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Sunday, August 29, 2010

Company Law - Derivative Action under Indian Companies Act


Derivative action is defined as - A suit brought by a shareholder on behalf of a corporation or by a member on behalf of an association to assert a cause of action usually against an officer which the corporation or association has itself failed to assert for its injuries called also derivative suit shareholder's derivative suit
- A shareholder or member bringing a derivative action must describe in the complaint attempts to obtain action from the corporate directors or association authorities, or from other shareholders or members, and the reasons these attempts failed. The plaintiff must fairly and adequately represent the other similarly situated shareholders or members, and the action may not be collusive. Federal Rule of Civil Procedure 23.1 governs derivative actions brought in federal court.

As part of their management of a company, directors must often decide whether to involve the company in a lawsuit. As long as they act in good faith and in the best interests of the company, their decision to sue or not to sue is unassailable. Problems arise when the directors themselves are harming the company as, for example, by being involved in competing businesses, neglecting the company's affairs or, worse, diverting opportunities or profits from the company to themselves. In such situations, the company
may be damaged and should consider suing to recover its losses. But the directors will not, of course, authorize the company to sue them personally, or to sue other businesses in which they are involved. Who then can protect the rights of the company? The law provides a procedural remedy called the "derivative action" (since it is derived from the company's own right to protect its interests) which may be appropriate in many situations where a wrong has been done to the company. Any shareholder or director of the company can apply to the court for permission to sue the wrongdoers on behalf of the company. In addition, the court may give that permission to anyone who, in its view, is a proper person to do so. Permission may be given if
(1)   the applicants have made reasonable efforts to urge the directors to authorize proceedings by the company;
(2)   the applicants act in good faith;
(3)   the proceedings are in the best interests of the company. These requirements are intended to protect corporations from wasteful actions by disgruntled members. Once begun, a derivative action cannot be discontinued, settled or dismissed without court approval.

Usually, the directors continue to manage the day-to-day business of the corporation during the litigation, and that may cause difficulties. Sometimes, the court is asked to clarify such questions as who conducts the derivative action on behalf of the company and how the company is to pay the cost. Directors who refuse to protect the company through litigation if they are themselves the wrongdoers may also be violating the rights of the shareholders or be in breach of some term in a shareholders' agreement. Permission to sue is not needed from the courts if, instead of vindicating the company's rights, shareholders or other directors sue for their personal and direct remedies against the wrongdoers.

What is Derivative action?

In English law, the shareholder may seek to enforce the company's rights by suing on behalf of the company against the wrongdoers. This procedure grew out of the representative action and it used to be required that the shareholder sue on behalf of himself and all the other shareholders in the company (except the alleged wrongdoers). It no longer seems to be necessary that the action be brought in representative form. The plaintiff is seeking to enforce, not his own right of action, but a right of action vested in or derived from company. Hence in modern discussions the action is referred to as a derivative action.[1] The alleged wrongdoers are made the defendants in the action but the company itself is joined as a nominal defendant in order that it can be bound by the judgment. If the action succeeds, any property or damages recovered go, not to the plaintiff, but to the company.[2] The plaintiff shareholder can complain in a derivative action of wrongs committed before he became a member.[3]

In recognition of the fact that in these cases the representative action is being used to enforce the company's rights, the Court of Appeal in Wallersteiner v Moir (No. 2)[4] sanctioned a procedure whereby the plaintiff shareholder can apply to the Master at the commencement of his action for an order that the company should indemnify the plaintiff against the costs of the action, whether the action succeeds or not. This rule aims to combine the claim for an indemnity with a method for giving effect to the view of the Court of Appeal in the Prudential case[5] that the question of whether the plaintiff has standing to bring a derivative action ought to be decided as a preliminary matter before the full trial of the merits of the claim. After the claim form has been issued, the claimant must apply to the court for permission to continue the claim, serving upon the court written evidence in support of the application.

The court's task in deciding whether to grant permission is not simply to decide whether the claimant has standing under one of the exceptions to the rule in Foss v Harbottle, but also to consider whether it appears the derivative action is being brought in the best interests of the company and whether there are alternative remedies available.[6] The court is expressly given power to order the company to indemnify the claimant against liability in respect of the costs incurred in the claim, if it gives the claimant permission to continue with the claim. However, it appears that any indemnity given to the shareholder suing derivatively creates no lien in his favour over the company's assets, even those assets recovered as a result of the derivative action.[7] It has been held that the definition of "company" is wide enough to embrace a foreign company, but that normally the courts of the place of incorporation would be the appropriate forum for dealing with derivative actions arising out of the exercise of the discretionary powers of management.[8]

In Wallersteiner v Moir (No. 2) it was said that the test for whether an indemnity ought to be granted was whether the legal action constituted "a reasonable and prudent course to take in the interests of the company".[9] In Smith v Croft[10] Walton J. held that an indemnity should not be granted if it could not be shown that the proceedings had an even chance of success or if it was opposed by a majority of the independently held shares. In Watts v Midland Bank[11] the judge took the view that an indemnity should not be allowed where the plaintiffs were very unlikely to benefit from the action qua shareholders but only as guarantors or would-be purchasers of corporate assets.
Any order made is normally limited to continue up to a specified stage in the main action. In Wallersteiner v Moir (No. 2) the Court of Appeal authorised the plaintiff to proceed with the prosecution of outstanding issues on a counterclaim down to the close of discovery, after which he should obtain further directions of the court. It may be that the recognition of the true nature of the representative action in this area as one which is brought to enforce the company's rights will lead to the imposition of fiduciary-like duties upon the individual plaintiff as to the terms upon which he may compromise, settle or abandon a derivative action.[12]

Where a derivative action is available to the plaintiff, it is advisable for him to sue in that way rather than in the name of the company. Quite apart from the plaintiffs' opportunity to obtain in a derivative action under procedure an early indication of his position as to costs, it has been said to be preferable to have the issue of locus standi fought out on the issue of whether a derivative action is available rather than over the right to use the company's name. Thus in Alexander v Automatic Telephone Co[13] Lindley M.R. said :
 "Under these circumstances an action by some shareholders on behalf of themselves and the others against the defendants is in accordance with the authorities, and is unobjectionable in form: see Menier v Hooper's Telegraph Works.[14] An action in this form is far preferable to an action in the name of the company, and then a fight as to the right to use its name."

