Derivative Claims
MARCH 2010
The Companies Act 2006 (“the “2006 Act”) has introduced an increased regime of accountability for directors to the shareholders of their company. The 2006 Act has codified the duties of directors and has created a new statutory procedure whereby shareholders can sue directors in the name of the company for negligence, breach of duty, default or breach of trust. This is known as a derivative claim.
There is a two stage test that the shareholder must satisfy before the court will permit a shareholder to continue a derivative claim. Firstly, the shareholder must produce evidence demonstrating that he has a prima facie case against a director (or directors). The court will only consider evidence submitted by the shareholder at this stage. If a prima facie case is established, the court will then decide whether the claim should proceed to a full hearing.
The court must refuse permission to continue the claim if it is satisfied that a person acting in accordance with the duty to promote the success of the company would not bring the claim (i.e. if the claim is likely to damage the business of the company) or if it is persuaded that the matter complained of had been authorised in advance or ratified subsequently by the company. Otherwise, in deciding whether to give permission, the court will exercise its discretion and will also have regard to the views of any independent shareholders. It is likely that they will take into account the following factors:
- Whether the claim is being brought in good faith;
- The importance of the claim to someone promoting the success of the company;
- The likelihood of the matter being authorised or ratified by the company;
- Whether the company has decided to bring the claim; and
- Whether the shareholder could bring a claim in his own right, rather than on behalf of the company.
If permission is granted by the court, the claim will proceed to a full hearing. The company may be ordered by the court to indemnify the shareholder against liability for costs incurred in the application for permission to continue with the claim or in the derivative claim, or both. If permission is not granted, the court has the power to make an order requiring the shareholder to personally bear the costs of the application. It is hoped that the court’s power to make a costs order against a shareholder will deter shareholders from bringing tactical claims aimed at causing disruption to the operation of the company.
The 2006 Act has introduced a number of hurdles for a shareholder to overcome if he wishes to pursue a claim against a director. This has been implemented to prevent a flurry of shareholders, motivated by reasons other than the success of the company from bringing vexatious claims.
There has not yet been much case law on derivative actions under the 2006 Act. In fact, the two sole reported cases of shareholders trying to use the derivative procedure have both failed at an early stage. In both Mission Capital Plc v Sinclair and Franbar Holdings Ltd v Patel, the court held that permission to continue with a derivative claim would be refused when the alleged damage was speculative and when a hypothetical director would not attach much importance to proceeding with the claim. Moreover in both claims, the court decided that the shareholders could pursue actions in their own right, rather than on behalf of the company.
Directors should ensure that they are fully aware of the duties that they owe to their company. It is not yet clear how the courts will apply this new procedure but the new process could potentially enable shareholders to bring claims for what they consider to be bad business decisions. It is hoped that the courts will intervene to prevent such actions.
Directors are certainly entitled to feel more exposed to potential litigation, particularly in the current economic climate. They need to be aware that if a shareholder succeeds in his derivative action, the director could be liable to repay the loss (or a proportion of it) to the company out of his own pocket.
For the moment, the situation remains uncertain for directors. Until we know how derivative claims will be decided by the courts, directors may wish to review their liability insurance policies to ensure that they are covered for defending derivative actions. Companies should also consider whether they have appropriate insurance coverage for liabilities incurred under a court order instructing that the company fund the costs of a derivative action.
If you have any concerns or would like any guidance in relation to derivative actions, please contact Philip Langford or Tanya Shillingford of Goodman Derrick LLPs corporate department on 0207 404 0606.
This guide is for general information and interest only and should not be relied upon as providing specific legal advice.
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