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Shareholders' derivative claims under the Companies Act 2006: market mechanism or
asymmetric paternalism?

Author: Raja Adnan Liaqat; Undergraduate (LLB) student, University of Bedfordshire

Subject: Company law

Keywords: Causes of action; Common law; Derivative actions; Directors' powers and duties;

Permission to issue; Ratification; Statutory provisions

Legislation: Companies Act 2006

In response to Joseph Lee article Market mechanism or asymmetric paternalism? With all
due respect I would like to draw focus of readers on another side of coin of issue of minority
protection.

The objective of this journal is to determine, in the light of Joseph Lee considerations and
judicial verdicts that at what extent the development in UK company law in relation to
derivative claims provide protection to shareholders. It is proposed to briefly examine the
common law derivative claims and then the recent interpretation of Companies Act 2006 in
relation to derivative claims, with the help of case law.

A brief overview of Common law derivative claims:

In the case of Foss v Harbottle1 it was generally accepted that under the principle of proper
claimant no individual shareholder has locus standi, as the wrong done against the company
is itself a company and therefore it would be illogical for individual shareholder to sue the
company in respect of that wrong particularly in respect of cadit quaestio 2 . It seems that this
rule was extremely unbalanced as it leaves individual and minority shareholders in extreme
voluntarily position and gave a chance to majority to may abuse the powers.

However to make the balance between both parties, later in the case of Edwards v Halliwell 3
Jenkins LJ set fourth four exception to the rule in Foss. It is important to note here that the
first three exception were concerned with the direct right of shareholders and only the fourth
exception ( fraud4 on the minority) address the wrong done with the company or minority
shareholders5 thus truly a directive action6 .

It has been noted that even after exceptions to the rule of Foss, scope of derivative claims
remained limited to fraud and self serving negligence. The case of Pavlides v Jensen 7 is the
best illustration for these type of situations, where the director of company sold the shares at
low price but court held that mere negligence does not constitute fraud and therefore minority
shareholder could not succeed.

However, in the case of Daniels v Daniels8 Templeman J distinguished the mere negligence
from self-serving negligence and held that;
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The principle which may be gleaned [from the cases] is that a minority shareholder who has
no other remedy may sue where directors use their powers, intentionally or unintentionally,
fraudulently or negligently, in a manner which benefits themselves at the expense of the
company9.

Weakness of Common law derivative action:

On one hand so called common law derivative actions started to provide minimal relief to the
minority shareholders, however, on the other hand it still left some loop holes and
complications due to which derivative actions limited the protection afforded to minority
shareholders which are as follows;

First of all the scope of derivative actions was limited to the fraud and self serving negligence
because of the fear of floodgate of claims and therefore litigants can pursue their claims only
in limited circumstances. Secondly the claimant had to prove that the fraud was committed by
the controller of the company and consequently those controllers benefited out of that
conduct and which seems to be difficult to prove for minority shareholders because they may
only have very limited access to the companys accounts or other information.

Thirdly at common law claimant of derivative actions and company were joined litigants10
and therefore it seems to be complicated that how minority shareholders can recover their
losses in an individual capacity or as a group but separately from company?

Fourthly the equitable hurdles that the claimant should come to the court with clean handed
and in the essence if claimant loses their claim they had to pay cost of claim themselves, it
led toward a new fear of baring cost of whole claim and therefore even genuine claimant
stopped to pursue their claims.

In the consequence of weaknesses of common law derivative actions mentioned above it

could be argued that the common law derivative action was dissatisfactory as rules were very
narrow, limited, obscure and complex.

An overview of Statutory derivative claims:

In 1997 the Law Commission publish a report on shareholders remedies and concluded that
the common law rules governing the derivative action are complicated, old fashioned and
unclear which are unable to meet with the modern business law requirements. Therefore
derivative claims should be reformed in such a way that they show more flexibility, clarity
and properly defined criteria that in what circumstances shareholder may pursue an action.

Derivative claims now governed under the part 11 of the Company Act 2006. This part of the
legal research examines the relevant provision of the Act that deals with derivative claims
and their judicial interpretation.

Grounds for derivative claims Section 260:

Section 260 (3) provides following grounds;

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A derivative claim under this Chapter may be brought only in respect of a cause of action
arising from an actual or proposed act or omission involving negligence, default, breach of
duty or breach of trust by a director of the company 11.

The word negligence instead of fraud12 or self-serving13 negligence obviously widens the
grounds for derivative claims as compared to the common law.

Breach of duty is another positive development mentioned in section 260 (3) of Company Act
2006 which states that claims can be brought in the essence of any breach mentioned in the
section 171 to 177. However through the case law it has been revealed that in derivative
claims establishing the breach of duty is a difficult task. In the case of Stimpson v Southern
Private Landlords Association14 when Mr Stimpson tried to pursue under article 261 for the
permission of continuity of derivative claim against the defendants from whom they sought
an account of profits. The court rejected the claim and Pelling J held that if the intended
benefit is not the basis of conflict then under section 176 of Company Act 2006 would not
regarded it as breach of duty.

