Companies act 2006: the impact on directors - update

July 2007

Extended right for shareholders to sue directors

Currently, at common law, a shareholder can bring an action on behalf of and for the benefit of the company in respect of a wrong done to the company. This is known as a derivative action because the shareholder’s right to claim derives from a right of the company to claim in respect of the wrong done to it. There are two important principles of English company law on which the common law derivative action was founded: the “proper plaintiff” rule and the “majority rule” principle (together referred to as the rule in Foss v Harbottle (1843)). The “proper plaintiff” rule provides that it is for the company itself (and not a shareholder) to bring proceedings to pursue an alleged wrong against it. The “majority rule” principle states that a board decision that has been ratified by shareholders cannot subsequently be challenged by those who disagree with it. Both of these rules reflect the English courts’ reluctance to interfere in companies’ decisions.

The changes introduced by the Act

Part 11 of the Act, which will come into force on 1 October 2007, implements a Law Commission recommendation to replace the existing derivative action with a new statutory derivative procedure, which has “more modern, flexible and accessible criteria for determining whether a shareholder can pursue an action”. The Law Commission recognised that reform may make it easier for shareholders to exercise their rights but did not see this as a reason for protecting directors who had breached their duties. The Law Commission recommended that the new procedure be subject to tight judicial control and, by reference to Canadian experience in codifying their derivative action, did not anticipate a large overall increase in litigation. However, at the time of the Law Commission’s recommendation in 1997, the new statutory statement of directors’ duties had not been drafted.

Scope

The Act extends the existing derivative action, making it easier for shareholders to sue directors (and others) in the name of the company for a broader range of conduct than is possible under the present common law. Shareholders may sue in respect of an “actual or proposed act or omission involving negligence, default, breach of duty” (including the new duty to promote the company’s success), “or breach of trust by a director of the company”. Notably, in a significant change from the present law, directors can be sued for negligence even where they have not personally profited by it. There is no need to show wrongdoer control or fraud on the minority.

Procedure

Although it will be easier for a shareholder to bring a claim, he will then need the court’s permission to continue it. The Act provides for a two-stage procedure for permission to continue a derivative claim:

• first, the claimant must show a prima facie case. The court will decide this on the basis of evidence filed by the claimant only. The court must dismiss the application if the claimant cannot show a prima facie case. The court can also make consequential orders, including as to costs, at this stage; and
• second, if the claimant’s evidence does disclose a prima facie case then the court may adjourn the application to require the company to provide evidence and, on hearing the permission application, the court may dismiss the application (for instance if the company’s evidence rebuts that of the claimant) or grant permission to continue the claim.

The court must dismiss the application at this second stage if it is satisfied that:

• a person seeking to promote the success of the company for the benefit of its members (i.e. a hypothetical director) would not continue the claim (this is a high threshold for those opposing the action to satisfy); or
• the conduct complained of has been authorised or subsequently ratified by the company (i.e. the shareholders) (although the law relating to ratification has been tightened by the Act as explained above).

If neither of those bars is met, the court has discretion to grant permission to allow the claim to continue. In doing so, the court must consider the factors set out in the Act, namely:

• whether the claimant is acting in good faith;
  
• the importance which a director promoting the success of the company would attach to continuing the claim;
  
• whether the conduct complained of would be likely to be authorised or ratified by the company;
  
• whether the company has decided not to pursue the claim itself;
  
• whether the claimant could bring a personal claim in his own right (i.e., under section 459 CA); and
  
• finally, the court must pay particular regard to the views of any disinterested shareholders.

Although the Act gives the courts a very broad discretion to decide such claims, it also helpfully sets out, for the first time, the factors which they must consider in deciding whether to grant leave. Unfortunately, though, no guidance is given as to what weight will attach to each of the factors. Nor is it clear that the courts are not free to consider factors other than those listed in the Act.

