MINORITY SHAREHOLDER PROTECTION

14

Minority shareholder protection

AIMS AND OBJECTIVES

After reading this chapter you should be able to:

  Understand the proper claimant principle, its origins and shortcomings

  Advise on the circumstances in which a shareholder may commence and will be permitted to continue a statutory derivative claim (s 260)

  Recognise when a shareholder has a personal right he may sue to enforce in a personal capacity

  Explain why a shareholder is not able to recover reflective losses except in one circumstance and why that exception exists

  Advise whether or not a shareholder is likely to succeed in a petition based on a company’s affairs having been conducted in a manner unfairly prejudicial to the interests of the shareholder (s 994)

  Advise on the basis of the just and equitable winding-up jurisdiction of the court

  Understand the relationship between s 994 and just and equitable winding-up petitions

14.1 Introduction

The introduction to this chapter highlights how the rights and claims considered in this chapter relate to one another and places those rights and claims in context.

In the following sections of the chapter, first, we examine the rule that the company is the proper claimant in proceedings in which a wrong is alleged to have been done to a company (the ‘proper claimant rule’), and limits of that rule. Second, we look at the circumstances in which shareholders may commence, and will be permitted to continue, a derivative claim. Third, we consider the personal rights of a shareholder to sue in his own name for legal wrongs done to him in a personal capacity, to make good losses he has suffered, including, potentially, reflective losses. We then examine petitions based on a company’s affairs having been conducted in a manner that is unfairly prejudicial to the interests of the shareholders (s 994 petitions) and their relationship to just and equitable winding-up petitions, the final type of petition covered in this chapter.

The law uses a number of legal mechanisms to protect companies from poor management and self-interested action by those in control, including imposition of the general and specific directors’ duties examined in Chapters 11 and 12. If the inadequate behaviour of directors causes losses to the company, the company can sue to recover losses caused by breaches of duty (see Chapter 13). The company and the company alone has the right to sue for breach of directors’ duties because, as we have learned, directors’ duties are owed to the company.

Where the wrongdoers are directors, the potential exists for wrongs to be overlooked and no remedies pursued by the company because it is the wrongdoers who are managing the company. This difficulty may be overcome by the shareholders becoming the decision-making organ of the company for the purposes of ensuring legal action is brought against the directors. The problem is more difficult to overcome, however, when wrongdoer directors also own a majority of a company’s shares.

We know from Chapter 9 that shareholder decisions are largely based on majority rule. Without more, then, the potential would exist for the holders of a minority of the shares in a company to have no procedure by which to assert the rights of the company when directors who were also majority shareholders acted in breach of duty to the detriment of the company. The derivative claim procedure has been developed to assist minority shareholders who find themselves in such a position to protect the company.

Rather than being concerned to protect the company, a minority shareholder in such a position is usually more concerned to protect himself personally from the adverse consequences of being a shareholder in a company with a majority shareholder managing the company in his (the majority shareholder’s) own best interests rather than for the benefit of all shareholders. The main procedure available to a shareholder to protect himself personally is to petition the court for a remedy pursuant to the Companies Act 2006, s 994 based on the company’s affairs having been conducted in a manner that is unfairly prejudicial to the interests of the minority shareholder.

If a company suffers loss caused by a breach of duty owed to the company its shareholders also usually suffer loss because the value of their shares is not as great as it would otherwise be. The shareholders’ loss of share value merely reflects the loss suffered by the company, and, for this reason, is called ‘reflective loss’. We know that shareholders are unable to sue wrongdoers who breach duties owed to the company, because those duties are not also owed to the shareholders.

Even where a wrongdoer owes a separate and additional duty to the shareholder, the shareholder may be unable to sue for breach of that duty and recover losses they have suffered. This is because insofar as the shareholders’ losses are reflective losses, to allow recovery could result in the wrongdoer being ordered to compensate more than one person for the same loss: the company (for the loss to the company) and individual shareholders (for the reduction in share value they suffer which is a reflection of the loss to the company). As a matter of public policy, the law has set its face against allowing shareholders to recover reflective losses except in one very limited circumstance.

Traditionally, analysis of shareholder remedies has been concerned with the extent to which the law can be used by minority shareholders to secure a remedy for losses arising out of self-interested action by directors who are also majority shareholders. The remedy could be either for the company, by way of a derivative claim, or for the shareholder personally, either by asserting personal rights (subject to the limits on recovery of reflective loss), or by bringing a claim based on a company’s affairs having been conducted in a manner that is unfairly prejudicial to the interests of the shareholders. This focus is, however, changing.

