483.Section 170 provides that directors’ general duties are owed to the company rather than to individual members (or third parties such as employees or pressure groups). It follows that, as now, only the company can enforce them. There are three main ways in which the company can take legal action against a director (or, more usually, a former director) for breach of duty:
if the board of directors decides to commence proceedings;
if the liquidator or administrator following the commencement of a formal insolvency procedure such as liquidation or administration decides to commence proceedings;
through a derivative claim or action brought by one or more members to enforce a right which is vested not in himself but in the company.
This part of the Act is concerned with the third of these types of action.
Existing Law
England and Wales or Northern Ireland
484.In England and Wales, it is possible as a matter of common law for a member to bring an action, in certain circumstances, on behalf of the company of which he is a member. This is known as a derivative claim. As noted above, a member may bring such an action to enforce liability for a breach by one of the directors of his duties to the company.
485.The law relating to the ability of a member to bring proceedings on behalf of the company is not written down in statute. The general principle – commonly known as the rule in Foss v Harbottle – is that it is for the company itself to bring proceedings where a wrong has been done to the company. However, where there has been conduct amounting to a «fraud on the minority», an exception may be made to the rule, so that a minority shareholder may bring an action to enforce the company’s rights (for example, where there has been an expropriation of company property or dishonest behaviour by a director, and the company is improperly prevented from bringing proceedings against the director by the majority shareholders, perhaps because the wrongdoing director controls the majority of votes).
486.Under the current law, if a wrong has been effectively ratified by the company, this will be a complete bar to a derivative claim. In addition, if a wrong is capable of being ratified, then even if there has been no formal ratification, it may not be possible for a minority shareholder to bring a derivative claim.
487.The law in Northern Ireland in this area is the same as that in England and Wales.
Scotland
488.Under Scots law, the member’s right to raise an action is conferred by substantive law. Accordingly, a member has title as a matter of substantive law to raise proceedings in respect of a director’s breach of duty to obtain a remedy for the company. The action is raised in the name of the member but the remedy is obtained for the company and the rights which the member can enforce against a director or third party are those of the company.
489.The member’s right arises where the action complained of is fraudulent or ultra vires and so cannot be validated by a majority of the members of the company. This remedy is not available if the majority of members acting in good faith have validated or may validate the act complained of.
490.Two rules of substantive law apply to actions brought by the member to protect the company’s interests (as well as to actions brought to protect the shareholder’s personal interests such as enforcement of rights in the articles of association). First, the directors of a company owe duties to the company and not to the members. Second, the court will not interfere in matters of internal management which may be sanctioned by a majority of the members. The effect of these rules is similar to the first two legs of the rule in Foss v Harbottle.
Chapter 1: Derivative Claims in England and Wales Or Northern Ireland
491.The sections in this Part do not formulate a substantive rule to replace the rule in Foss v Harbottle, but instead reflect the recommendation of the Law Commission that there should be a «new derivative procedure with more modern, flexible and accessible criteria for determining whether a shareholder can pursue an action» (Shareholder Remedies, paragraph 6.15). In line with the recommendations of the Law Commission, the derivative claim will be available for breach of the duty to exercise reasonable care, skill and diligence, even if the director has not benefited personally, and it will not be necessary for the applicant to show that the wrongdoing directors control the majority of the company’s shares.
492.The sections in Chapter 1 of this Part introduce a two-stage procedure for permission to continue a derivative claim. At the first stage the applicant will be required to make a prima facie case for permission to continue a derivative claim and the court will be required to consider the issue on the basis of the evidence filed by the applicant only, without requiring evidence from the defendant. The courts must dismiss the application if the applicant cannot establish a prima facie case. At the second stage – but before the substantive action begins – the court may require evidence to be provided by the company. The sections set out a list of the matters which the court must take into account in considering whether to give permission and the circumstances in which the court is bound to refuse permission.
493.The sections will be supplemented by amended Civil Procedure Rules.
Section 260: Derivative claims
494.This section sets out the key aspects of a derivative claim.
Subsection (1) defines what is meant by a derivative claim. There are three elements to this: the action is brought by a member of the company; the cause of action is vested in the company; and relief is sought on the company’s behalf. (A «member» is defined in section 112. Subsection (5) provides that references to a member in this Chapter include a person who is not a member but to whom shares in the company have been transferred or transmitted by operation of law, for example where a trustee in bankruptcy or personal representative of a deceased member’s estate acquires an interest in a share as a result of the bankruptcy or death of a member).
Subsection (2) provides that the claim may only be brought either under this Chapter or in pursuance of an order of the court in proceedings under section 994 (proceedings for protection of members against unfair prejudice).
Subsection (3) provides that a derivative claim «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». As such, a derivative claim may be brought in respect of an alleged breach of any of the general duties of directors in Chapter 2 of Part 10, including the duty to exercise reasonable care, skill and diligence (section 174).
