a substantial sum or a nominal sum and later realizes that the company has fallen into bad times. This has subsequently resulted in a loss of profits for the business and now the business is on the verge of closure. The shareholder believes that this loss of profits was down to bad decision making on behalf of the directors of the organisation. Now the shareholder wishes to litigate.

The Derivative claim is not about claiming from a ‘company’ just because that company is failing to exceed your expectations as a shareholder or due to a pandemic such as COVID 19 which has now wiped the prices of your shares. It is more specific than that.

The question lies as to accountability and specific decisions which can be evidenced. Who is therefore responsible for these losses?. Usually when we look at such claims we could take the American example of CEO Richard Fuld known in the famous film th Wolf of Wall Street as the ‘Gorilla’  . To date the downfall of Lehman Brothers is attributed to specific individuals within the company, with Richard Fuld being highest on that list. An example of a Director who was considered responsible for both the success and the failure of the organisation. You can read about Richard Fuld here;

What was the response to this global banks failure? The Director was attributed by many stakeholders with the blame and more importantly for walking away with what many consider should have been confiscation of almost £400m dollars in personal takings.  What was the response from the Shareholders? Not much, they naturally lost out on millions along with many employees losing their jobs.

So where does the Derivative claim fit into such a big collapse such as this. Of course as mentioned earlier the Derivative Claim is still a very grey area and is naturally approached with caution by both the courts and Directors with scepticism as to its use. There is very little in Case law to argue for either a shareholder or director as we will see.  S.170(1) of the Companies Act 2006 which emphasises that such duties which result in the success or failure of a company by Directors are for the benefit of the company only and not its stakeholders or in our article The Shareholders.

The same goes for the company who tries to litigate against the bad decisions of its directors. They may end up doing more self harm then good. After all it is the company who appointed its Director and furthermore it has reputational consequences. This type of action could also be blocked on the grounds of consent or illegality.

So far the Director seems to be able to escape both the shareholder and the company he is Director for. This makes the Derivative claim almost non existent. This brings into question whether any of the legislation in Section 172 of the Companies Act has liabilities attached to it but from what it seems these liabilities are not often enforceable.  But as we will see there are instances where the courts have had to take a different approach against self serving directors.

What does the Law say about Derivative Claims?

A risk to shareholders is that by litigating as a company against a director the recovery and proceeds of any judgment in favour of the Shareholders will go to the company and not to the individual shareholder. This leaves a shareholder with little to pursue a claim for personal gain.  More importantly  the court seems to be promoting what the Director failed to do in his duty which under S.172 of the Companies Act 2006  is  to promote the success of the company.

This therefore requires that when claiming against a director, that the company is joined as a respondent into the Claim. A requirement by the CPR Rules of procedure.

So in fact the court is standing by the statutory provisions of the Companies Act and reinforcing these duties which means that the shareholder who is the Claimant has to act in the interests of the company and join the company into the claim even if not claiming against it.  This means that a claim has to be drafted with this in mind prior to its initiation.  An example of this Derivative action  is below.

Andrew Jones (C) wishes to sue Director John Humphries (R) who has wronged C. However C cannot make the claim without drafting ‘the company’ (B) into this claim.

If C wins the case, the proceeds still go to the company B the company in this derivative claim due to the Section 172 Companies Act rules to promote the success of the company.

Looking at this scenario you may ask, what is the point of this action.

The Authority

With limited case law we turn to probably the most accurate authority of this illustration which is the case of  Foss v Harbottle (1843) 2 Hare 461, 67 ER 189 where two shareholders took legal action against the promoters and directors of the company alleging that they had misapplied the company assetsand that a breach of the duty by the directors was a wrong done to the company for which it could sue. In this case the company was the plaintiff and not the individual shareholders.

The rule is derived from 2 different legal principles;

  1. A company is a legal entity separate from its shareholders
  2. The court will not interfere with the internal management of companies acting within their powers.