Increased emphasis on good corporate governance in the interests of all stakeholders in companies, the enshrinement of ‘enlightened shareholder value’ in s 172 of the 2006 Act and the placing of the derivative claim on a statutory footing, have come together to raise the question of to what extent shareholder remedies may be used to enforce better management of companies in the interests of all stakeholders. Minority shareholders may challenge, or threaten to challenge, management decisions as having been taken in breach of duty by commencing a derivative claim. This has raised the spectre in some commentators’ minds of minority shareholders who support public interest groups using the law to influence board decision-making in favour of public interest groups. Detailed consideration of the role of derivative claims in influencing board decision-making is outside the scope of this book but may be pursued by reading relevant literature listed under further reading at the end of this chapter.

14.2 The proper claimant principle

We know already that the company is a separate legal entity from its shareholders and consequently has legal rights and liabilities. If its rights are infringed, by a person failing to perform a contract they have entered into with the company, for example, the company may sue to enforce its rights under the contract. We also know that the decision to litigate rests with the board of directors as part of the general powers of management of the company (see Chapter 9). From this perspective, it makes perfect sense to have a basic rule, known as the rule in Foss v Harbottle, that in any legal proceedings in which a wrong is alleged to have been done to a company, the proper claimant is the company.

Although logical on its face, the rule has presented enormous difficulty to courts over the years.

QUOTATION

14.2.1 Majority rule and the business judgment rule

Quite apart from reflecting the separate personality doctrine, the proper claimant principle also reflects a couple of sentiments nineteenth-century courts felt towards companies. It is perhaps an over-zealous commitment to these sentiments that resulted over the years in the unfulfilled rights and ruinous litigation to which Sugarman refers. First, is the reluctance of the courts to become involved in business decisions. Second, is the fear felt by the courts of multiplicity of legal actions arising from differences between shareholders:

14.2.2 Limits to the proper claimant principle

The courts were compelled to recognise limits to the rule in Foss v Harbottle (1843). The rule was not applied, for example, if a minority shareholder complained to the court about action by the company for which more than a simple majority was needed, as in Edwards v Halliwell [1950] 2 All ER 1064, which is a trade union case, but the principle is applicable to companies.

The principal area where the rule presented difficulties was where those who control the company and, in particular, the decision to sue or not sue a person who has legally wronged the company, are themselves the wrongdoers. The most important limit to the rule, which is the only true exception to the rule, came to be referred to as ‘fraud on the minority’. Where directors who were also majority shareholders had perpetrated a fraud on the company, a minority shareholder was permitted to commence an action based on a wrong done to the company to secure a remedy for the company. The action was called a ‘derivative action’.

With the exception of multiple derivative actions, the Companies Act 2006 has replaced the common law derivative action with a statutory derivative claim in ss 260–264 (considered below in section 14.3). All circumstances in which permission to continue a derivative action is granted may now be seen as exceptions to the proper claimant principle.

14.2.3 Example: proper claimant principle

It is helpful to illustrate how the proper claimant principle, and the exception to it, works by analysing a hypothetical scenario.

Directors as wrongdoers

Consider a company with two directors. They find out informally that planning permission will be granted for a piece of land owned by the company. They keep this information to themselves and buy the land from the company for £250,000, a price representing its value without planning permission which is far lower than its value with planning permission.

In these circumstances, the directors cannot act as a decision-making organ of the company and decide to sell the land to themselves because they are conflicted-out. Articles normally provide that they cannot vote on the decision of the company to sell the land to them, and, even if the articles did not say this, and the directors cause the company to sell the land to them, they are in breach of ss 172, 175 and 190, as they have not acted to promote the success of the company (s 172), have used information obtained as directors to personal advantage (s 175) and they have failed to obtain the approval of the shareholders (s 190). Consequently, the transaction will be voidable by the company, the directors will be liable to account for any profits they have made and must indemnify the company against any losses caused by the breach of duty.

Although the directors, as the board, ordinarily have the power to decide whether or not to commence any legal action, in these circumstances control of the decision to litigate transfers to the shareholders and the shareholders, as a decision-making organ of the company, decide whether or not the company will sue the directors. The legal proceedings are still brought by the company, in the name of the company, seeking a remedy for the company.