Section 260 widened the category of defendants and now claimant may take action against
director or another person (or both). Recently in the case of Iesini v Westrip Holdings Ltd 15
Lewison J interpreted the word another person and suggested that action may be brought
against, those who assisted the directors dishonestly in breach of fiduciary duty.

Furthermore as compared to the common law section 260 (4) allow the shareholders to take
action in respect of those wrongs which occurs even before they became shareholders,
because new shareholders may harmed due to previous decisions.

In conclusion section 260 widen the grounds for derivative claims and category of defendants
which empower the minority shareholders. On the other hand many claimants have failed due
to strict criteria for giving permission and strict interpretation of terms such as breach of duty.

An overview of section 261:

Section 261 (2) states that if claimant failed to bring prima facia case then court must dismiss
the application which means that the only cases should allowed which could at least result in
mini trial.

The history of English law derivative claims shows that passing the criteria of prima facia
case is not big deal because the required evidence from the claimant to pass the criteria of
prima facia case may only establish zero percent of chances of success.

Most critics argue that the requirement of prima facia case should be removed because many
cases like wise Mission Capital Plc v Sinclair16 the first stage was passed on the basis of
section 263(2)(a) using the mandatory bar and not on prima facia criteria17 . Furthermore
requirement of prima facia case put extra cost and waste of time of claimant and
consequently it may put hurdle for small private companies to bring claim in the court.
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On the other hand David Gibbs argued in support of validity of prima facia requirement that
prima facia case and mandatory bar are two different considerations as it is possible for a case
to be prima facia case even though directors would not willing to continue it but is not
possible for the directors to continue the case without requirement of prima facia case18 .

An overview of Section 262

This section enables a shareholder to apply to the court for permission to take over a claim
that the company has already brought. This is an innovation of the 2006 Act. The Law
Commission intended the provision to deal with those situations where the company's real
intention in commencing proceedings is to prevent a successful claim being brought19 .

An overview of section 263 and its relation with section 172 & 994

Section 263 provides the criteria for giving permission and empowers the court in deciding
the question that whether the derivative claim is persuasive or not. These include the
intention of the shareholder behind the claim, whether the directors acting in accordance with
section 172, rectification and authorisation of wrong and available remedies.

Section 263 (2)(a) provides mandate to the court whereas (3)(b) refers towards the important
factors while deciding the question of permission of continuity of claim thus both prefer to
the duty to promote the success of the company in section 172. Although this principle seems
to be vitiate the principle in Burland v Earle20 and Re Elgindata Ltd21 that the court should
not interfere or go against the internal decision of company.

In the light of cases like Iesini v Westrip Holdings Ltd 22 it has been transparent that the
judicial lens of section 263 (2) does not empower the court to make commercial decision for
company are to give them guidelines that how to deal with company`s internal business.
Although court may only use it as a device to determine that whether the directors would
have acting in accordance with section 172 particularly in situation where claimant pursues
his/her action on the basis of fraud or negligence.

The actual assessment of s.263(2)(a) is not vastly different from that of the second stage in
section 263(3)(b), and as mentioned earlier in Stimpson, the court saw a relationship between
assessing this section and the second stage. To digress slightly, the key difference between
section 263(2)(a) and s.263(3)(b) is not between these sections themselves, but the other
subsections under s.263(3). We will see later that assessing section 263(2)(a) and section
263(3)(b) is mainly carried out on a basis of legal validity, except in a clear case where
commercial considerations may be included. If the legal claim is very weak, as in Iesini, then
section 263(2)(a) will apply. If the claim has some legal merit to it as in Franbar, the court
will move on to the second stage and may attach weight to the claim based on the strength of
the legal claim. In allowing the claim to proceed, all the other factors must be considered
under section 263(3), such as the availability of another remedy, and the court must decide at
its discretion whether to allow the claim based on all the considerations. Here we can see
there is no great difference between section 263(2) (a) and establishing a prima facie case,
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other than there being evidence from the defendants. There is, however, a difference between
a prima facie case and section 263(3), contrary to the views of Keay and Loughrey 23.

In the case of Mission Capital Plc v Sinclair24 while considering the issue that whether a
person acting in accordance with section 172, on the fact mandatory bar under section 263
(2) had not been established nor the court held that director would not seek to continue this
claim. The court refused to give permission to continue under section 263 on the ground that
a director would not seek to continue the case, as he would not attach much importance to it
given that the damage suffered by the company as a result of their wrongful dismissal was
speculative. This was despite the fact that the action was brought in good faith25 .

In the case of Franbar Holdings Ltd v Patel26 where the shareholders were in minority and
the remainder of shares were belongs to third party, minority shareholder claimed that the
third party wrongly suspended the nominated director and failed to provide proper financial
situation. The court took many factors into account which the hypothetical director should
take into account including the chances of success, damage to the reputation of business, if
the action by minority fail the cost of the proceeding and whether the shareholder are able to
bring the action and obtain the remedy under unfairly prejudicial conduct the etc.

