Derivative claims against directors - are you at risk? Companies Act 2006

Transcription

1 Derivative claims against directors - are you at risk? December

2 Background It is more than three years since the ( Act ) introduced a new statutory regime for derivative claims. Concerns were raised that this, coupled with the codification of directors general duties under the Act, would lead to increased volumes of claims against directors. We examine: a. whether these concerns were justified; b. the safeguards provided against frivolous or vexatious claims; and c. what steps company directors can take to guard against potential claims. Part 1 of this note summarises the relevant provisions of the Act, while Part 2 considers the early decisions of the courts and the practical implications for companies and directors. What is a derivative claim? A derivative claim is defined by the Act as proceedings brought by a member of a company: in respect of a cause of action vesting in the company, and seeking relief on behalf of the company. Ordinarily, it would be for the company itself to pursue the action. However, it may not be possible for the company to do so where the claim is against the company s own directors, who are in a position to prevent this. Common law Before looking at the statutory regime, it is worthwhile considering briefly the position at common law. As a general rule, where a wrong is done to a company, it is only the company which may sue for the damage caused to it and a member has no right to bring an action in order to protect the value of his shares or interest. This is often referred to as the rule in Foss v. Harbottle following the 19th century case in which it was laid down. A number of limited exceptions have been developed, but essentially only where there has been a fraud on the minority, typically involving expropriation of company money or property by the directors who control a majority of the shares. This area of common law is generally recognised to be complex and obscure. Part 1 - Derivative claims under the Act Statutory regime The new regime under the Act took effect from 1 October It does not remove the rule in Foss v. Harbottle, but provides a further exception to that rule and replaces the common law derivative action. Under the Act, a derivative claim can 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 the company. These categories are significantly wider than the common law exceptions. In particular: the common law requires some element of lack of good faith and/or benefit to the wrongdoers, and arguably would not apply in the case of negligence alone; and under the common law, the member would have to show that those implicated in the fraud were in control of the company, but this is not a requirement under the Act. The cause of action may be against the director or another person (or both), although it is likely to be rare for a claim to be brought against a third party possibly this could arise where the third party knowingly receives company funds or property from a director who is in breach of trust. A shadow director is treated as a director for the purposes of derivative claims. It is possible for a member to bring or continue a derivative claim where the cause of action arose before he became a member. 2

3 Permission to continue a claim During the passage of the Companies Bill, concerns were raised that directors could become subjected to a large volume of unmeritorious claims which prevent them from running the company s business. Examples were given of environmental activists buying shares in oil companies in order to launch derivative claims. As a result, the Act introduced a preliminary hearing aimed at weeding out frivolous or vexatious claims. Having issued the claim form, the member must apply to court for permission to proceed with the derivative claim, and has to make out a prima facie case. Various consequences follow: a. if a prima facie case is not disclosed by the application and the evidence filed with it by the member, the court must dismiss the application and may make any consequential orders considered appropriate, which could include a costs order against the applicant; b. if the court does not dismiss the application at the first stage, it may give directions for the filing of evidence by the company and may adjourn the application for that evidence to be obtained; and c. on hearing the application, the court may grant permission to continue the claim on such terms as it thinks fit (which could include requiring the company to indemnify the applicant against the costs of bringing the proceedings), or dismiss the claim, or adjourn the proceedings and give such directions as it thinks fit. Permission could be granted to continue the claim up to trial, but the court might alternatively grant permission on a shorter term basis essentially requiring the position to be reviewed at regular intervals over the course of the proceedings. Relevant factors The court will take into account a number of factors in determining whether to give permission for the applicant to continue the claim. It must refuse permission if it is satisfied: a. that a person acting in accordance with section 172 of the Act (the general duty of a director to act in the way he considers in good faith would be most likely to promote the success of the company for the benefit of its members as a whole) would not seek to continue the claim; or 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 (i.e. by a shareholder resolution); or c. where the cause of action arises from an act or omission that has already occurred that the act or omission was authorised by the company before it occurred, or was subsequently ratified by the company. The first criterion has been interpreted in the early caselaw to apply only where the court is satisfied that no director acting in accordance with that general duty would seek to continue the claim. If some directors would, and others would not, seek to continue the claim then the court would proceed to consider the discretionary grounds discussed below. It should be noted that in the case of ratification, the director in question and persons connected to him cannot (where members) vote on the resolution. If none of the above factors apply, the court is not obliged to refuse permission to continue but must take into account a number of further factors in determining whether to give permission, including: whether the member is acting in good faith; the importance which a person acting in accordance with the duty to promote the success of the company would attach to continuing the claim; whether the company could and would be likely to authorise or ratify the act or omission; whether the company has decided not to pursue the claim; and whether the member could bring the claim in his own right, such as by way of an unfair prejudice action if so, it is likely to be inappropriate to use a derivative claim. 3

