Minority Shareholders and Derivative Actions

Christian Chin elaborates on the common law and statutory derivative actions available for the protection of minority shareholders.  

 

Introduction

Where a wrong has been done to a company and no action is being taken to remedy this wrong, there are several courses of action that are open to a member of the company:

  1. a member may request the board of directors to take action on behalf of the company; or

  2. he may requisition a general meeting for the purpose of passing a resolution to commence litigation;1 or

  3. if neither of the above is possible, then the member may either:

Where the potential defendant is in a position to thwart the efforts of those seeking to enforce the company’s legal rights by bringing an action against the potential defendant, the only courses of action open to a member would be those enunciated in the third option above

Common Law Derivative Action

A member of a company can commence an action against the defendants himself where he can demonstrate that the case at hand comes within one of two exceptions to the rule in Foss v Harbottle (1843) 2 Hare 461 (also known as the ‘proper plaintiff’ rule, which, briefly, states that no member can arrogate to himself the company’s cause of action).

The ultra vires exception

As an action to restrain an ultra vires act is an action seeking to enforce a member’s personal rights, the rule in Foss v Harbottle does not operate to prevent a member doing so. However, as an ultra vires act is not void vis-à-vis a third party (see section 25(1) of the Companies Act (Cap 50)), the question of recovery of the company’s property from a party to an ultra vires transaction would, therefore, not arise. This means that for all practical means and purposes, the ultra vires exception to the rule in Foss v Harbottle is effectively defunct.

The fraud on the minority exception

If there has been a fraud on the minority and the wrongdoers are in control of the company, a minority member may bring an action to enforce the company’s rights. However, it is important to bear in mind that this exception is merely a procedural device to enable justice to be done. As such, a member has no right to bring such an action. The court maintains its discretion to disallow a member from bringing such an action if he does not come with ‘clean hands’ or where the justice of the case otherwise dictates that such an action should not be allowed (Nurcombe v Nurcombe [1985] 1 All ER 65). In determining what amounts to a fraud on the minority for the purpose of allowing derivative actions, it appears that the courts tend to allow for a more generous interpretation as compared with fraud at common law, including within its ambit fraud in the equitable sense (eg where there is an abuse of power — Estmanco (Kilner House) Ltd v Greater London Council [1982] 1 All ER 437). Furthermore, it appears from the study of relevant case law that fraud on the minority would exist where the majority uses their voting power in a manner that the law regards as illegitimate to cause some injury or loss to the company or to the minority members. This is weighed against the countervailing principle that a member has a right to vote as he pleases; which dictates that where the majority votes to excuse a breach or waive a right, the minority is bound by that vote and may not sue in defiance of the majority’s decision. The balance is struck where fraud is being perpetrated on the minority — in such cases, the power of the majority to pass resolutions is necessarily circumscribed and the decision of the majority will not be binding on the minority.

It has been suggested that a general rule for establishing fraud on the minority can be culled from the study of relevant case law. This proposed rule calls for three requirements to be satisfied:

  1. the majority must have obtained some benefit;2

  2. the benefit must have been obtained at the company’s expense or some loss or detriment must have been caused to the company;3 and

  3. the majority used their controlling power to prevent an action being brought against them by the company.4

Statutory Derivative Action

Despite of the courts’ efforts to come up with a general rule for determining when there has been a fraud on the minority, the uncertainty of its application and the haphazard procedure that has to be followed in bringing such an action gave rise to the enactment of sections 216A and 216B in the Companies (Amendment) Act of 1993, which together sought to clarify and reform the situation regarding derivative actions.

Procedure

Section 216A substitutes the ad hoc procedure involved in common law derivative actions with a two part procedure requiring a complainant5 to, firstly, apply to court for leave to commence an action on behalf of the company and, secondly, upon obtaining leave of court to commence such an action, to take the necessary steps to initiate the action using the company’s name.

Before applying to court to commence an action under section 216A, the complainant must first give fourteen days’ notice to the company’s directors to give them a reasonable opportunity to commence the action themselves (section 216A(3)(a) — this requirement for fourteen days’ notice, however, is not an absolute rule and is open to the complainant to show, in each instance, why notice could not be given). This notice should state what it is that the complainant wishes the directors to do. As the law recognises that it would be unduly onerous on the complainant to require the complainant to specify each and every cause of action in the notice (see Re Bellman and Western Approaches Ltd (1981) 130 DLR (3d) 193, where it was held that a complainant’s failure to specify each and every cause of action in a notice did not invalidate the notice as a whole), all that is necessary to fulfil this requirement is that the notice ‘sufficiently specifies the cause of action and contains sufficient information to found an endorsement on a writ’ (Re Northwest Forest Products Ltd [1975] 4 WWR 724). If the directors consider the matter and honestly decide that it would not be in the company’s interest to commence or defend the action, the court would not intervene. This is because it is neither the role nor the function of the courts to hear appeals from management decisions honestly arrived at (Howard Smith Ltd v Ampol Petroleum Ltd [1974] AC 821).

