Minority protection

Historically, the rule in Foss v Harbottle (1843) 2 Hare 461 has been of the utmost significance in governing when shareholders can take action on behalf of the company in which they hold shares. The facts of the case were as follows.

Certain burghers in Manchester had got together to purchase parkland to dedicate to the then heiress to the throne, Princess Victoria. The park opened to great acclamation but difficulties soon followed. It was alleged by some of the company’s members that some directors had misapplied company property. The case was heard by Wigwram VC. He held that the action could not proceed as the individual shareholders were not the proper claimants. If a wrong had been committed, the wrong had been committed against the company and the company was therefore the proper claimant. The rule in Foss v Harbottle has acted like a dead hand on minority protection in British company law. The rule is, to some extent, justifiable. It has sometimes been justified as preventing a multiplicity of actions and sometimes by the argument that the company can ratify what directors have done and that, therefore, litigation might well be pointless.

In Stein v Blake [1998] 1 All ER 724, the claimant and the defendant each owned 50 per cent of the shares of the company. The defendant, who was the sole director of the company, transferred assets at an undervalue to companies under his control.

The claimant brought an action in his personal capacity, alleging that the defendant had breached his director’s duties. The Court of Appeal upheld the decision of the trial judge. Millet LJ quoted from the judgment of the Court of Appeal in Prudential Assurance Co Ltd v Newman Industries (No 2) [1982] Ch 204: ‘… what [a shareholder] cannot do is to recover damages merely because the company in which he is interested has suffered damage.’

The rule in Foss v Harbottle, however, quickly gave way to certain exceptions where a minority action may be brought by a member arguing that a wrong has been done to the company. Historically at common law, these exceptions were:

(a)  ultra vires acts;

(b)  where a special majority is needed;

(c)  the personal rights exception; or

(d)  fraud by those in control of the company.

Historically it has not been possible to bring an action as an exception to the principle in Foss v Harbottle as a derivative claim where the claim is one of negligence – at least where the directors have not profited from the negligence in question.

It is proposed to examine each of these exceptions to the principle in Foss v Harbottle and then to examine the change brought about by s 260 CA 2006, which introduces a new statutory procedure for a ‘derivative claim’.

If the company’s constitution stipulates that a special majority is needed before a particular course of conduct can be accomplished then, if the company seeks to fly in the face of this provision and not obtain the particular majority, a single shareholder may maintain an action as an exception to Foss v Harbottle. This is the basis of the decision in Edwards v Halliwell [1950] 2 All ER 1064.

In fact, the case involves a trade union rather than a company. The law in this particular is the same in both categories of law. The National Union of Vehicle Builders was seeking to increase its subscriptions and it was alleged that this was in contravention of the union rule book without obtaining the consent of the union members to the increase. Members of the Cricklewood branch of the union complained about this and were successful. The same principle operates in company law.

The case is an interesting one and the judgment of Jenkins LJ is particularly helpful in setting out lucidly the law in this area.

If the company denies a shareholder rights that are set out in the company’s constitution, the shareholder can bring an action on behalf of himself and all other shareholders denied the right to enforce the rights that have been negated. Thus, in Pender v Lushington (1877) 6 Ch D 70, a shareholder was able to enforce his right and that of other shareholders that they should be able to cast their votes. The action was brought by a Mr Pender on behalf of himself and all shareholders who voted against an amendment, and on behalf of the Direct United States Cable Company Ltd as claimants. The defendants, E.H. Lushington and other gentlemen, had rejected the votes on the contention that the shares were held in trust for others.

The judge held that the rights accorded to members were the rights accorded to registered members and therefore their votes were wrongly rejected.

In Wood v Odessa Waterworks Co (1889) 42 ChD 636, a shareholder was able to enforce his right to a dividend in cash rather than a dividend in specie (in the form of property) as provided for under the company’s articles. The company’s articles of association provided for the payment of a dividend. The general meeting had approved a resolution that dividends be paid by way of a distribution of debentures. The judge, Stirling J, held that the implication of the article of association was that a dividend must be paid in cash and could not be paid in kind, i.e. by a distribution of property such as debentures. The company was accordingly restrained from acting upon the resolution.

