The derivative action

18.2.1 Introduction

A company is a separate legal person that is capable of suing and being

sued in its own name. Where a wrong is done to a company, the ‘proper

plaintiff’ is the company itself. This principle is commonly known as the

rule in Foss v Harbottle. It usually is the board of directors that has the

authority to institute legal proceedings in the name of or on behalf of the

company.

The derivative action, in terms of s 165 of the Act, is an exception to

the proper plaintiff principle. A derivative action is brought by a person on

behalf of a company in order to protect the legal interests of the

company. It is worth repeating that a derivative action is brought by

another person, such as a minority shareholder, in order to protect the

legal interests of the company. Consequently, the need for another person

to bring a derivative action to protect the company’s legal interests will

generally arise where the claim is not brought by the company itself. The

derivative action is so called because the shareholder (or other applicant)

‘derives’ his or her right of action from that of the company.

This must be distinguished from the situation where shareholders wish

to enforce their own shareholder rights. In this regard, where a wrong is

done to a shareholder (for instance, in the case of a wrongful refusal of

the right of a shareholder to cast a vote at a meeting) and the

shareholder consequently wishes to assert his or her

individual shareholder rights - as opposed to the rights of the company -

the derivative action would not be appropriate.

The classic case of the derivative action is where those who commit a

wrong against the company are the controllers of the company. For

instance, the company is defrauded by its directors, who are also the

majority shareholders - so the wrongdoers subsequently use their control

or influence over the company to prevent the company from instituting

legal proceedings against them to remedy the wrong done to the

company.

The derivative action is an important minority shareholder protection

measure. It protects the minority shareholders from the effects of

corporate personality and majority rule. It enables a minority shareholder

who learns of a wrong that is done to the company and that has been left

unremedied by management (often because they are the wrongdoers) to

institute proceedings on behalf of the company and thereby protect the

legal interests of the company.

But the derivative action in terms of s 165 is much wider than this. It is

available to a wider class of applicants than just minority shareholders, as

discussed in 18.2.2. Moreover, its use is not limited to wrongs that are

committed by the management or the controllers of the company - it even

extends to wrongs that are committed by third parties or outsiders

(although practically it could be more difficult to bring a claim in such

circumstances).

A derivative action may be brought only under s 165 of the Act. The

common-law derivative action has been abolished. The procedure for the

derivative action, as set out in s 165, is discussed below.

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18.2.2 Persons who have legal standing under s 165

The derivative action is available to the following categories of persons:

Shareholders: This includes shareholders of the company,

shareholders of a related company, and persons entitled to be

registered as shareholders of the company or a related company.

Directors or prescribed officers: This includes the directors and

prescribed officers both of the company and of related

companies.

Registered trade unions representing employees of the company, or

other representatives of employees.

Any person who has been granted legal standing by the court. The

court has the discretion to grant legal standing to other persons

where it is satisfied that it is necessary or expedient to protect a

legal right of that other person.

18.2.3 The demand

The applicant must serve a demand on the company, requiring the

company to institute legal proceedings to protect its legal interests. The

requirement of a demand gives the company the opportunity to

reconsider the conduct complained of, and to take suitable remedial

action itself to protect its own interests.

The demand may relate to the protection of any ‘legal interests’ of the

company. The term ‘legal interests’ appears to be wider than the ‘rights’

of the company. The derivative action is not restricted to protecting any

particular type of legal interest or cause of action, nor is there any

restriction to any particular class of wrongdoer. The scope of the

derivative action includes a breach of fiduciary duty committed by a

director of the company, but is wider than this. The wrongdoers may

conceivably be the directors, one or more prescribed officers, the majority

shareholders or even outsiders (including, but not limited to, those

outsiders against whom the controllers of the company decline to act by

reason of their wish to shield the outsider).

The demand may concern the commencement or the continuation of

legal proceedings or related steps to protect the legal interests of the

company. This, first, allows scope for a person to bring (or defend)

derivative proceedings on behalf of the company in the event that the

company has failed to initiate proceedings. Second, it creates scope for a

person to intervene in proceedings that the company has already

commenced in its own name, and to continue these proceedings as

derivative proceedings. Third, it permits a person to take related steps to

protect the company’s legal interests which could comprise, for instance,

settling or compromising legal proceedings on the company’s behalf. The

applicant’s demand may relate to legal proceedings in which the company

is the plaintiff, as well as legal proceedings that are brought against the

company.

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18.2.4 Application to set aside the demand

The company may, within 15 business days, apply to a court to set aside

the demand, only on the grounds that the demand is frivolous or

vexatious or without merit.

This is one of the safeguards directed at protecting the company from

frivolous or vexatious demands made by shareholders (or other

applicants). It is an important safety measure that is designed to prevent

abuse of the right of applicants to bring a derivative action.

18.2.5 Investigation of the demand

Upon receipt of a demand (and on the assumption that it is not set aside

by the court on the basis that it is frivolous, vexatious or without merit),

the company must appoint an independent and impartial person or

committee to investigate the demand. The investigator or the committee

must report to the board on the facts or circumstances that may give rise to the cause of action,

or may relate to the proceedings, contemplated in the demand;

the probable costs that would be incurred if the company pursued

the cause of action or continued the proceedings; and

whether it appears to be in the best interests of the company to

pursue the cause of action or continue the proceedings.

18.2.6 Company’s response to the demand

Within 60 business days after being served with the demand (or such

longer time as the court may permit) the company must either initiate or continue legal
proceedings, or take related legal steps to

protect its legal interests, as contemplated in the demand; or

serve a notice on the person who made the demand, refusing to

comply with it.

18.2.7 Application to court for leave

A person (who has served a demand on the company) may apply to a

court for leave (or permission) to sue on behalf of the company. This may

be done only if the company has failed to take any particular step relating to the

investigation of the demand and its response to the demand (as

discussed in 18.2.5 and 18.2.6); or

the company appointed an investigator or committee who was not

independent and impartial; or

the company accepted a report that was inadequate in its

preparation, or was irrational or unreasonable in its conclusions or

recommendations; or

the company acted in a manner that was inconsistent with the

reasonable report of an independent, impartial investigator or

committee; or

the company has served a notice refusing to comply with the

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demand.

If the company complies with the demand (by initiating or continuing legal

proceedings or taking related legal steps to protect the legal interests of

the company, as the case may be), the court will generally not grant

leave to an applicant to sue on behalf of the company. This is logical and

sensible. Where the company itself engages in legal proceedings to

protect its own legal interests, it will generally be unwarranted to allow an

applicant to sue on the company’s behalf.