The derivative action is subject, however, to the doctrine of clean hands. As an equitable invention, the derivative action cannot be used to do injustice. This principle has been applied in cases of acquiescence by the plaintiff shareholder in the wrongdoing of which he later complains[15]   and in cases where the plaintiff has been regarded as the puppet of outsiders whose interests are opposed to those of the company.[16]  In general it can be said that a shareholder seeking to sue derivatively must act bona fide for the benefit of the company and not in order to further an ulterior purpose.[17] The requirement of clean hands does not apply to the personal action.[18] Moreover the derivative action is a remedy of last resort, and so a shareholder will not be permitted to use it where there is an alternative action available which would provide an adequate remedy for the wrongs in question. This is likely to be the case where the company is in liquidation or could easily be put into liquidation, for then the liquidator can bring litigation against the wrongdoers in the name of the company, where he regards it as in the interests of the company to do so. The alleged wrongdoers no longer have control of the company's machinery for bringing litigation, and the shareholder can challenge before the court the liquidator's refusal to institute litigation, if that refusal is unreasonable.[19]

Rule in Foss v. Harbottle

Shareholders' Actions - the Present Remedies
Present remedies are as follows:
(1) the derivative action;
(2) direct action by shareholder to enforce rights against a company;
(3) statutory remedies for shareholders.

Derivative actions to recover damages or property for the company
A company is a separate legal entity; any action to vindicate the rights of the company must be brought by the company itself. Under the company's articles the power to manage the affairs of the company will be vested in the directors. This carries with it the right to use the corporate name in litigation. A company can only be represented in litigation through a solicitor and the solicitor must obtain his instructions from those in authority within the company.
The proper plaintiff in proceedings to redress a wrong against a company or to enforce a right of the company is the company: Foss v Harbottle.[20] There is considerable life left in the Rule in Foss v Harbottle as it approaches its 150th anniversary. As a general rule, cause of action for the shareholder will lie only where the act complained of is either:
(a) a "fraud on the minority'; or
(b) ultra vires or illegal; or
(c) an infringement of the personal rights of a shareholder; or
(d) something which can be carried out only by special resolution but which the company is seeking to implement by an ordinary vote.
The plantiff shareholder seeks to recover damages for breach of duty from directors or third parties or restitution of property for the company. It is known as a derivative action since the right of the shareholder is derived from the rights of the company. It is therefore a restricted procedure with limited or no personal gain for the plaintiff shareholder. What is recovered must go into the company's coffers; it cannot go to a plaintiff representing the minority. The action must be brought genuinely in the company's interests. A fundamental difference incidentally between the derivative and class actions is that the latter would be brought against the corporate entity and not on its behalf.

The "fraud on the minority' exception to the Rule in Foss v Harbottle
The exception is important in that it determines the extent to which minority shareholders may enforce the duties owned by directors to their company.
To come within the fraud on the minority exception (which could be better defined as fraud on the company as the shareholder is complaining of a wrong done to the company) the shareholder has to satisfy two requirements: (i) wrongdoer control; and (ii) fraud.

Wrongdoer control: The requirement of showing wrongdoer control will obviously be satisfied if the wrongdoers have de iure control, that is to say if they hold a majority of the voting shares. In Prudential Assurance v Newman (No. 2[21]) Vinelott J held this requirement would be satisfied if the plaintiff could show that the wrongdoers were in a position to prevent an action being brought to vindicate the rights of the company. Vinelott J also held that the requirement might be satisfied if the plaintiff could establish that if the minority were not allowed to sue on the company's behalf, the interests of justice would be defeated. The "justice of the case' principle was rejected obiter by the Court of Appeal [22]but it did not expressly address the question of control. That part of Vinelott J's judgment dealing with control is generally considered to be correct.

Fraud. The plaintiff does not have to show fraud in the common law sense. In this context, it normally involves a taking of property, the making of an incidental profit or a mala fide act, that is one that is not in the interests of the company but which is taken to further the interests of the directors. Not all breaches of duty are fraudulent, for example negligent acts where the director does not make a profit (contrast Pavlides v [23][FN9] with Daniels v Daniels.[24] In Daniels v Daniels Templeman J (as he then was) neatly summarised the authorities:
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 company.

The rationale of these requirements is that the courts should not be involved in second-guessing management decisions with the benefit of hindsight. The procedural difficulties with the Rule are highlighted by Prudential Assurance v Newman Industries Limited (No. 2) and Smith v Croft (No. 1)[25]. Those difficulties raised by Prudential Assurance v Newman must now be briefly summarised, since this also especially highlights those resulting from the Rule in Foss v Harbottle.

The Prudential, a minority shareholder in Newman Industries Limited, brought an action against two directors, Bartlett and Lawton and a third party company, which was a shareholder in Newman, in connection with the sale of assets of a third party to the company Newman. The Prudential alleged that the circular which had been drafted with the assistance of Bartlett and Lawton was misleading and tricky. The Prudential action was based on:
(1) a minority shareholder derivative claim against Bartlett and Lawton;
(2) a personal action on behalf of itself for damages for conspiracy; and
(3) a claim for declarations against Bartlett and Lawton as to the misleading and tricky nature of the circular acting as representative of Newman shareholders generally.

The difficulty with the Rule in Foss v Harbottle is highlighted particularly by the judgment of the Court of Appeal. Vinelott J had refused, at first instance, to decide as to whether the minority shareholders' action could properly be brought until after the plaintiffs had proved the fraud. This took 36 days in court. The dilemma facing the court if the defendants challenge the title of the shareholder to bring the action is as follows:
(1) either the court can assume that every allegation of fraud in the statement of claim is proved; if that is the case then the plaintiff merely has to allege "fraud and control' to obviate the Rule in Foss v Harbottle; or
(2) if the plaintiff has to prove fraud and control, then a lengthy trial is needed before the court can decide whether the shareholder has title to sue. By this time the purpose of the Rule disappears since the action has already been tried.

