DERIVATIVE ACTIONS AND THE ACTIVIST SHAREHOLDER
A COMPANIES ACT 2006 BRIEFING NOTE
The Companies Act 2006 (the “Act”) places the right for shareholders to sue directors for negligence and other defaults (referred to as a “derivative action”) on a statutory footing. This provision comes into force on 1st October 2007.
Under the old law a shareholder could bring an action on behalf of and for the benefit of the company in respect of a wrong done to the organisation. This was known as a derivative action because the shareholders’ rights to claim derive from a right of the company to claim in respect of the wrong done to it.
However, that right of action had become severely restricted by case law in the instance of a director not acting in good faith toward the company. Such narrowing of the right to bring a derivative action had been criticised for resulting in injustices, particularly in respect of minority shareholders.
The Act removes some of these barriers to bringing a derivative claim. It makes two important changes to the common law derivative action. Firstly, it extends the existing derivative action common law right making it easier for shareholders to sue directors in the name of the company for a broader range of conduct than is possible under the present common law.
Secondly, 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.
THE NEW DUTY TO PROMOTE THE COMPANY’S SUCCESS
Section 172 of the Act states:
“The director of a company must act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of the members as a whole, and in doing so have regard (amongst other matters) to:
1. the likely consequences of any decision in the long term
2. the interests of the company’s employees
3. the need to foster the company’s business relationships with suppliers, customers and others
4. the impact of the company’s operations on the community and the environment
5. the desirability of the company maintaining a reputation for high standards of business conduct
6. the need to act fairly as between members of the company.”
The new duty requires directors to promote the success of the company (a subjective test) and in doing so they must also consider the principle of “enlightened shareholder value” which is embodied in the factors 1 to 6 listed above (an objective test).
The list of factors is non-exhaustive. It merely highlights particular areas to which the directors must “have regard to”. It is not clear how directors are expected to balance the different factors they are required to consider or what weight they should attach to them.
It is also unclear what “success for the benefit of the company members as a whole” means. Currently the law requires directors to act in good faith in the best interests of the company. This is, in most cases, judged by reference to the interests of:- current and future shareholders as a body, employees and, in certain circumstances, creditors.
A Department of Trade and Industry’s Guidance Note on the Act states that the decision as to what will promote the success of the company and what constitutes such success is for the director’s good faith and judgment. The Government’s view is that it should not be open to challenge in the Courts provided that the directors make a decision in good faith and have exercised reasonable care, skill and diligence in reaching that decision. This would preserve the Courts’ reluctance to overturn directors commercial decisions provided they have been made in good faith, commonly called “the business judgment rule”.
For example, the directors of Northern Rock are likely to rely upon the “business judgment rule” in the event that a disgruntled shareholder threatens action against them. The board might argue that the raising of finance via the wholesale credit market was a reasonable business strategy and that the company has been a victim of the global credit crunch triggered by the subprime mortgage crisis in the USA which it could not have been predicted. Consequently the “business judgment rule” is likely to defeat any disgruntled shareholder action if the directors can show they acted in good faith and have exercised reasonable care, skill and diligence in adopting their business model in raising substantial finance via the wholesale credit market.
PROCEDURE
Whilst the Act makes it easier for a shareholder to bring a claim (by lowering the threshold to that of negligence), any such claimant will only be able to proceed with its claim with the Court’s permission. The Act provides for a two-stage procedure for permission to continue a derivative claim. At the first “initial filter” stage the claimant must convince the Court that it has a prima facie case for permission to continue a derivative claim. The Court must dismiss the application if the claimant cannot show a prima facie case. At the second stage the Court can require the company to provide evidence, and, on hearing of 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 refuse permission to continue the claim at the second stage if:-
1. A person acting in accordance with a director’s duty to promote the success of the company would not continue the claim; or
2. 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).
If the claimant overcomes these bars the Court must consider the six factors set out in the Act and then decide whether to grant permission to allow the claim to continue. These factors include 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, and whether the applicant could bring a personal claim in his own right (i.e. under Section 459 of Companies Act 1985). In considering whether to give permission, the Court must pay particular regard to the views of any shareholders who have no personal interest in the matter.
REMEDIES
It may be possible to seek injunctive relief, in an attempt to prevent directors from doing something where the directors have failed to have regard to the matters set out in the six factors listed above.
It should also be borne in mind that any damages awarded as a result of a successful derivative action belong to the company and not the claimant. This is because a derivative claim is a claim brought for and on behalf of the company in respect of a wrong done to the company.
COSTS
As derivative claims are brought for and on behalf of the company an organisation cannot indemnify directors against them. Directors are therefore exposed to paying their own defence costs. A possible solution for directors would be to ensure that defending derivative claims is covered by D&O insurance.
CONCLUSION
(i) Derivative actions will be available to Activist Shareholders so long as they can pass the two hurdle test.
(ii) Activist Shareholders must ensure that they do not utilise this right primarily for ulterior motives such as with the predominant intention to embarrass the board of directors of a target company or with the predominant intention of seeking the removal of all or some of the board directors
(iii) Activist Shareholders will need to consider carefully the “business judgment rule” with particular reference to the Courts undoubted reluctance to interfere with decisions even where substantial losses have been incurred and shareholder value has been eroded .If directors have acted in good faith and have exercised reasonable care, skill and diligence in reaching their decision any derivative action is unlikely to succeed.