There are 4 exceptions to the rule

  1. Illegal acts
  2. Transactions requiring special majorities
  3. Personal rights and
  4. The ‘fraud on the minority’ exception

The court has interpreted the term fraud to include fraud in a strict sense aswell as a breach of duty which results in conferring some benefit on directors or third parties. The court will allow a derivative claim where the wrong doers have benefitted personally from self serving negligence. Examples include diverting business from the company to themselves at undervalue or selling worthless assets to the company.

Why is permission required to make a Derivative Claim?

A derivative claim is not an automatic right for the Claimant. They must apply for permission from the courts. There are 3 situations where permission is usually denied.

The evidence element is extremely crucial to determine a derivative claim based on evidence of the member. If the member cannot make out the case then no permission is granted. The company will not be joined to the claim at this stage and is not required to file any evidence or be present.

Discretionary grant of permission

The first test of granting permission is

  1. Will it fail to promote the success of the company. This is ultimately the test ‘will the litigation promote the success of the company’.

Varieties of Derivative Claim

The statute also specifically provides that a shareholder to apply to the court for permission to take over as a derivative claim litigation which the company has commenced.

The shareholder must show why he or she should be allowed to take over the company claim. The permitted grounds are that the proceedings have been concluded by the company in a way which constituted an abuse of power or that the company has not prosecuted the litigation diligently or for other reasons is appropriate.

Information rights

The case of Wallersteiner v Moir  (no.2) CPR rules showed that a Claimant shareholder could claim costs under the civil procedure rules. It is stated

the court may order the company to indemnify the Claimant against any liability for costs incurred in the permission application or in the derivative claim or both.

The rules give the courts the power to order that the claim may not be discontinued, settled or compromised without permission of the court giving the court the chance to scrutinise the agreement and potentially stop shareholders from exploiting the system for their own personal benefit.

The statutory derivative claim against unauthorised political expenditure

A companies’ policy to make political donations and incur political expenditure is subject to approval by the shareholders in general meeting.

If the company breaks this rule then it has contravened Section 370 which provides for a statutory derivative claim in order to enforce the directors liability. The right to sue is only in company name and not individual shareholders as in the general derivative action but on an ‘authorised group of members’ meaning in a case of a company limited by shares by not less than 5% of its members or either case by not less than 50 members of the company.

The same duties of care and loyalty are owed to the company by the authorised group as would be owed to the company in the claim.

My conclusion

The Derivative claim is still a strongly contested area and has a long way to go before becoming a strong legal mechanism for the minority groups. The Companies Act 2006 and the Directors duties still tend to approach shareholder theory in a pessimistic way.  This is simply the case due to the principles which in some sense protect the Directors of the company such as ensuring the success of the organisation and the duty of care and loyalty. These duties have given the impression that Directors are following guidelines when they may not be. The Director knows he has the back up of the courts and also the company he works for. UK law doesn’t penalise him with a strict liability approach which in return allows the Director to continue as he is. However with accountability and the UK Corporate Governance Code gaining prominence, this may make way for change in the future with stricter penalties for those who manipulate the system.

Our service

I really hope you enjoyed my article and should you have any questions on making a derivative claim, then please feel free to contact our Commercial Law legal centre on 0203 733 6366 . We are based in the heart of Chelsea and Kensington between Sloane Square and Kings Road. We can help with;

  1. Helping you decide if you have a claim against a director
  2. The potential risks and advantages of such litigation
  3. Free initial legal advice on the Derivative claim and Directors duties
  4. Help with our fee structure and court costs etc associated with such a claim
  5. Pre action protocol which may resolve the claim prior to its entry into the court system

As legal consultants we are not authorised to conduct litigation on your behalf but as Mc Kenzie friends we would need to seek the permission of the commercial courts in order to do this.

The benefits of using our service include

  1. Save you the high street costs of using a commercial solicitors practice to begin your claim
  2. Help and assist you as a lay representative in person
  3. Help you with all the necessary documents and paperwork filing.

We hope that should you decide you have a claim we would need to review this with our case consultants to ensure that you have the maximum benefit of your claim. Call us today on 0203 733 6366.