In the Newman case, the Court of Appeal decided there should be a half-way house and the plaintiff must establish a prima facie case that the company is entitled to relief and the action falls within the proper boundaries of the exception to the Rule in Foss v Harbottle. This particular requirement specified by the Court of Appeal extricated the law from what otherwise would have been a serious difficulty with the Foss v Harbottle line of authority. The Court of Appeal concluded that the public spirit of the Prudential as a pioneering method of controlling companies in the public interest, without involving regulation by a statutory body, was not to be applauded. Voluntary regulation of companies was regarded as a matter for the City. The Prudential were the wrong plaintiffs and the action should have been brought by the company.

As for the representative proceedings, they were linked to the Prudential's personal claim. The Court of Appeal was strongly critical of the personal action since they considered that the plaintiffs were only interested in the personal action as a means of circumventing the Rule in Foss v Harbottle. At first instance Vinelott J, however, thought that the direct representative claim was admissible. He saw the derivative claim as not being a truly representative claim, since damages recovered under it would be recovered not by the shareholders or the plaintiff but by the company.

The Foss v Harbottle point has to be taken early in the proceedings so that the court can determine the issue of standing at the commencement of the litigation. The purpose is to cut down the length and costs of litigation but the Rule is not achieving this purpose (see Smith v Croft (No. 2)).

The exceptions to the Rule have been restrictively interpreted by Knox J in Smith v Croft (No. 2) where a third factor has been identified as being relevant: that is whether the plaintiff can establish that the independent "majority' of the minority do not oppose the claim being brought; if they do oppose it, then in the ordinary case it is likely that the claim will not succeed.

The derivative action must be brought in the representative form (that is in the name of the company) on behalf of the plaintiffs themselves and all the other shareholders of the company, apart from the defendant. The company must be joined as a nominal defendant. As a general rule, a derivative action should not be combined with a direct action in respect of a wrong done to a plaintiff shareholder personally, since whatever is recovered is for the benefit of the company. As with other representative suits, the representative plaintiff has control of the action and can discontinue or settle as he wishes. This should be contrasted with the position in derivative and class actions under the US system.

Costs of the shareholder in a derivative action
It was established in Wallersteiner v Moir that a minority shareholder who brings a derivative action may have a right to an indemnity against the company in respect of his costs. The right will depend on whether the minority shareholder acted in good faith and reasonably in bringing the proceedings.
The minority shareholder should apply by summons for an order against the company for an indemnity as to costs. The Court of Appeal in Wallersteiner emphasised that the application should be simple and inexpensive. Directions might be made as to the joinder of certain other parties. The application should not be allowed to escalate into a minor trial.

In Smith v Croft (No. 1) Walton J placed some qualifications on the procedure. The main procedural points concerning an application now basically are as follows:
(1) the application is made inter partes by summons in the main action;
(2) an ex parte application should be made only in circumstances which would justify such an application as a matter of general principle, for example urgency;
(3) the plaintiff's evidence should be served on the company and all respondents to the application except where any exhibits contain privileged matters;
(4) any order made is normally limited to continue up to a specified stage in the main action;
(5) the court may make an order on terms that any offer of settlement be referred back to the court for consideration.

Walton J also considered that the plaintiff shareholder would have to show that the order for costs was genuinely needed. His view should be constrasted with that of Mr Michael Wheeler QC in Jaybird Group Limited v Wood[26] where he considered that the means of the plaintiff was not an appropriate test. The provision that the court may make an order that any offer of settlement be referred back to the court for consideration is useful to prevent settlements that are beneficial to the plaintiff shareholder and the defendants but not in the interests of the company.[27] This procedure is analogous to that in the US system for class and derivative actions, which does not otherwise exist in the procedure under English law.

In Wallersteiner v Moir the Court of Appeal held that legal aid was not available to a shareholder bringing a derivative action: section 25 of the Legal Aid Act 1974 defined "person' in a way which excludes a body of persons corporate or unincorporated. Legal aid has remained unavailable in practice right up to the present time, although Buckley LJ thought that legal aid might be available to one of the shareholders in a company of a kind which is a quasi-partnership.

While Lord Denning MR advocated the possibility of relaxing the Law Society's Practice Rules so as to allow the American contingency fee system as a way of providing a more adequate financial incentive for bringing derivative actions, the other members of the Court of Appeal were opposed to such an innovation in view of the issues of public policy raised by it.

The conditional fee agreement must be in writing and meet four basic conditions:
(1) it must not relate to criminal or matrimonial proceedings;
(2) it must provide for the lawyer's fee or expenses (or any part of them) to be payable only in specified circumstances;
(3) it must comply with such requirements as may be prescribed by the Lord Chancellor; and
(4) it must not be a "contentious business

In relation to costs, where a party to legal proceedings has made a conditional fee agreement and a costs order is made in his favour, the costs payable to him cannot include any element which takes account of any percentage increase payable under the agreement. It should be noted that the new provision specifies that rules of court may make provision on the taxing of any costs which include fees payable under a conditional agreement.

The conditional fee agreement arrangement will have considerable scope for use in relation to shareholders' actions on the assumption that sufficient commercial lawyers will be prepared to participate in its use, which may depend initially on the economic state of the market for lawyers' services once the provision has been brought into operation.

Nevertheless, at present, despite the ability of a shareholder potentially to obtain an indemnity for costs, there is in short little incentive in practice for a minority shareholder in a company of any size to bring derivative proceedings.

Judicial Control of Derivative Action

Reasons for Judicial non interference:-

Business Judgment: - a number of reasons account for judicial non interference in the affairs of a company at the action of a member. One of them is that the court does not want to involve itself in disputes over business policy. Judges have repeatedly said that a court determines question of law and not questions of business judgment. The court will not look into the merits of a lawful decisions of the members or directors of a company.[28]

Wishes of Majority:- the second suggested reason is that the membership of any association involves an obligation to settle the dispute within the organization and to abide by the majority decisions.[29]

Multiplicity of suits:- The third suggested reason is the public policy of preventing multiplicity of actions. See the remarks of MELLISH LJ in Mac Dougall v. Gardiner,[30]. The court should not deal with matters with which they are not familiar and for which domestic settlement procedure exists and where allowing one action would lead to an overwhelming number of similar actions.

Ratifiability:-  The fourth reason is the principle of ratifiability. Where majority approval can eliminate the wrong, there any order of the court would be rendered infructuous. Just by majority approval.