Although it was a prima facia case but court held that there would be more required to
establish a claim for breach of duty as the court was of the view that the relief they seeking
could be pursued under section 994. Both cases discussed above shows that the discreation of
hypothetical directors is still very wide and in practice refusal of derivative claims seems very
common.

Can a majority shareholder bring a derivative claim?

Traditionally the derivative claims are used to protect minority shareholders from the
majority shareholders however in the case of Cinematic Finance Ltd v Ryde 27 where a
majority shareholder applied under section 261 (1) on the grounds of breach of fiduciary duty
and argued that it was not stated in common law neither in any provision of Company Act
2006 that the only minority shareholders can apply for the permission of continuity of
derivative claims. However the court reject the appellant arguments and held that only in
exceptional circumstances court may allow the claim from majority shareholders and it would
be difficult to mention at this stage that what circumstances it would be.

In conclusion the statutory footing apparently give the protection to the minorities and assist
the claims to become more transparent however on the other hand courts are reluctant to
adopt suitable approach to access the claim. In order to proceed the derivative claims the two
statutory provisions are available to bring the claim section.263 (3) and 263(2) perhaps the
procedures under that provisions are not very clear.

Furthermore the three stage slow down the efficiency of the claim and thus the permission
stage should be based on single stage that whether or not to allow the permission to plaintiff.

Another reform is in the area of indemnity order as the purpose of derivative claims should
have to protect the minorities from majority and therefore once the claimant get permission at
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first stage he/she should be able to receive indemnity order. In current law litigant cannot
benefit from legal aid or any other funding which may leads toward the fear of making even
genuine derivative claims.

Furthermore it should also be added in the Act that before making a claim, claimant should
give a written notice to the company for remedy, for instance if the company failed to ratify
in three months then the claimant would peruse in the court.

Due to long debate and importance of this issue, in future EU directive is also expected to
give the equal rights to minority and majority shareholders.

In summery current case law and statutory provisions does not provides sufficient protection
to the minorities .In that essence wrongdoers always found beneficial although they have
plenty of reasons to escape from their wrongdoers .

I would like to appreciate contribution in writing this journal and I have no hesitation to
accept that it was not possible for me to respond Joseph Lee publication without Dr
Konstantinos Sergakis kindness.

1
67 E.R. 189; (1843) 2 Hare 461 Ct of Chancery
2
Edwin C. Mujih, The new statutory derivative claim: a paradox of minority shareholder protection: Part 1
Comp. Law. 2012, 33(4), 76
3
[1950] 2 All ER 1064
4
The definition of fraud was given by Lord Davey in Burland v Earle [1902] AC 83, that the fraud on the
minority would occur when:
The minority is endeavouring directly or indirectly to appropriate to themselves money, properties or
advantages which belong to the company or in which other shareholders are entitled to participate.
5
In Smith v Croft (No 2) [1988] Ch 114 it was decided that while the rule in Foss v Harbottle has no application
where the claimant seeks to restrain an intended ultra vires act it does apply where the act has already been
committed.
6
Ed Weeks, A statutory derivative action (2007) Comp. Law., 28(8),225
7
[1956] 2 All E.R. 518 Ch D
8
[1978] Ch. 406 Ch D
9
Ibid at 414
10
Cooke v Cooke [1997] 2 B.C.L.C. 28 Ch D.
11
Section 260 (3) Company Act 2006
12
Pavlides v Jensen [1956] 2 All E.R. 518 Ch D
13
Daniels v Daniels [1978] Ch. 406 Ch D.
14
[2010] B.C.C. 387 Ch D.
15
[2009] EWHC 2526; [2010] B.C.C. 420.
16
[2008] EWHC 1339 (Ch)
17
Demetra Arsalidou, Litigation culture and the new statutory derivative claim (2009) Comp. Law. 30(7), 208
18
David Gibbs, Has the statutory derivative claim fulfilled its objectives? A prima facie case and the mandatory
bar: Part 1 (2011)Comp. Law. 32(2), 41-45
19
Law Commission, quoted by Lewison J. in Franbar Holdings Ltd v Patel [2008] B.C.C. 885 Ch D at [80].
20
[1902] AC 83
21
[1991] B.C.L.C. 959.
22
[2009] EWHC 2526
23
David Gibbs, Has the statutory derivative claim fulfilled its objectives? A prima facie case and the mandatory
bar: Part 1 (2011)Comp. Law. 32(2), 45
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24
[2008] EWHC 1339 (Ch)
25
Edwin C. Mujih,The new statutory derivative claim: a paradox of minority shareholder protection: Part 2
(2012) Comp. Law., 33(4), 100
26
[2008] EWHC 1534 (Ch)
27
[2010] EWHC 3387