This blog provides an overview on derivative claims in general terms. The intention is not to advise on whether or not to bring a derivative claim.
The decision in Foss v Harbottle (1843) established the common law principle that a company is the only legal entity that can sue for a wrongful act against that company. This means that individuals such as shareholders were not entitled to bring an action on behalf of a company though they could be adversely affected by a certain cause of action. This rule combined with the majority shareholders’ principle (that minorities couldn’t complain if the majority approved something) meant minority shareholders were seen to be poorly protected.
The UK legislator, acknowledging the risk of abuse against minority shareholders, enacted a significant measure in the Companies Act 2006 (CA 2006), Part 11, based on ‘derivative claims’. A derivative claim permits a shareholder to institute proceedings on behalf of a company in an attempt to redress a wrong perpetrated by one or more directors who do not take decisions in the interests of the company as whole (i.e. safeguarding all shareholders).
Private company directors are more likely to be the subject of a derivative claim and, in order to limit their risk of this litigation, they should ensure that they are adequately protected by the provisions of shareholders’ agreements and articles of association as well as ‘Directors and Officers (D&O)’ insurance.
The derivative claim is a two-phase procedure set out in sections 261 and 263 of the CA 2006. The first stage requires the member to disclose a preliminary case. The second phase involves the Court considering the existence of certain factors.
According to section 261 of the CA 2006, whether a shareholder decides to take a derivative action he or she needs to apply for the Court’s permission in order to commence such action. If the Court is satisfied with the evidence presented by the claimant, it will grant the permission to proceed. This first phase is a sort of preliminary hearing simply based upon papers filed at the Court, where the claimant has to demonstrate a credible chance of success. Then, the Court will involve the company in the claim by asking the company itself why the permission to proceed should be refused. Under section 263(2) of the Act, the Court rejects the permission only if one or more of the following criteria are satisfied:
- a person with a duty to promote the company’s success would not continue the claim;
- the action, or the act or omission that constitute the foundation of the claim, was authorised or ratified by the company.
If none of these criteria applies, the Court – in order to finally decide whether the claim can continue – has to take into consideration various factors as set out in section 263(3) of the CA 2006, namely the Court has to evaluate whether:
- the claimant is acting in good faith;
- a person that would promote the success of the company would continue the claim;
- an act or omission that gives origin to the cause of action is likely to be ratified by the company;
- the company has decided not to pursue the claim; and
- the act or omission in respect of which the claim is brought gives rise to a cause of action that the member could pursue in his own right rather than on behalf of the company.
The practical implications and risks for the claimant
The factors listed both in section 263 subsections (2) and (3) are open to a wide range of discretion. Either the promotion of the success of the company or the concept of good faith and the probability of success of an act or omission have caused concern to the Courts and they have not as yet determined an unambiguous interpretation of these.
Additionally, another risk that a claimant should take into consideration is the cost of a derivative action. Section 19.9E of the Civil Procedure Rules, states that ‘The Court may order the company, body corporate or trade union for the benefit of which a derivative claim is brought to indemnify the claimant against liability for costs incurred in the permission application or in the derivative claim or both’. However, this is not an obligation for the Court. In the last decade, the Courts have only ordered companies to indemnify derivative claimants on a very few occasions.
As a result, minority shareholders should consider the complexity and risk of derivative claims before going into litigation. Communication with the company and directors is, therefore, always highly recommended.