Proper plaintiff doctrine- The next important reason is that a company being a separate legal person is the only proper plaintiff for anything wrong dome against it.[31] In Bhajekar v. Shinnkar[32], where the court said: “it is difficult to see how a few shareholders who represent a minority are entitled to maintain the suit and ask the court to interfere on the question as to who should be the managing agents of the company”

Is litigation in the interest of the company?

It is important not to jump from that banality to the conclusion that in every case where it is arguable that a director has infringed his or her duties to the company, the company should be contemplating litigation. The test, it is submitted, is whether it is in the best interest of the company that litigation be instituted, and that question can be answered only on the facts of a particular case. It is easy to imagine many reasons as to why litigation would leave the company worse off than before. There may be doubts about whether a verdict in favor of the company will be obtained, either because of disputes about the law or because of difficulties of proving the events said to constitute the breach of duty. Or the defendants may not be in a position to meet the judgment even if the litigation is successful. Or the senior management time spent on the litigation might mpre profitably be used else where or, finally, whilst winning the legal arguments and obtaining an enforceable from the litigation. In other words the decision whether to initiate litigation in respect of an alleged breach of directors duty will not always be an easy one, and a negative decision is not necessarily a sigh that the company is being too lax towards its directors.

On the other hand the decision not to sue a director may indeed be hheavily influenced by that directors personal intreset, rather than those of the company. The conflicts of intresst which we analysed in the previous chapter are not magically excluded from the corporate decision whether to sue. Thus the need is to distinguish between the litigation decisions which are in the intrest of the company and which are not. Given the structure of the directors duties, analysed in the previous chapter, it is no surprise to learn that the common law has not approached this problem by asking the courts to assess whether the best intresets of the company lie in brining or not brining the litigation. Instead, the common law has taken the approach of creating a set of rules to determine who is appropriate person or set of persons, within the company to take the litigation decision of behalf of the company. In other words the approach of the common law has been to treat this issue as an example of the more general. However in the context of litigation against the directors, the crucial question turns out to be for reasons we shall examine, to what extent individual or minority shareholder can bring litigation on behalf of the company against allegedly wrongdoing directors and theat is a question of law. Thus the question of who is the company and who can act on behalf of the copany in respect of the initiation of litigation against wrongdoing directors tool on a life of its own in the common law. The answer provided by the common law to this question is that rarely will the individual or the minority shareholder be able to initiate the litigation: that is normally a decision to be taken either by the board or the shareholder as a whole. This traditional answer is know to company lawyer under the title of “the rule in Foss v. Harbottle”. It might be thought that the courts would be better at making this judgment, since it is a mixture of legal and business elements, than at assessing the company’s best interests in purely commercial context.

Essentially, the need for judicial control arises because of the unique nature of the derivative action. The use of the derivative action ensures that the wrong is remedied on behalf of the company, albeit at the instigation of an individual shareholder. In English law it has been described as an exception to the:
"elementary principle that A cannot, as a general rule, bring an action against B to recover damages or secure other relief on behalf of C for an injury done by B to C. C is the proper plaintiff because C is the party injured, and, therefore, the person in whom the cause of action is vested".

That an action under one of the exceptions to Foss v Harbottle [33] is truly a derivative action, rather than one brought by the minority shareholder in his own right, was a late recognition in English law.[34]  This change in terminology also helped to clarify the fact that in these circumstances the individual shareholder is not enforcing a right which belongs to him but which is rather vested in and therefore derived from the company.
Painting with a broad brush, the rule in Foss v Harbottle which stresses that in relation to a wrong done to the company the company is the only proper plaintiff, emphasises the collective nature of the process of enforcing directors' duties. As a rule, shareholders agree to subordinate their individual interests by joining the company and this explains why, as a starting point, directors' duties are owed to the shareholders as a whole, at least in a solvent company. It is generally the shareholders as a whole that have the decision whether to enforce them. If a minority shareholder wishes to enforce these duties alone, then the collective nature of this process is clearly in evidence in the only true exception to the Foss v Harbottle rule, namely the fraud on the minority exception. The shareholder must show that the wrong is unratifiable, i.e. the shareholders acting together cannot ratify it; that the wrongdoers are in control--if not, the collective decision making of the shareholders continues to trump the individual shareholder; and finally, that the majority of the minority wish the action to proceed.[35] Under a derivative action then, the claim against the wrongdoers belongs to the company and should be treated as being equivalent to a claim by the company itself. First and foremost the issue for the court is doing justice to the company, i.e. the shareholders as a whole in a solvent company, and not to the petitioning shareholder. It follows that a shareholder should not have an indefeasible right to bring an action on the company's behalf. If a shareholder has a unique interest in bringing the petition which is not shared by the other shareholders, and if a majority of those are opposed to the action, then it is right and proper that the derivative action should be denied.[36] As a result, the occasions on which the derivative action should be available to a minority shareholder are rather confined.[37]  It follows, as Henderson Q.C. explained in Portfolios of Distinction, that when a challenge is made to the right claimed by a shareholder to bring a derivative action on behalf of the company, it is thus the duty of the court to decide as a preliminary issue the question whether or not the plaintiff should be allowed to sue in that capacity. In taking that decision, it is not enough for the court to say that there is no plain and obvious case for striking out; it is for the shareholder to establish to the satisfaction of the court that he should be allowed to sue on behalf of the company.