One reason for restricting derivative claims to fraud was to prevent a multiplicity of claims where it was possible that the action complained of would be ratified by the company. The exception of fraud enabled a shareholder to bring an action on behalf of the company (a derivative action deriving from the company’s right to sue) for a fraud perpetrated by somebody in control. Fraud can never be ratified so the ratification objection does not arise. In Cook v Deeks [1916] 1 AC 554, a Privy Council case on appeal from Ontario, a shareholder was able to bring an action under this head complaining that directors had diverted corporate opportunities to themselves. The exception does not extend to cases of negligence: see Pavlides v Jensen [1956] 2 All ER 518, where the complaint was that the directors had been negligent in selling an asbestos mine in Cyprus at an undervaluation. The exception did not extend either to negligence tantamount to expropriation, which was the way that the cause of action was pleaded in Heyting v Dupont [1964] 1 WLR 843, which concerned a Jersey company formed to exploit an invention of the defendant consisting of a machine for the manufacture of plastic pipes. A particularly difficult case arose in Daniels v Daniels [1978] Ch 406. In this case a director had purchased property from a company for £4,250 and then resold it shortly afterwards for £120,000. The allegation was pleaded as one of negligence. The judge, Templeman J, allowed the action to proceed. This has sometimes been misinterpreted. The case is not authority for the proposition that where there has been gross negligence, an action is possible as an exception to Foss v Harbottle. The judge specifically stated:

To put up with foolish directors is one thing; to put up with directors who are so foolish they make a profit of £115,000 odd at the expense of the company is something entirely different.

Clearly, the decision is exceptional. Templeman J is indicating that there is more to the case than meets the eye.

Another important decision in the area of fraud is that of Prudential Assurance Co Ltd v Newman Industries Ltd [1980] 2 All ER 341. The case dealt, inter alia, with the question of control. In this case, Vinelott J held that management control was sufficient and seemed to accept that the directors were in management control. The Court of Appeal took a different view as it considered it would need a trial to see if management control actually existed. Voting control, on the other hand, is easy to demonstrate. Vinelott J had erred in not considering as a preliminary issue whether the claimants could bring a derivative action. A derivative action should be permitted, according to the view of the Court of Appeal, where the board of the company was shown to be under the control of the fraudsters; only then could the issue of fraud be considered.

Section 260 of the Companies Act 2006 now allows a derivative claim to be brought 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 a company.

It may be that this new procedure will increase claims against directors but the provisions do encompass some safeguards.

The safeguard is that a member of a company who brings a derivative claim must apply to the court for permission to continue with the claim (s 261 CA 2006). The same applies where a member applies to take over an action that has been brought by a company where it is appropriate for the member to continue the claim as a derivative claim (s 262 CA 2006).

If it appears to the court in either case that the evidence filed by the applicant does not disclose a prima facie case for giving permission for the continuation of the derivative claim, then the court should dismiss the application and make any consequential order that it considers appropriate.

The matters that are to be considered in determining whether permission is to be given or not are set out in s 263 CA 2006.

Permission must be refused if the court is satisfied:

(a)  that a person acting in accordance with s 172 (duty to promote the success of the company) would not seek to continue the claim;

(b)  where the cause of action arises from an act or omission that is yet to occur, that the act or omission has been authorised by the company; or

(c)  where the cause of action arises from an act or omission that has already occurred that the act or omission:

In general, in considering whether to give permission the court must take into account, in particular, the following:

(a)  whether the member is acting in good faith in seeking to continue the claim;

(b)  the importance that a person acting in accordance with s 172 (duty to promote the success of the company) would attach to continuing;

(c)  where the cause of action results from an act or omission that is yet to occur, whether the act or omission could be, and in the circumstances would be likely to be:

(d)  where the cause of action arises from an act or omission that has already occurred, whether the act or omission could be, and in the circumstances would be likely to be, ratified by the company;

(e)  whether the company has decided not to pursue the claim; and

(f)  whether the act or omission in respect of which the claim is brought gives rise to a cause of action that the member could pursue in his own right rather than on behalf of the company.

In Franbar Holdings Ltd v Patel [2008] BCC 885, the appellant company Franbar applied for permission to continue a derivative claim against the respondents on behalf of the third respondent company (M).

M’s business was in providing healthcare. It was at one stage wholly owned by Franbar but Franbar had sold 75 per cent of the shares to another company (C). C appointed two directors who were the first and second respondents.