At the hearing of the application, the court must be satisfied that the complainant is acting in good faith and that it is prima facie in the interests of the company that the action should be brought before granting leave to commence the action (section 216A(3)(b) and (c). In deciding whether or not the latter requirement has been satisfied, two factors usually weigh heavily on the courts’ mind. The first is whether or not there is an arguable case against the proposed defendant; the second is that extraneous considerations may be taken into account in deciding whether or not to commence an action on behalf of the company. This is because the courts acknowledge that the decision whether or not to commence an action on behalf of the company is often as much a matter of business as of law. It would therefore be fair to assume that the fact that the majority have decided against pursuing the action is a factor that courts would take into account in deciding whether or not to grant leave.

If the court decides to grant leave to the complainant to commence an action, the court has the power to make an order requiring the company to pay reasonable legal fees and disbursement incurred by the complainant in connection with the action (see section 216A(5)(c)). The court may, in suitable cases, only order a partial indemnity (Turner v Mailhot (1985) 28 BLR 222).

In addition to the power to order payment of costs, the court has a wider power to make such other orders as it thinks fit in the interests of justice (section 216(5)). This would presumably give the court the power to grant a complainant access to a company’s records in order to make it easier for a complainant to gather evidence to buttress his case against the wrongdoers.

While it is clear that the cumulative effect of the above provisions is to considerably strengthen the position of minority shareholders vis-à-vis the majority, section 216A is not without its shortcomings, two of which will be discussed below.

Who may intervene?

Section 216A goes further than the common law derivative action in the protection of minority shareholders. This is because section 216A allows a complainant to intervene in an existing action, whereas the common law merely allows a minority shareholder to bring an action. A situation may, therefore, arise whereby shareholders take turns to hijack an action, resulting in a carousel of applications being made by the shareholders. While this is less likely to arise due to the court’s supervision, the courts may still be placed in a quandary where a complainant applying to court satisfies the section 216A requirements but is nevertheless not the most appropriate person to bring the action. It then falls for the court to decide whether or not to allow the complainant to go ahead with the action, bearing in mind the possibility that another party may apply to take over the proceedings.

The fact that there is no time limit within which a complainant must make an application further exacerbates this problem. This is because a potential complainant, being comforted by the knowledge that he may jump into the fray anytime to intervene in the action, lacks the necessary impetus to act expeditiously in the matter.

Another curious upshot of the width of section 216A is that there may be a situation whereby the majority manages to wrest control of the action from the minority.

An unnecessary divide?

Section 216A does not apply in the case of listed companies. The rationale for this appears to be twofold. Firstly, there is a concern that unscrupulous people may take advantage of this provision to make frivolous applications to harass listed companies and even manipulate their share prices. Secondly, it is believed that minority shareholders of listed companies do not require as much protection as those of other companies as discontented shareholders of the former may divest themselves of their interest more easily than those of the latter.

It is difficult to be convinced that the above rationalisations are sufficient to justify maintaining separate regimes for bringing derivative actions. This is because it is no easier to make an application to bring an action under section 216A than it is under the common law. Neither is it necessarily true that shareholders of listed companies are less desirous of protection than those of unlisted companies. In fact, one would think that there is a greater need to protect the shareholders of listed companies from mismanagement.

Conclusion

Thus, while section 216A goes some way towards developing the law in respect of corporate derivative actions, it is equally evident that it is far from a panacea to the ills of the common law derivative action. The need to fine tune section 216A as a comprehensive provision for derivative or representative actions is particularly pressing in light of a recent High Court decision holding that section 216A is the only recourse open to a minority shareholder who wishes to commence a derivative action against the directors of a company for alleged misfeasance against the company. If the only recourse available is fraught with uncertainty, it is unlikely that a minority shareholder will seek this recourse. Should this be the case, then all the efforts that have gone into seeking to enhance the minority shareholders’ position vis-à-vis the controlling majority would have come to naught.  


Christian Chin  
Drew & Napier

Endnotes

1 Members may authorise actions to be brought in the company’s name despite the opposition of the board of directors — Marshall’s Valve Gear Co v Manning, Wardle & Co [1909] 1 Ch 267.

2 Pavlides v Jensen [1956] 2 All ER 518 — a minority member would not be allowed to maintain an action on the company’s behalf if the wrongdoer obtains no benefit for himself.

3 Regal (Hastings) Ltd v Gulliver [1942] 1 All ER 378 — the majority should be allowed to forgive a breach of duty where the company has suffered no loss.

4 There is little reason to allow an exception to the rule in Foss v Harbottle where the defendant is not in control of the company. In relation to this requirement, it is clear that what amounts to ‘control’ is a question of fact to be decided by the courts. Clearly, there is little doubt that a person holding the majority of shares in a company would have control of the company. However, there may be instances where a party holding less than the majority of shares may fairly be considered to have control of the company. It has also been decided that it is permissible to go behind the apparent ownership of the shares to determine if a company is in fact controlled by the wrongdoers (eg where the shares are held on trust for someone else).

5 ‘Complainant’ is defined as either any member of a company, the Minister of Finance in the case of a declared company or any other person who, in the discretion of the court, is a proper person to make an application.