Can an individual shareholder adequately represent the interests of the company?
There are also a number of additional important factors that underline the need for judicial oversight of derivative actions. First, as the Court of Appeal in Prudential Assurance Co Ltd v Newman Industries Ltd[38] stated, the individual shareholder will not always be in the best position to judge whether or not to commit the company's resources to the costly process of litigation. The commencement of litigation can cause a substantial diversion of management time and resources, quite apart from the financial drain that may occur. Secondly, even where the individual shareholder is not motivated by malice or personal factors,[39]  that shareholder may simply misjudge the issue of whether a piece of litigation is in the company's best interests. Apart from the fact that directors, not shareholders or claimants' attorneys, direct the company’s affairs, what looks like a hasty decision by company managers may simply reflect their knowledge of the subject and their desire to avoid the expense of hiring outside experts.[40] For example, a seemingly self-interested decision to accelerate the exercise of share options may well be the most efficient method of awarding an increase in compensation. Finally, because of his small stake in the venture, the complaining shareholder has very little incentive to consider the effect of the action on other shareholders, the supposed beneficiaries, who ultimately bear the costs. It could be argued that shareholders have money invested in the company and so the decision whether or not to bring an action in relation to directors' wrongdoing will often have an economic impact on them. This may often be supposed to sharpen their concern to protect the company, since if the company prospers then, generally speaking, the shareholders will also prosper. However, there may well be circumstances in which their economic interests conflict with those of the company.[41]

Strengthening the public nature of derivative actions
This purpose behind the judicial control of a derivative action is almost invariably lost sight of. Research in the United States indicates that the value of derivative action is tied to the public's perception of the value of such litigation[42]. The higher the public esteem of the derivative action, the greater will be its deterrent value.[43] The most important inhibitions that can be used to nurture positive deterrent effects flowing from derivative actions are, first, pre-trial procedures that lead to the dismissal of baseless suits and, secondly, control of settlements by the court. The court's early involvement in the facts supporting the derivative action complaint provides an important pre-trial screening mechanism by which the action's merits may be assessed. Screening the action's merits provides an important bulwark against the continuation of strike suits past the leave to proceed. [44]The pleading requirement therefore has a positive winnowing effect so that derivative actions that meet these pre-trial demands enjoy greater merit than if these requirements did not exist. Furthermore, upon satisfying the court's requirement, the derivative action can more easily be understood to reflect a public condemnation of the conduct that is the subject of the action. It is only through satisfying the court's requirements that the claimant earns the right to bring the action (a procedure which otherwise does not exist in ordinary civil cases). To the extent that following the pre-trial procedures meritorious cases tend to survive, a suit's continued prosecution can be expected to have a greater public value than if there were no pre-trial procedures. This is because, on average, there would be a higher likelihood that any action's complaint addressed actual misconduct.

In addition to the court's approval which confer some sort of a public status on the action, a strength in the settlement process enables the derivative action to secure its position as a mechanism for vindicating public norms. Theoretically, the derivative action may open the possibility for "gold-digging" claims, which are settled on terms advantageous to the claimant shareholder and the defendants but which do not reflect the value of the company's right, or are not in the interests of the company. Because of the dangers that this obviously presents, and in order to eliminate the possibilities for "gold-digging" claims, the abandonment or compromise of a derivative action is made subject to judicial control. An order for an indemnity in respect to costs that may be awarded to a shareholder to help him maintain a derivative action also requires the claimant to refer back to the court for approval of any offer of settlement of the action.  The provision that the court may make an order that any offer of settlement be referred back to the court for consideration is useful to prevent settlements that are beneficial to the claimant shareholder and the defendants, but not in the interests of the company. This procedure is analogous to that in the US system for class and derivative actions, which does not otherwise exist under English law.[45] Control of settlements is thus an important check on the right to pursue derivative actions. If properly understood, it is a check that, combined with the screening of the action's merits, should raise the public image of the action, so that the derivative action is more likely to be viewed as an instrument that affirms desirable norms in the corporate setting.

Criteria for the Grant of Leave

Common criteria employed in other jurisdictions studied include the good faith of the applicant and whether the action is in the interests of the company. By their very nature, these are open textured concepts but it is nevertheless considered helpful to include them, often as mandatory requirements for the grant of leave.

(1)   Ultra Virus and illegal transactions:- In cases where the act complained of is wholly ultra vires the company, the rule of Foss v. Harbottle has no application because there is no question of the transaction being confirmed by any majority.[46] In Bharat Insurance Co. Ltd. v. Kanhaya Lal, where at the action of  a shareholder, directors were restrained from laying out the funds of the company on investments which were outside the provisions of the memorandum.
In this respect the following valuable opinion is worth noting on the subject: “We suggest that the common factor in the personal rights cases is that a member is alleging that a decision is unlawful in the sense that it fails to comply with the law generally or with the memorandum or articles of the company. We suggest that a member of a company has standing to challenge the lawfulness of any decision of the members or the directors or the chairman of a meeting of member, subject only to the irregularity principle. The recognition of a member’s standing to challenge the lawfulness of a company’s decision would we suggest, provide a means of enforcing the entitlement of shareholder’s ‘to have the affairs of a company conducted in the way laid down by the company’s constitution which ROMER LJ recognized in Re, H. R. Harmer Ltd.[47]
(2)   Applicant's good faith. Although this should not be a prerequisite for leave as in Canada, it is a relevant factor to be taken into account.[48] However, it must have more weight than this since it is impossible to countenance the court granting leave to an applicant exhibiting bad faith. The "good faith" should not be defined in the rules of court, on the assumption that there is no great debate on this matter since the meaning of good faith is ""generally readily recognizable". That may be true, but it lends itself to subjective interpretation and might lead to differences of opinion and hence to complexity of case law.

On the other hand, it is not favored that a test of whether the applicant is acting ""honestly" and ""without ulterior motive". It gives as an example a situation where the applicant would benefit financially from a successful derivative action (and thus have an ulterior motive) but, if acting honestly, the court might still grant leave. This is clearly a desirable criterion (however defined) in the case of private companies, large or small, or in respect of individual shareholder litigants in the case of listed plcs. It would seem unnecessary in the case of those institutional investors (alone or in combination) meeting a percentage threshold. Such litigants should be encouraged in their special role of providing a sanction for the system of corporate governance established by the Cadbury Report. They should be well able to meet the costs of such litigation. Any compromise or abandonment of derivative proceedings (by these or any other type of litigant) would be subject to the control of the court granting leave.

(3)   Acts requiring special majority:- The rule did not prevent an individual member form suing if the matter in respect of which he was suing was one which could validly be done or sanctioned, not by a simple majority of members, but only by some special majority. If this were not so the effect would be to allow a company acting in breach of its articles to do de facto by ordinary resolution that which according to the company’s own regulations or the companies act could only be done by special resolution.[49]

(4)   Interests of the company. The court must refuse leave and dismiss the derivative claim if it is satisfied that the claim is not in the interests of the company. This is a matter of concern since it is likely to result in a restrictive approach to the grant of leave. The court is expressly required to have regard to the views of the directors on the question of whether there are good commercial reasons for not pursuing the action, such as the fact that the recovery would be less than the cost involved. This requirement is an application of business judgment but it can operate to abrogate the court's discretion in favour of that of the company's management, who could effectively scupper any derivative action.