Majority shareholders as wrongdoers

Staying with the hypothetical situation, the company has three shareholders each owning one-third of the shares. Two of the shareholders are the directors. The wrongdoer directors are not going to decide to sue themselves therefore the decision to litigate or not reverts to the shareholders. Does this help the company if the wrongdoers are also shareholders?

Shareholders take most decisions by ordinary resolution, which encompasses majority rule (see Chapter 9). In our hypothetical situation, the wrongdoers own a majority of the shares and, as majority shareholders, they are able to pass or defeat ordinary resolutions. Are they, therefore, permitted to:

  pass an ordinary resolution approving the sale of the land pursuant to s 190?

  pass an ordinary resolution ratifying the breach pursuant to s 239?

  defeat a proposed resolution to sue the directors to recover the land?

  have any legal action commenced by the minority shareholder stopped because he is not the proper claimant?

The answer to the second question is no. On a resolution to ratify his breach of directors’ duty, the votes of both the director/shareholder and any person connected with him are disregarded (s 239(4)). Curiously, there is no similar provision in s 190 requiring the votes of the director to be discounted on a resolution to approve a substantial asset transaction which leaves the matter moot and the answer to question 1 dependent upon the approach the court takes to statutory interpretation. A literal approach would suggest that all shareholders can vote, as the section does not state otherwise, whereas s 239 does state otherwise. A purposive approach may suggest otherwise. Turning to the third question, a resolution to sue the directors, if defeated, could be characterised as an indirect decision of the company to ratify a breach of duty, thereby bringing it within s 239 which requires the directors’ votes to be disregarded. It is surprising that the answers to these questions are not clear cut.

14.3 Statutory derivative claims

The statutory derivative claim is the only proceeding by which a minority shareholder, notwithstanding his lack of control over company decision-making, can commence legal action in respect of a cause of action vested in the company, seeking relief on behalf of the company, to remedy a wrong done to the company. The 2006 Act has expanded the grounds on which a derivative claim may be brought but requires court permission for the continuation of claims. The consequences of introduction of the new statutory procedure were not easy to predict. Although a number of claims have been commenced, the number for which permission to continue has been granted by the court to date has been very small.

QUOTATION

14.3.1 Grounds for claim

A statutory 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. The cause of action may be against the director or another person or both (s 260(3)). Note that the exposure of third parties to a s 260 claim will depend upon dishonest assistance and knowing receipt as the courts have developed these concepts in the context of breaches of duty by directors (these concepts are usually addressed in trusts courses when examining the liability of strangers to the trust in the event of a breach of duty by one or more trustees and you may find cases you study there relevant here). Claims cannot be brought under s 260 against third parties based on causes of action arising independently from the directors’ legal shortcomings (Iesini Westrip Holdings Ltd [2010] BCC 420).

14.3.2 Claim procedure

The parties

The claimant in a s 260 derivative claim is the shareholder. Note that because the shareholder is bringing the action to secure relief for the company, the company must be made a defendant to the claim along with the directors and any third parties against whom relief is sought. An application to continue a derivative claim by a majority shareholder was rejected in Cinematic Finance Ltd v Ryder [2010] EWHC 3387. The court accepted that a derivative action could be brought by a majority shareholder but stated that permission to continue would be given to a majority shareholder only in very exceptional circumstances and it was difficult to envisage what such circumstances might be. In Stimpson v Southern Private Landlords Association [2010] BCC 387 (Ch D), the question of the importance of wrongdoer control of the members arose, although the comments in the case on this issue were obiter. In the absence of such control, the fact that it was open to the claimant to requisition an extraordinary general meeting and try to obtain a replacement board that could, if it considered it appropriate, authorise the litigation, was stated to be a powerful and perhaps overwhelming factor against granting permission to continue.

Application for permission to continue claim

Once the claim form has been drafted and either before or after it has been issued, an application must be made to the court for permission to continue the claim (s 261(1)). The shareholder is precluded from taking any further step in the proceedings until the court has given permission for the claim to continue. A two-stage process exists by which the court decides whether or not to permit the claim to continue.

Stage 1: a prima facie case

The court must be satisfied that the particulars of claim and the evidence submitted to support it disclose a prima facie case for giving permission to continue. If no prima facie case is disclosed, the court must dismiss the application and make any consequential order it considers appropriate (s 261(2)). If the court does not dismiss the application, the application moves to stage 2. At this stage, the claimant will submit written evidence with his application for permission to continue, supporting his statement of claim, and there is no requirement to involve the defendant.