Subsection (3) also provides that the cause of action may be against the director or against a third party, or both. Derivative claims against third parties would be permitted only in very narrow circumstances, where the damage suffered by the company arose from an act involving a breach of duty etc on the part of the director (e.g. for knowing receipt of money or property transferred in breach of trust or for knowing assistance in a breach of trust).
Subsection (4) provides that a derivative claim may be brought by a member in respect of wrongs committed prior to his becoming a member. This reflects the fact that the rights being enforced are those of the company rather than those of the member and is the position at common law.
Under subsection (5), the reference to a director in this Chapter includes a former director; and a shadow director is treated as a director.
Section 261: Application for permission to continue derivative claim
495.This clause provides that, once proceedings have been brought, the member is required to apply to the court for permission to continue the claim. This reflects the current procedure in England and Wales under the Civil Procedure Rules. The applicant is required to establish a prima facie case for the grant of permission, and the court will consider the issue on the basis of his evidence alone without requiring evidence to be filed by the defendant. The court must dismiss the application at this stage if what is filed does not show a prima facie case, and it may make any consequential order that it considers appropriate (for example, a costs order or a civil restraint order against the applicant). If the application is not dismissed, the court may direct the company to provide evidence and, on hearing the application, may grant permission, refuse permission and dismiss the claim, or adjourn the proceedings and give such directions as it thinks fit. This will enable the courts to dismiss unmeritorious claims at an early stage without involving the defendants or the company.
Section 262: Application for permission to continue claim as a derivative claim
496.This section addresses the possibility that, where a company has brought a claim and the cause of action on which the claim is based could be pursued by a member as a derivative action:
the manner in which the company commenced or continued the claim may amount to an abuse of process (e.g. the company brought the claim with a view to preventing a member bringing a derivative claim);
the company may fail to prosecute the claim diligently; and
it may be appropriate for a member to continue the claim as a derivative claim;
497.The section provides that, in these circumstances, a member may apply to the court to continue the claim as a derivative action.
Section 263: Whether permission to be given
498.This section sets out the criteria which must be taken into account by the court in considering whether to give permission to continue a derivative claim.
499.Subsection (2) provides that the court must refuse leave to continue a derivative claim if it is satisfied that:
a)a person acting in accordance with the general duty of directors to promote the success of the company (section 172) would not seek to continue the claim; or
b)the act or omission giving rise to the cause of action has been authorised or ratified by the company. Section 180(4) preserves any rule of law enabling the company to give authority for anything that would otherwise be a breach of duty. Section 239 preserves the current law on ratification of acts of directors, but with one significant change. Any decision by a company to ratify conduct by a director amounting to negligence, default, breach of duty or breach of trust in relation to the company must be taken by the members, and without reliance on the votes in favour by the director or any connected person.)
500.Subsection (3) sets out the criteria which the court must, in particular, take into account in considering whether or not to grant permission for the derivative claim to be continued.
501.Subsection (4) provides that, in considering whether to give permission, the court must have particular regard to any evidence before it as to the views of independent members of the company i.e. members who have no personal interest, direct or indirect in the matter.
502.Subsection (5) confers on the Secretary of State a power to make regulations with regard to the criteria to which the court must have regard in determining whether to grant leave to continue a derivative claim and where leave of the court must be refused. Subsection (6) provides that, before making any such regulations, the Secretary of State must consult with such persons as he considers appropriate. The power reflects a recommendation by the Law Commission in its 1997 report on shareholder remedies in respect of analogous shareholder actions in Scotland. Under subsection (7), the regulations will be subject to the affirmative resolution procedure.
Section 264: Application for permission to continue derivative claim brought by another member
503.This section addresses the possibility that, where the court has already decided that there is an appropriate case for a derivative claim and a member has commenced or continued a claim:
the manner in which the member commenced or continued the claim may amount to an abuse of the court (e.g. the member brought the claim with a view to preventing another member from bringing the claim);
the member may fail to prosecute the claim diligently;
it may be appropriate for another member to continue the claim (e.g. because the member who brought the claim has become very ill).
504.The section provides that, in these circumstances, another member may apply to the court to continue the claim as a derivative action.
Chapter 2: Derivative Proceedings in Scotland
505.Sections 265 to 269 seek to ensure maximum consistency between the position in England and Wales and Northern Ireland and the position in Scotland (although the clauses reflect the different procedural requirements which apply where proceedings are commenced in the Scottish courts, in particular the fact that the leave of court must be obtained before derivative proceedings may be raised). In view of this, they also put the rights of the member to raise actions on behalf of the company on a statutory footing.
506.Section 265 differs from section 260 in its approach in that it confers the right to bring the proceedings in the first place, and then, in the clauses which follow, regulate the proceedings. (By contrast, the sections relating to proceedings in England and Wales and Northern Ireland assume that there is already a right to bring such proceedings in England and Wales and Northern Ireland; they therefore regulate the proceedings rather than confer the right to bring them.)
507.Subsections (4) to (6) of section 268 confer on the Secretary of State a parallel power to that in section 263 to make regulations with regard to the criteria to which the court must have regard in determining whether to grant leave to continue a derivative claim and where leave of the court must be refused.