4 The court shall also have particular regard to evidence from members who have no personal interest in the matter. Accordingly, the attitude of independent members as well as independent directors will be influential. Continuation of claims by others A member can apply to continue by way of derivative action either a claim brought by the company, or a derivative claim brought by another member, where: the manner in which the company or claimant commenced or continued the claim amounts to an abuse of process; the company or claimant has failed to prosecute the claim diligently; and it is appropriate for the member to continue the claim as a derivative claim. It is not obvious when this would be necessary, but may be aimed at preventing the directors from starting off an action in order to try to prevent the members from doing so, but then deliberately not pursuing the matter (or arranging for a supportive member to start a derivative action and then to let it drift). Similar principles and procedures apply to those discussed above in terms of the member applying for permission to continue the assumed claim, and the factors which the court will take into account. Part 2 - Impact of the new regime Lessons from the early caselaw As explained above, the statutory regime can apply where the common law would not assist a claimant. Further, the new regime was introduced alongside the statutory statement of directors general duties, and in particular the broad and somewhat imprecise duty under section 172 of the Act. Concerns were expressed that these changes could result in directors becoming involved in defending themselves against a multitude of claims, to the detriment of the company. more to emerge from the period since October 2007 which have simply not yet reached the courtroom. However, it could be that the court s approach in the initial cases is (at least partially) responsible for the low number of actions. The interesting feature of the very first decisions is that consideration of the duty to promote the success of the company has led to the courts refusing permission for the claim to continue. Even if the test for mandatory refusal was not met, because a director acting in accordance with that duty might have continued the claim, it was found on the discretionary test that such director would not have attached much importance to the claim. Accordingly, the very duty which was predicted to cause a proliferation of actions has served to prevent claims surmounting the first hurdle. Admittedly, these early cases were arguably not true derivative claims and could have been more properly pursued as unfair prejudice actions. The first examples have now emerged of claimants succeeding in obtaining permission to continue. Nevertheless, permission may be qualified and in one instance was confined to proceeding to the disclosure stage. This was on the basis that a director acting in accordance with the section 172 duty would pursue the claim to the point where the director alleged to have breached his duties must produce corroborative documents to support his defence. It remains to be seen what further patterns emerge from the caselaw. Overall, it is difficult to be certain whether or not the concerns over multiple claims were overstated. The legislators could claim that the staged application process has fulfilled its intended purpose of weeding out, or simply deterring, unmeritorious claims. Others may contend that it was unrealistic to imagine that derivative actions would increase exponentially on the straightforward basis that (as under the common law) any damages obtained would be paid to the company and the claimant would not benefit directly. So have these concerns proved valid?it is still too early to make a definitive assessment. Despite the recent economic conditions, which have inevitably led shareholders to seek explanations for falling share values, there have only been a handful of reported cases under the Act. There may be 4

5 How should directors respond? The courts are able to dismiss a claim without the directors and company becoming involved at all, but if the application does at least proceed to an initial hearing, the directors can face a difficult choice. They may prefer not to raise any substantive opposition at that stage since this could require the disclosure of board minutes and other documents (and such publicity may be precisely what the member is seeking to achieve). However, there are also risks in simply asserting that the claim is groundless without seeking to contest the application actively. A mini-trial should not be conducted when considering whether to grant permission to continue, but in one of the first cases where such permission was granted it counted against the director in question that he had submitted several personal witness statements yet produced no corroborative evidence. Credence may then appear to be given to the claim where permission to continue is granted, even if the claimant ultimately fails at trial. Conclusion The provisions of the Act regarding derivative claims are a significant development of the law in this area. Directors should ensure that they are fully informed of those provisions, and have policies and procedures in place to deal with any derivative claims that may be issued. Clearly, the best course of action is for directors to minimise the risks of acts or omissions arising which could be challenged using such claims. In this regard, they should ensure that they comply with the directors duties set out in the Act and document appropriately their decision making process (see our separate briefing note: Directors duties: Restatement or substantive change? ). Where a director has reason to apprehend that a claim will or might be made against him in respect of negligence, default, breach of duty or breach of trust, he will have the general right under the Act to apply to the court for relief from liability (in whole or part) on the grounds that he acted reasonably and honestly, and that having regard to all the circumstances of the case he ought fairly to be excused. If facing a potential derivative claim, a director could seek to make a pre-emptive application rather than having to wait and see if the claim is made. Directors would also be advised to examine the company s D&O liability insurance policies, and the indemnities contained in the articles of association and individual service contracts, to see if these arrangements require any extension (subject to the restrictions provided in the Act on a company s indemnification of its directors). 5

6 Contacts Colin Gibson Commercial Litigation Partner t: +44 (0) e: Andrew Blankfield Corporate/Commercial Partner t: +44 (0) e: 6

7 This publication is not a substitute for detailed advice on specific transactions and should not be taken as providing legal advice on any of the topics discussed. Copyright Field Fisher Waterhouse LLP All rights reserved. Field Fisher Waterhouse LLP is a limited liability partnership registered in England and Wales with registered number OC318472, which is regulated by the Solicitors Regulation Authority. A list of members and their professional qualifications is available for inspection at its registered office, 35 Vine Street London EC3N 2AA. We use the word partner to refer to a member of Field Fisher Waterhouse LLP, or an employee or consultant with equivalent standing and qualifications. 8