Confusion has emerged from recent cases as to precisely what a claimant has to establish at this first stage. The burden of proof imposed on a claimant and the range of issues necessarily considered at this stage define the process within which the courts balance protection of the company from the cost and distraction of bogus actions on the one hand, and minority shareholders from unacceptable excesses of majority shareholder rule on the other. If a heavy burden is imposed, many claimants will have to be denied permission to continue at this stage.

In Scotland, the Court of Session in Wishart v Castlecroft Securities Ltd [2010] BCC 161 has been described as adopting a ‘low threshold’, stating that, ‘no onus is placed on the applicant to satisfy the court that there is a prima facie case; rather the court is to refuse the application if it is satisfied that there is no prima facie case’. This approach has been contrasted with two English cases in which the approach taken has been that the court has to decide based on the evidence before it that there is a prima facie case both that the company has a good cause of action and that the cause of action arises out of a director’s default, breach of duty (etc.) (Iesini Westrip Holdings Ltd [2010] BCC 420, Franbar Holdings Ltd v Patel [2008] BCC 885 (Ch D)). Presumably, these two cases imply that the claimant must present evidence rather than simply asserting the relevant breach of duty (etc.) in the statement of claim. Stimpson (above) highlights the question of the extent to which this stage should involve consideration of the factors the court is required to consider at a later stage in determining whether or not it should give permission to continue (see s 263(3) and (4)). The confusion is assisted by the practice of stages 1 and 2 (below) sometimes being combined. Clearly, appellate court guidance is needed. Guidance should separate out (i) which issues are under consideration at stage 1 from (ii) where the burden of proof lies, and how the burden can be satisfied, in relation to those issues. If, for example, a breach of duty by a director is clearly established, is this the stage at which the court should look at whether the circumstances for granting permission to continue a claim have been established?

In relation to authorisation, as noted in the context of directors’ duties, the Companies Act 2006 does not make clear how far an interested shareholder may vote to authorise a transaction for which the Act requires shareholder approval. The principle in Cook v Deeks should, arguably, be extended to any case in which the transaction for which authorisation is sought would amount to an expropriation of company property. In such a case, the court would surely be permitted to find that, as a matter of law, the transaction had not been authorised so that the court must refuse permission for a minority shareholder to continue a statutory derivative claim.

Permission to continue and discontinuance

If the court gives permission for a derivative claim to continue, the claim continues much like any other action with remedies available that would be available in a case brought by the company against its directors (see Chapter 13). In its report on ‘Shareholder Remedies’ (No 246), the Law Commission recommended that the consent of the court should be a pre-requisite to any subsequent discontinuance of a derivative action. This recommendation reflected concern that the claimant and the directors could collude, with the claimant being bought off by the directors which, even at a premium in the eyes of the shareholder, would in many cases cost the directors far less than their liability were the claim to proceed to judgment. Such arrangements would be unlikely to be in the interests of the company. This recommendation has not been adopted. It may be, however, that when judges grant permission to continue, they use the power given to the court in s 261(4)(a), ‘to continue the claim on such terms as it think fit’, to order that the claim cannot be discontinued without the court’s permission.

14.3.3 Costs

A derivative claim is brought by a shareholder for the benefit of the company. The shareholder is an agent acting on behalf of the company (per Lord Denning MR in Wallersteiner, below, and see also Re Sherborne Park Residents Co Ltd [1986] 2 BCC 99528 considered at section 14.4). For this reason, the court is usually prepared to grant a costs order, typically applied for early on in proceedings, that the claimant shall be indemnified by the company against his liability for costs of both the derivative claim and the application for permission to continue, whether the claim is successful or not.

The authority for such an order, now reflected in the Civil Procedure Rules (CPR 19.9E), is Wallersteiner v Moir (No 2) [1975] QB 373. Note that it is only as valuable as the creditworthiness of the company, as it does not provide the shareholder with any form of property interest to secure the sum payable by the company (Qayoumi v Oakhouse Property Holdings plc [2003] 1 BCLC 352).

Aware of the danger of imposing a potentially large financial obligation on companies, the courts in both Stainer v Lee and Kiani v Cooper made costs indemnity orders subject to restrictions. In Stainer v Lee, for example, it was capped at £40,000 (with liberty to apply for its extension).