Margaret Hodge issued a Written Statement on 26 June 2007 regarding the Government’s position on certain key areas covered by its February 2007 consultation paper on implementation of the Act. In it she confirmed that, in light of responses to the consultation, the new court procedures will be used for all derivative claims commenced on or after 1 October 2007. However, where the director’s act or omission the subject of the claim occurred before 1 October 2007, the courts will determine the outcome of the claim on the basis of the common law that applied at the time of the act or omission.

Directors’ views

Although a director’s views on the wisdom of continuing a derivative action are a factor to be considered by the courts, they are not determinative as the Act sets out an objective test for the courts to apply: namely, the importance a person seeking to promote the company’s success would attach to continuing the claim. This is an objective test requiring the court to consider the views of a hypothetical director rather than the subjective views of the directors of the company involved in the litigation. Furthermore, a director’s views are just one of the factors the court must consider in deciding whether to grant permission.

Ratification

Ratification will continue to limit the ability to bring derivative actions. See Ratification of directors’ breaches.

In relation to derivative actions, the Act provides that if the conduct complained of has not actually been ratified, the court must consider whether the conduct “could be, and in the circumstances, would be likely to be”, ratified by the company. (Currently, following the majority rule principle, no derivative action may be brought if the conduct complained of is ratifiable, even if it has not been ratified.) However, this is simply one of the factors for the court to consider in exercising its discretion whether to grant the claimant permission to proceed. Although the court may adjourn proceedings to allow the company to pass a shareholders’ resolution ratifying the conduct this may not be a practical solution for quoted companies with a large shareholder base.

The changes to the law may make it more difficult to either achieve ratification or even demonstrate that ratification is likely, with the result that more shareholders may obtain leave of the court to continue a derivative action.

Constraints on bringing actions

There are three main constraints on bringing a derivative action:

• first, the claimant must show that the company has suffered financial loss;
  
• second, the court generally awards costs against a claimant if it refuses leave to proceed; and
  
• third, because a derivative claim is a claim brought for and on behalf of the company in respect of a wrong done to the company, any damages awarded belong to the company and not to the claimant.

Generally, in English cases, costs follow the event so that if a claimant is unsuccessful he will be liable for the costs of bringing the claim. The court can, in appropriate cases, order the defendant company to indemnify the claimant against the costs of the action, whether or not the action succeeds. This will, however, require the claimant to demonstrate that such an indemnity is necessary; the test being whether an independent board would bring the action.

These factors may act as a break on any potential litigation.

What does this mean for directors?

In extending the conduct in respect of which shareholders can complain, there is concern that the new provisions may be abused by disgruntled or activist shareholders, especially in quoted companies. In addition to the possibility of claims for negligence, the ability to claim for breach of duty would allow a shareholder to bring a claim for breach of any of the general statutory duties imposed on directors by the Act, especially the new duty to promote the company’s success as well as regulatory obligations, of which there are many. Shareholders in quoted companies could bring claims for matters such as breaches of the Listing Rules or the new Disclosure and Transparency Rules. We are seeing more shareholder activism in the UK, and Europe, and some well-organised shareholders, especially hedge funds and pressure groups, may use the new procedure as an additional weapon in their armoury of tools to push for change at companies run in a manner which they are unwilling to accept. Even if a claim is unmeritorious, the mere fact that it has been brought will waste management time and may result in adverse publicity for the company concerned. Companies may wish to consider how they would deal with the threat of a derivative action. The potential for successful derivative claims remains very limited. Threats of litigation, however, may become more frequent – particularly once Part 11 is brought into force in October this year – as parties test the boundaries.

Directors’ and officers’ (D&O) insurance

As derivative claims are brought for and on behalf of the company, a company cannot indemnify directors against them. A possible solution would be to ensure that defending derivative claims is covered in directors’ and officers’ insurance. Derivative claims can sometimes be excluded from D&O insurance so it would be worth company secretaries checking policies to ensure that defending them is covered. If such claims are excluded companies should consider amending their policies to include them. Recently, rates for D&O insurance have been falling so it should be possible to obtain cover at competitive rates. Premiums are unlikely to rise to reflect changes in the law until we have had some two to three years’ worth of claims being made.

Next section: Other changes affecting directors