Franbar claimed under s 260 CA 2006 that the first and second respondents were liable for neglect, default and breach of the duty of care to M. They claimed that the respondents had driven down the share price of M by driving business away and by failing to provide adequate financial information.

They also made a claim for breach of a shareholders’ agreement with C and also under s 994 CA 2006 in relation to unfairly prejudicial conduct.

The court refused Franbar leave to continue with the derivative claim as they had the shareholders’ agreement action and the petition under s 994.

The court took the view that a hypothetical director would be more likely to regard the pursuit of the derivative claim as less important in the light of the fact that several of the complaints were more naturally formulated as claims in relation to the breach of the shareholders’ agreement.

In Mission Capital plc v Sinclair [2008] BCC 866, former directors (S) sought permission to continue a derivative action against the company (M). M had terminated S’s employment and required them to resign as it was alleged they had failed to meet financial forecasts and submit important financial information to the board. M obtained an injunction to exclude S from the company’s premises and requiring them to deliver up documents. S counterclaimed and brought a derivative action against M, the non-executive directors and P, a replacement director.

It was argued that the company would be liable to a substantial claim for wrongful dismissal.

The court took the view that there was a two-stage process under s 260. The first stage under s 263(2)(a) requires the court to consider whether a notional director would continue with the action. The court took the view that it was possible that a notional director would continue with the action because of the impact of a wrongful dismissal claim.

The second stage requires the court to exercise discretion under s 263(3). Here the court took the view that a notional director would not attach much significance to the liability for wrongful dismissal and it would be more likely to replace S than to take action against those responsible. It was further noted that S might succeed under s 994 and this was a factor in the decision too.

In Kleanthos v Paphitis and others [2011] All ER 33, the court had to consider the possibility of the success or otherwise of the derivative claim. K, the applicant, was seeking permission to continue a derivative action in relation to an alleged breach of duty by Paphitis and three other directors. Theodore Paphitis was well known, of course, as one of the ‘dragons’ in the popular enterprise-promoting TV programme Dragons’ Den. The company was the office stationery company, Ryman Group Ltd.

The court dismissed the applicant’s claim in relation to breach of duty by Paphitis and the other directors. It found that there was the possibility of success and the award of a significant sum of money, but held that a director acting in accordance with s 172 CA 2006 – that is to say in a way which would be most likely to promote the success of the company – would not continue with such a claim.

In Johnson v Gore Wood & Co [2002] 2 AC 1, the House of Lords had to consider the extent to which a shareholder could bring a collateral claim where the company had already sued.

The case concerned an allegation that the defendant firm of solicitors had failed in its undertaking to serve efficaciously a notice to exercise an option to purchase land. The company that held the option had already sued the firm and obtained satisfaction of a large part of its claim. Before the settlement agreement was concluded the claimant, who owned all but two of the shares in the company, notified the firm that he too would be suing on the basis that the firm had contracted with, or otherwise assumed responsibility to him, as well as to the company. The settlement agreement contemplated the claimant retaining his right of action against the firm. The House of Lords struck out the claimant’s claims to the extent that they reflected the loss suffered by the company. They left in place claims for consequential loss that the claimant may have suffered that were not so reflected.

This principle is entirely reasonable. A shareholder should not be able to reopen a case by seeking to pursue the defendant in a personal capacity where the company has already sued if his loss is merely reflective of the company’s loss. As Lord Millett said in Johnson, ‘Mr Johnson cannot be permitted to challenge in one capacity the adequacy of the terms he agreed to in another.’

The issue of reflective loss arose in Giles v Rhind [2003] Ch 618. Giles and Rhind were both shareholders, employees and directors of SHS Ltd. Rhind left the company and diverted business away in breach of a shareholders’ agreement. The company started proceedings against him but the proceedings were discontinued by the administrator as the company could not afford to continue. Giles then started an action in his personal capacity. Could he proceed as the company had a right of action against Rhind? Waller LJ, in the Court of Appeal, said it hardly seems right that a wrongdoer in breach of contract to a company and to a shareholder should be able to block an action by a shareholder where he had prevented the company pursuing an action by demanding costs from the company. The shareholder’s action was allowed to proceed.

Thus, as seems entirely reasonable, the defendant cannot shelter behind the no reflective loss principle where the defendant’s wrongdoing has caused the company to be unable to sue.