14.4 Personal actions by shareholders

Shareholders may bring legal actions asserting their personal rights as shareholders. The rule in Foss v Harbottle is not relevant to these actions. The proper claimant is not the company, rather, the proper claimant for a wrong done to a shareholder is the shareholder in his personal capacity. In fact, the company in such cases is usually one, if not the only, defendant. Wood v Odessa Waterworks Co (1889) LR 42 Ch D 636 is an example of a shareholder bringing an action on behalf of himself and other shareholders, all in their personal capacity. This is known as a representative action. Representative actions are common when shareholder rights are asserted because there are often a number of shareholders with the same right.

The precise scope of the personal rights of shareholders is not completely clear. When we examined the rights of shareholders to sue to enforce provisions of the articles of association we saw that there is disagreement as to precisely which rights set out in the articles of association may be enforced as personal rights by shareholders (see Chapter 6). The importance of defining the strict legal rights of shareholders has been eclipsed by the availability of the very popular unfairly prejudicial conduct petition under s 994 of the Companies Act 2006, for which a very wide range of remedies may be granted by the court (see s 996). Section 994 petitions can be brought to protect the ‘interests’ of one or more shareholders. This concept of ‘interests’ is broader than ‘rights’ and therefore s 994 petitions can be successfully brought in fact situations in which no strict legal rights of a shareholder have been infringed. Section 994 petitions are examined in the next section of this chapter.

Confusion often arises where a given fact situation gives rise to both a right of the company to sue its directors and a right of the shareholder to sue the company. Examples are when directors abuse the power to allot shares, or allot shares without first respecting the pre-emption rights of existing shareholders. An improper exercise of powers is a breach of duty by the directors (s 171). It is a wrong done to the company for which the company can sue the directors for a remedy against the directors. It is also a breach of the articles of association and an individual shareholder can sue the company for acting inconsistently with the articles (through the agency of its directors). Re Sherborne Park Residents Co Ltd [1986] 2 BCC 99528 is just such a case. The report is of a hearing of a motion (a preliminary hearing for a specific order, here, an order for costs) in what would today be a s 994 case brought by an individual shareholder.

14.4.1 Reflective loss: denial of the personal right to recover

As explained in the introduction to this chapter, when a company suffers a loss which significantly diminishes its assets, shareholders are likely to experience a reduction in the value of their shares. If these losses are caused by a breach of duty owed to the company, the position is clear: the company is the proper claimant and can sue for the breach. The shareholder cannot sue because the duty is not owed to him. Where, however, in addition to the company being owed a duty, the shareholder is also owed a duty by the wrongdoer, the principle that the shareholder has no right to sue to recover purely ‘reflective loss’ comes into play and is referred to as the ‘no reflective loss principle’ (Day v Cook [2002] 1 BCLC 1).

Where there is a breach of a duty owed to both the company and the shareholder, if the shareholder’s loss is reflective loss, the shareholder cannot recover it because the company’s claim ‘will always trump that of the shareholder’ (per Arde, LJ in Day v Cook [2002] 1 BCLC 1). This is because otherwise double recovery (by the company and the shareholder) will occur, or, if the action were to be allowed on a first come first served basis, a shareholder could recover at the expense of the company. Lord Millett stated the justification for the principle succinctly in Johnson v Gore Wood & Co [2001] 2 AC 1 (HL), the leading case on reflective loss.

In Johnson v Gore Wood (2001), Lord Bingham summarised the law in three principles:

Only one true exception appears to exists to the no reflective loss principle. Where the company is unable to pursue its claim against the defendant because of the defendant’s wrongdoing, a shareholder will be permitted to bring an action to recover reflective loss (Giles v Rhind [2003] 1 BCLC 1 (CA)).

14.5 Unfairly prejudicial conduct petitions

14.5.1 Introduction

The unfair prejudice petition in s 994 has existed since 1980 when it replaced an ‘oppressive behaviour’-based remedy introduced in 1948. Between 1948 and 1980 only a couple of cases were reported in which oppressive behaviour had been successfully established. The unfair prejudice petition allows petitions to be made based on a much wider range of fact situations and remedies are awarded in a far higher proportion of cases than under the predecessor section.

Consequently, s 994 petitions are extremely popular. Many petitioners now choose to seek relief pursuant to ss 994–996 who, prior to 1980, would have:

  brought an action asserting a particular personal right, based on breach of contract, breach of duty or a statutory provision providing him with a cause of action;

  presented a winding-up petition on just and equitable grounds; or