In other jurisdictions this specific reference to the views of the directors is not included since the danger must be that the courts will give too much weight to the views of those who may be involved in the wrongdoing and must be encouraged to question the background to the views of directors. However, the business judgment principle provides that the court cannot question the judgment of the directors who are in the best position to make such decisions. As the Consultation Paper argues, if the directors are the wrongdoers their decisions on whether action is in the interests of the company will not normally be made in good faith. Such an approach might well reopen the issues that used to preoccupy the courts in the context of the fraud on the minority exception to Foss.

(5) Wrongdoers in control :- Where the wrongdoers are themselves in control of the company’s affairs, the rule is relaxed in favour of aggrived minority who are allowed to bring what is known as a minority shareholder’s action on behalf of themselves and all others. The reason for this is that, if they were denied that right, their grievance could never reach the court because the wrongdoer themselves being in control would not allow the company to sue. Thus where a company was controlled by the two plaintiffs and the two defendants and the plaintiff’s allegation was that the defendants had diverted the company’s assets  to their own use, the court said: while the general principle was for the company itself to bring an action where it had an interest, it was appropriated for the two plaintiff here to bring an action on behalf of the company since the defendants controlled the company in the sense that they would prevent the company from taking action.[50]

(6) Ratification of the breach of duty. Another of the factors to be taken into account in determining leave is whether the breach of duty in question either has been approved by the company in general meeting or may so be approved. There is a danger that our desire to simplify the derivative action could be undermined by the complexities which arise where it is claimed that the relevant breach of duty has been (or may be) ratified."

Nevertheless, the there ought to be no change to the law on ratification so that no leave should be granted where ""effective" ratification has occurred. This means that the question of whether a ratification is ""effective" will have to be addressed at the leave stage in the proceedings and this will reintroduce pleadings similar to those necessary under the current law to establish fraud by wrongdoers in control.[51]

This position will not, of course, prevent a shareholder commencing a derivative action and obtaining leave if the wrong in question is capable of ratification but not yet ratified. There is, nevertheless, a continuing risk that the action will be struck out if ratification should occur. The recommendations include the power to adjourn the derivative action for a meeting to be held (at which the wrong could be ratified). It must be questioned whether this is a costeffective way of proceeding. It is certainly arguable that, having been given the opportunity to take action via the notice requirement, if the company chooses not to do so at this initial stage, it ought not to be given the opportunity at a later stage in the proceedings unless there are exceptional circumstances. It might also be simpler to provide that, having been given notice, if the company does not ratify the wrong it ought to pursue the action to redress the corporate wrong. Similarly, if the company considers that it is not in the interests of the company to pursue the matter, it ought to ratify and cure the defect. This would retain control with the company itself and would accord with guiding principles (iii) and (v) by leaving decisions on litigation with the company and preventing unwelcome shareholder interference.

In any event, there is a continuing danger that although ratification has not taken place at the time of the application for leave, the court will subconsciously be concerned with this danger when determining leave, especially when it is considered that the policy is only exceptionally to allow derivative actions.

The Dickerson Committee in Canada also made a suggestion for assessing ratifications that might usefully be adopted as a suitable test:
"If, for example, the alleged misconduct was ratified by majority shareholders who were also the directors whose conduct is attacked, evidence of shareholder ratification would carry little or no weight. If, however, the alleged misconduct was ratified by a majority of disinterested shareholders after full disclosure of the facts, that evidence would carry much more weight indicating that the majority of disinterested shareholders condoned the act or dismissed it as a mere error of business judgment".

The fundamental problem with the ratification issue is that what is required is a thorough assessment of the complexities of the law on ratification in the context of directors' duties.  Unfortunately, the two are interdependent and it is not possible to make any truly effective recommendations on shareholders' remedies without first rationalising the effect of ratification
(7) Resolution of general meeting and opinion of independent organ. The Report also considers that in determining the question of leave the court should take account of any resolution by the company in general meeting not to pursue the breach of duty. However, although this is not the same as ratification, it is affected by the same difficulties, namely the question of whether that decision was obtained after shareholders had been presented with the full facts and whether there was any control by the wrongdoers. Arguably it is for these reasons that this is not a factor that has concerned legislators in other jurisdictions.

The court should take account of any opinion of an independent organ on whether the derivative claim should be pursued. In determining the question of leave the court is therefore bound to take account of the views of the directors, the general meeting and any body that can fall within this very broad concept of ""independent organ". There are not the same concerns relating to influence in the case of the views of an independent organ since it is expressly required that this body be independent of the alleged wrongdoers. However, this raises the question of how ""independence" is to be judged and by whom. In addition, there is no indication of any size criteria for this independent organ and it could be a very small group indeed. The weight attached to the views of this organ ought to reflect this fact. These are the very difficulties that have caused so much controversy in the United States in the context of the role of independent litigation committees.

(8) Availability of alternative remedies. The final criteria requires that before granting leave the court should take account of any alternative remedy to that available in a derivative claim. Although the availability of an alternative remedy is not conclusive on the issue of leave, it would mean that despite complying with notice, leave for the derivative action might be refused[52]
(9) Individual Members Rights:-  This was the type of situation involved in Edwards v. Haliwell,[53] By altering rules without following the prescribed procedure, the complaining member of a union were excluded from their status of membership. Their rights following from that status were invaded. The gist of the case was that the personal and individual rights of memberships were invaded by the purported, but invaled, alteration of the table of contributions. “In these circumstances”, said JENKINS LJ, “the rule of Foss v. Harbottle has no application at all, for the individual members who are suing sue, not in the right of the union, but in their own right to protect from invasion their individual rights as members.” A shareholder’s right to vote, to have his vote recorded, to contest for directorship, to have a dividend paid in cash if the articles if the articles so specify, to enforce a declared dividend as a legal debt, to have the articles observed if they specify a certain procedure to be followed in particular matters etc. have been recognized as individual membership rights. [54]

