Shareholder disputes – understanding derivative claims and their uses

What are derivative claims?

Derivative claims refer to claims brought by shareholders on behalf of a company against a director or third party.

It is usually the position that when a wrong is committed against a company, the appropriate party to bring the claim is the company itself. The decision to do so lies principally with the company’s board of directors, who are responsible for managing its day-to-day operations, and not with its shareholders. But what happens when, for example, the wrongdoing in question is committed by a director and the other directors refuse to act?

The Court has discretion to allow shareholders to pursue these claims on behalf of the company, typically where a director or directors are alleged to have breached their duties or mismanaged the company. These are known as “derivative claims”, as the benefit of the claim goes to the company and not the initiating shareholder.

What constitutes a statutory derivative claim?

There are procedures under both statute and common law for bringing derivative claims.

Dealing first with statutory derivative claims (under Part 11 of the Companies Act 2006), these can only arise in relation to an actual or proposed act or omission by a director involving:

• Negligence
• Failure to comply with statutory duties under the Companies Act 2006
• Breach of contractual or other duties
• Breach of trust.

Importantly, shareholders are not required to show that the director or directors in question benefitted personally from the alleged misconduct, which is different from claims brought under common law.

There is a two-stage process that a shareholder must follow in order to obtain the Court’s permission to pursue a statutory derivative claim:

Stage 1: initial review of the claim

The shareholder must seek permission from the Court to commence derivative proceedings. The Court will firstly review the shareholder’s application on paper only, without oral submissions, to determine whether there is a case to be answered.

If the Court decides that there is a case for granting permission to continue the claim, it will give directions as to evidence to be provided and will add the company, directors and other relevant parties as respondents to the application.

Stage 2: substantive hearing of the claim

If the application passes the first stage, the Court will then hold a full hearing of the application for permission. The Court will hear evidence from all interested parties at this hearing and scrutinise this in order to decide whether the derivative claim should continue, and if so, under what conditions.

When making this assessment and deciding whether to use its discretion, the Court will consider whether the derivative claim is in the best interests of the company. It will also consider various other factors, including:

• Whether the shareholder is acting in good faith
• The importance that a person acting in accordance with the duty to promote the success of the company would place to the proposed derivative claim
• Whether the company has decided not to pursue the claim by its directors
• Whether the shareholder has an alternative cause of action available that they could pursue personally rather than on behalf of the company.

The Court will also look beyond the strength of the shareholder’s claim, including the size and cost of the claim and the prospects of recovery from the director or directors if successful.

If permission is granted, the claim proceeds to trial. If it is denied, the claim is dismissed.

When must the Court refuse permission?

The Court must refuse to grant permission for a statutory derivative claim to continue if it finds that either:

1. Pursuing the claim would be contrary to the duty to promote the success of the company; or
2. The proposed or past act or omission for which the shareholder/s want to bring the claim has been:
   • a) Authorised by the Company before it occurred; or
   • b) Ratified by the Company since it occurred.

However, certain acts cannot be authorised or ratified, including:

• Acts which are ultra vires (meaning beyond the company’s powers)
• Illegal acts
• Fraudulent conduct
• Acts which harm the interests of the company’s creditors.

Common law derivative claims

Claims brought outside the provisions of the Companies Act 2006 are rare in practice. They usually arise in situations where a shareholder of a parent company wants to pursue a claim vested in a subsidiary company (known as a ‘double derivative claim’) or a claim vested in a subsidiary of a parent company’s subsidiary (a ‘triple derivate claim’). These are known as common law derivative claims, which also arise in respect of LLPs or overseas companies.

The process for bringing such claims is distinct from the statutory process but involves similar principles, such as seeking the Court’s permission to continue the claim and the Court retaining a discretion to allow such claims by reference to the company’s best interests.

If a derivative claim succeeds, what can the Court do?

There are a wide range of remedies available to the Court when a derivative claim is successful at trial. It can order the removal of a director from their role, order the director to pay damages and/or costs of the claim to the company or even order an injunction preventing that director from undertaking certain actions in the future.

Derivative claims allow minority shareholders to protect both their interests and the interests of the company in situations where the directors or a majority of shareholders fail to act. They can be an effective method to hold company directors to account for their wrongdoing. However, as you can see, bringing such claims is rarely straightforward as there are many hurdles to be passed and pitfalls you should seek to avoid.

If you require advice on bringing or defending a derivative claim, please get in touch with our expert team and we would be happy to assist.