Derivative Claims – Exam Answer

Note: In problem question, write less about history and more about procedure of DC and
mandatory bars. Also, identify the breaches of director duties in introductory para. Speak a bit
about connected persons as well.

Derivative Claims
In order to understand the concept of Derivate Claims (“DC”) we must first go back to the
case of Foss v. Harbottle, where two shareholders brought a claim against the directors,
that the directors had misappropriated assets of the company. The court held in the case that
the harm was suffered by the entire company and therefore it should be majority’s decision to
approve or disapprove the directors’ conduct, since anything otherwise would mean frustrating
the majority’s wishes. We see that the rule arising from the case of Foss v. Harbottle is that if a
wrong gets committed against a company, then the company itself would be the proper claimant
in this regard, since if minority shareholders were permitted to bring forward claims each time a
company was wronged it would lead to hundreds or perhaps thousands of cases. Thus we see
that in the case of Foss v. Harbottle, the principle of majority rule was upheld, making the
minority bound by the decision when the majority decides to not pursue an action if the
company has been wronged, and the rule was reiterated in the case of Edwards.
The courts have time and again affirmed and reiterated that if the company is wronged then the
proper claimant remains the company (Burland) (Mozley) (Gray), with such a claim being
termed as corporate action. However, there still was a way which enabled a shareholder to claim
directly, known as a derivate claim (“DC”), in which if the shareholder got the court’s approval,
the company would sue the third party and thereafter the third party will compensate the
company, if the decision is against the third party. Initially the law for DC was set out under the
common law, due to which this remedy was only available to the shareholder where there was a
fraud on the minority (Edwards). There were two aspects that were to be proven for a successful
claim, the first aspect being that the minority was to prove that there had been fraud, with the
meaning of fraud being unclear and being determined case to case (Megarry) (Burland)
(Daniels). While, the second aspect was to prove that the wrongdoer was in control, however, the
meaning of this term also remained unclear, for example, in the case of Prudential, the court
adopted quite a narrow definition of wrongdoer control, which only made it difficult to prove.
Therefore, owing to their inaccessible and unclear nature, the rules for derivate claims set out
under the common law were criticized and it was felt that the rules were too restrictive, making it
difficult for shareholders to bring a derivative claim.
Finally, a new statutory derivative claim procedure was introduced in part 11 of Companies Act,
2006 (“CA 2006”), in which it was hoped that the new law would be clearer. s. 260(1) of CA
2006 defines DC as proceedings brought by a shareholder with respect to a cause of action
vested in the company, to seek relief on behalf of the company. Pursuant to s. 260(3) of CA
2006, any breach would give rise to a claim, therefore making the new procedure much more
wide compared to common law, even allowing claims against third parties who assist duty
breaching directors and receive gifts. In order to bring a claim, pursuant to s. 261 of CA 2006,
the shareholder will apply to the court with the relevant documents to seek the permission of the
court, after which the court will hold a paper hearing to assess the merits of the claim, and if the
court believes that the claim has merit, then there would be full oral hearing and if the court then
gives permission, DC will be allowed. However, pursuant to s.263 (2), there are some mandatory
bars which if present, the court will refuse permission.
In the mandatory bars set out under s. 263(2), the court refuses permission where a person acting
in line with s. 172 of CA 2006 would not continue such a claim, where the breach was
authorized or where the breach has been authorized (Re Singh), however, the court will see
whether the director made full disclosure of his wrongdoing to the shareholder and whether the
director and connected persons’ vote was counted or not (Cullen). Additionally, pursuant to s.
263(3), the court also considers whether the member bringing the claim is acting in good faith,
the importance a person acting in line with s. 172 of CA 2006 would attach to pursuing
such a claim, the possibility of prior authorization or subsequent ratification, whether the
company decided to not pursue the claim and finally whether the shareholder could pursue
the action in their own right. Finally, if the court does give permission, the courts may order
the company to indemnify the shareholder with regard to the cost incurred (Wallersteiner),
however, the courts will refuse and indemnity award where the courts feel that the shareholder is
using the DC to pressurize the majority and the parties can better settle under s. 994 of CA 2006
(Bhullar) (Hook).
While the new law under statute regard DC was wider compared to common law, the increase in
the number of claim which some hoped while others feared has not materialized as is evident
from the fact that each year only 2 to 3 claims are brought, out of which only 40% are given
permission by the court to continue. The procedure and the bars, continue to make the law both
restricted and uncertain. In fact, the old common law procedure also remain relevant, since
“multiple derivative procedures” are not covered by the new statutory provisions (Re Fort) and
secondly the old procedure still influences judges when they make use of the new statutory
provisions.

Reflective loss – Contract Law – Tort Law part

While shareholders can sue if a personal right of theirs is breached and also bring representative
active, another option possessed by them is a personal action for reflective loss. Reflective loss
taken place when the company suffers a loss, due to which the shareholder is adversely impacted
owing to the decrease in value of the company’s shares. However, in order to initiate a claim for
reflective loss, pursuant to the rule set in Foss v. Harbottle, the shareholder will have to prove
that the director who breached their duty owed the shareholder a duty of care too (Sharp) and
that the shareholder suffered a personal loss above the general loss. Additionally, a shareholder
who is also a creditor/director can sue under the reflective loss principle if they have suffered in
the capacity of a creditor/director (Sevilleja), the reflective loss principle can also be availed to
recoup a loss where a company has a cause of action with regard to an actionable wrong
(Breeze), and lastly where the company faces a legal barrier in suing the director who have
breached their duties, the reflective loss principle can be availed (Giles).
The directors can also be liable under tort law (i.e. they may owe a duty to a shareholder) in case
they are found to have given negligent or false advice to a shareholder, however in order to liable
under tort law, the director would have to be assuming personal responsibility for the advice
given to the shareholder (Williams). Additionally, the director may enter into a fiduciary
relationship with the shareholders in small companies if the director frequently advises
shareholders (Allen) (Platt). Finally, a duty might also arise between a shareholder and a director
where the director has a separate contract with the shareholder (Giles).