Advantages and Disadvantages
of Derivative Action

In these circumstances, it is hardly surprising that arguments are made for permitting individual or minority shareholders subject to appropriate safeguard, direct access to the courts in order to bring an action on behalf of the company against the alleged wrongdoers, Indeed the principle just articulated can be said to have been accepted for over 150 years, because the substance of the controversy has centred on the definition of the appropriate safeguards. On one hand, relatively free access to the courts for individual shareholders suing on behalf of the company will increase the levels of litigation against wrongdoing directors. If it is through that the levels of such litigation are at present sub- optimal because of the ability of the wrongdoer to discourage such litigation at either board or shareholder level, then such increase in litigation is likely to be welcomed.  However it is difficult to demonstrate that such litigation brought derivatively by individual will invariabily be in the interests of the company. In may be initiated more to promote the personal interest of the shareholder that the interests of the company. This is a particular risk because, as we shall see further below, in a derivative action, recovery in the litigation goes to the compaby not the individual shareholder brininging the litigation. A person with a small shareholding this has a little financial incentive to sue on behalf of the company, because the return to that person will be at most a percentage of the recovery which reflects the percentage of the shares of the company that person holds.[55] So, litigation nevertheless brought by such a person runs a risk of being motivated by concerns other than to increase the value of the company’s business.[56] Of course the larder the shareholder the less the risk but by the same token, the less obstacles are which prevent the shareholder from using the mechanism of the general meeting.

As we shall see below, the English common law has always been more impressed by the risk of derivative actions being motivated by personal objectives that it has by the risk that confining derivative action will lead to less litigation that the company interests require. Accordingly the rule in Foss v. Harbottle has rendered individual access to the courts on behalf of the company very difficult. Finally, one should note that one has not exhausted all the possible locations for the litigation decision, even within the company, by considering the board, the shareholder’s meeting and the individual shareholder. One might consider as well a sub-set of the member of the board, such as its independent NED’s. Traditionally the common law has not taken his step, seemingly on the principle that the company is entitled to the unbiased advice of all its directors and that if this is not available the board cannot act.

Equally, the law could consider some group of shareholder, lying between the shareholders as a whole and the individual shareholder as the appropriate body to take the litigation decision. The common law has not used this device. However, it is worth noting that in one area minority shareholder action on behalf of the company has been introduced explicitly by the legislature. If this requirement in contravened, every director of the company at the relevant time is liable to pay to the company the amount of the donation and damages in respect of any loss or damage suffered by the company in consequence of the unauthorized donation or expenditure.

Having conferred a statutory right of action upon the approved group of members the Act also takes steps to facilitate the use of the power by the minority but also to ensure that the power is exercised by the group in the interest of the company as a whole.

The same duties are owed to the company by the shareholder as would be owed to the company if the action had been brought by the directors of the company. However, action to enforce these duties against the minority cannot be taken without the leave of the court, presumably so as to protect the minority from the tactical use of counter litigation by the alleged wrongdoing directors.

Proceedings may not be discontinued or settled by the group without the leave of the court and the court may impose terms any leave it grants. This thing reduces the risk of “gold digging” claims where the purpose of the action is to extract from the company a private benefit for the group in exchange for the settlement of the claim rather than to advance the interest of the company as a whole.

The shareholders may apply to the court for an order that the company indemnifies the shareholders in respect of the costs of the litigation and the court may make such orders as it think fit. The group is not entitled to be paid its costs out of the assests of the company other than by virtue of an indemnification order or as a result of a costs order made in the litigation in favour of the company. This recognizes the principle that the company in appropriate circumstances should pay for derivative litigation which is brought for its benefit. And make is less easy for the shareholders to pursue “gold digging” claims in the guise of generous payments by the company to the shareholders by the way of recompense for costs incurred in litigation.

On the other hand in an interesting innovation, there is conferred upon the group an express right to information from the company relating to the subject matter of the litigation, so that the group can better decide in what way to prosecute the litigation. This right extends to both information in the company’s possession or control or which is reasonably obtained by it.


A derivative action on a statutory basis "subject to tight judicial control", essentially, serves a very useful purpose--namely, strengthening the features that contribute toward derivative actions being understood as a positive social force. It is most unfortunate then that the need to comply with the mandatory provisions with respect to permission to continue a derivative action seems to have been lost sight of in the earlier stages in Portfolios of Distinction, in particular, in light of the High Court's comments that given the conflict of interest on the part of POD. The best way forward might well be for an independent receiver or liquidator to be put in charge of Services, and for him to investigate the claims which should be pursued on Services' behalf. Put simply, the use of the derivative action was at minimum inappropriate, clearly requires judicial scrutiny (and sanction) of every step in a derivative action and to have one that is properly constituted is a powerful tool in the hands of a minority shareholder, although there is no doubt that the threshold is quite a high one (and rightly so). The danger must be that the judiciary will adopt an overly restrictive approach to the criteria in order to give effect to the perceived exceptional nature of shareholder derivative actions. Therefore, the true test of the effectiveness of this action will be whether the complexity surrounding the ability to pursue a derivative action will continue to act as a deterrent to potential actions when compared with the broad scope of the section 10 petition.

[1] Wallersteiner v Moir (No. 2) [1975] 1 Q.B. 373, 390-391 ("stripped of mere procedure, the principle is that ... an action can be brought on behalf of the company by the minority shareholders, on the footing that they are its representatives, to obtain redress on its behalf", per Lord Denning M.R.); Prudential Assurance Co Ltd v Newman Industries Ltd  [1981] Ch. 257, 304- 306; (No. 2) [1982] Ch. 204, 210. See also Re A Company (No. 005136 of 1986) [1987] B.C.L.C. 82: action in respect of directors' exercise of their powers for an improper purpose not maintainable as a derivative action because in essence wrong is done to the shareholders, not the company.
[2] Spokes v Grosvenor Hotel Co [1897] 2 Q.B. 124 ; Wallersteiner v Moir (No. 2) [1975] 1 Q.B. 373, 391-392.] 
[3] Bloxham v Metropolitan Ry (1868) 3 L.R. Ch.App. 337.]
[4] [1975] 1 Q.B. 373.] 
[9] [1975] 1 Q.B. 373, 392. See also Jaybird Group Ltd v Greenwood [1986] B.C.L.C. 319 applicant for an indemnity does not have to show he is impecunious or that his shareholding in the company is very small. Cf. Smith v Croft [1986] 2 All E.R. 551, 565.
[10] [1986] 2 All E.R. 551, 564-565 
[11] [1986] B.C.L.C. 15.]
[12] It appears that a court making an indemnity order may do so on terms that any subsequent offer to settlement be referred back to the court for consideration: Supreme Court Practice 1991, Vol. 1, 15/12/5A.
[14] 22 W.R. 396.
[15]Towers v African Tug Co. [1904]1 Ch. 558; Whitwam v Watkin (1868) 78 L.T. 188; Knight v Frost [1999] 1 B.C.L.C 364.]
[16] Forrest v Manchester, Sheffield and Lincoln Ry Co. 9 W.R. 818; Robson v Dodds (1869) 8 L.R. Eq. 301; cf. Seaton v Grant (1867) 2 L.R. Ch.App. 459.
[17]  Nurcombe v Nurcombe [1985] 1 W.L.R. 370; Barrett v Duckett [1995] 1 B.C.L.C. 243, CA. 
[19] Ferguson v Wallbridge [1935] 3 D.L.R. 66; Fargro Ltd v Godfroy [1986] 1 W.L.R. 1134; Barrett v Duckett [1995] 1 B.C.L.C. 243.
[20] (1843) 2 Hare 461.
[21] [1980] 2 All ER 841.
[22] See [1982] Ch 204
[23] [1956] 1 Ch 204.
[24] [1978] Ch 406.
[25] [1986] 1 WLR 34.

[26] (1986) BCLC 319.
[27] D. Prentice, "Wallersteiner v Moir: A Decade Later', (1987) Conveyancer at 167 to 176.
[28] Shuttleworth v. Cox Bros & Co., (1927) 2 KB 9 Ch 22, Sunil Dev v. Delhi & District Cricket Association, (1994) 80 Comp Cases 174
[29] Cooper v. Garden, (1869) LR & Eq 249. Lord WILBERFORCE remarked in King Thai Sawmills case, (1978) 2 MLJ 227 PC: “Those who take intrest in companies limited by shares hace to accept the majority rule”
[30] (1875) 1 Ch D 13 at 25
[31] Prudential Assurance Co. Ltd. v. Newman Industries Ltd. , 1982 Ch 204, (1982) 1 All ER 354
[32] AIR 1934 Bom 243; to the same effect see Jhajharia Sholapur Spinning and Weaving Co., AIR 1941 Cal 174
[33] (1843) 2 Hare 461
[34] Wallersteiner v Moir [1975] Q.B. 373; [1975] 2 W.L.R. 389.

[35] Smith v Croft (No.2) [1988] Ch. 144.
[36] Ibid
[37] Modern Company Law for a Competitive Economy: Developing the Framework, URN 00/656 (London, DTI, March 2000) para.4.112 et seq.

[38] [1982] Ch. 204
[39] As in Barrett v Duckett Duckett [1995] 1 B.C.L.C. 243 where the court refused to allow the derivative action since the claim was not being pursued "bona fide on behalf of the company".
[40] D. Fischel and M. Bradley, "The Role of Liability Rules and The Derivative Suit in Corporate law: A Theoretical and Empirical Analysis" (1986) 71 Cornell Law Review 261, at p.273.
[41] See Rock Ltd v RCO Holdings Ltd [2004] EWCA Civ 118 in relation to s.459 of the Companies Act 1985, and see also Peter Gibson L.J. in Re Ring Tower [1989] B.C.L.C. 427, at [437] who suggested that the jurisdiction of s.459 should be carefully controlled to prevent it from becoming an instrument of oppression.
[42] See, J. Cox, "The Social Meaning of Shareholder Suits" (1999) 65 Brooklyn Law Review 3.
[43] This reflects the well-documented tendency of individuals to make social choices by reference to the conduct of others. For articles discussing the extensive literature on this point, see D.M. Kahan, "Social Influence, Social Meaning, and Deterrence" (1997) 83 Vanderbilt Law Review 349, at pp.352-361; J. Scholtz, "Enforcement Policy and Corporate Misconduct: The Changing Perspective of Deterrence Theory" (1997) 60 Law & Contemporary Problems 253.
[44] See further, J. Cox, "The Social Meaning of Shareholder Suits" (1999) 65 Brooklyn Law Review 24. Under English law, indeed, a shareholder who wishes to undertake/continue a derivative action in the name of the company has to actually satisfy very high threshold, as well illustrated in Barrett v Duckett Duckett [1995] 1 B.C.L.C. 243.
[45] See further, A. Marks and W. Rees, "Shareholders' Actions" (1991)2 International Company and Commercial Law Review 39.
[46] Bharat Insurance Co. Ltd. v. Kanhaya Lal, AIR 1935 Lah 792
[47] (1958) 3 All E R 689
[48] It also means that there is no minimum time period for a shareholder to have been a shareholder in order to pursue such an action since a shareholder would not be acting in good faith if he had purchased his shares solely for the purpose of commencing the litigation.
[49] Dhakeshwari Cotton Mills Ltd. v. Nil Kamal Chakravarti, AIR 1937 Cal 645; Nagappa Chettiar v. Madras Race Club, AIR 1951 Mad 831
[50] Satya Charan Lal v. Rameshwar Prasad Bajoria, AIR 1950 FC 133
[51] S. Friedman, ""Ratification of Directors' Breaches" (1992) 10 Company and Securities L.J. 252."There is the further danger that the case law on ratifiable and non-ratifiable directors' duties would once more dominate the new statutory derivative action". See also
[52] See Barrett v. Duckett [1995] 1 B.C.L.C. 243
[53] (1950) 2 All ER 1064
[54] Nagappa Chettiar v. Madras Race Club, AIR 1951 Mad 831
[55] Even then the directors may choose not to pay out the recovery by way of dividend and instead to invest it in some unsuccessful venture.
[56] For an example of a derivative action brought for what appears to be a collateral purpose see the rather unsusual case of Konammaneni v, Rolls Royce Industires Power (India) Ltd. [2002] 1 All ER 979.

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