New derivative action may lead to increased claims against directors

A new statutory framework for derivative actions comes into force today under the Companies Act 2006. These provisions widen the scope of such actions and have the potential to increase claims against directors.

The Action

A derivative action is a claim against a director brought by a shareholder on behalf of the company. Such claims are brought when a wrong has been committed against the company which the company itself does not pursue.

Before today, shareholders could only bring derivative actions in very limited circumstances. Generally, an action could be brought only where the conduct complained of amounted to a "fraud on the minority", which the company itself was not pursuing because the wrongdoers controlled the company.

The new derivative action allows shareholders to bring claims for:
• any actual or proposed
• act or omission
• involving negligence, breach of duty or breach of trust

by a director, including breach of those duties codified for the first time in the Act. Importantly, the director does not have to have benefited personally from the conduct of which the shareholder complains.

Derivative actions may also be brought against third parties provided the claim arises from a director's default.

As with the former regime, a shareholder will need the permission of the court to continue any derivative claim. The Act, together with amendments to Part 19 of the Civil Procedure Rules that also come into force today, set out in detail how the court will deal with the permission stage.

In summary, after issuing a claim form, the shareholder must issue an application for permission to continue the claim supported by written evidence and notify the company of the claim and the application. The court will then decide whether the shareholder has a prima facie case on the evidence filed by the shareholder. If the court rules against the shareholder at this stage, the shareholder may request that the court’s decision be reconsidered at an oral hearing. If the court decides that the shareholder does have a prima facie case, it may then order the company to file evidence, which will be considered at a full permission hearing. The court will determine whether to grant permission by reference to a number of factors set out in the Act. If permission is granted, the shareholder will then be able to bring the proceedings against the director or third party on behalf of the company.

Comment

The extension of the right to bring a derivative action for negligence or any breach of duty has the potential to increase the number of claims against directors initiated by shareholders. In addition, third parties could find themselves being named in a derivative action, for example, if they enter into a transaction with a company in circumstances where they knew, or ought to have known, that the director concerned was acting in breach of fiduciary duty.

Activist shareholders or special interest groups may use the procedure to object to a company being taken in a particular direction or to highlight a specific issue of concern to them. Other shareholders may also seek to use the procedure as a means of challenging what they regard as bad business decisions.

Shareholders may be discouraged by the fact that any damages recovered will belong to the company, rather than the shareholder, and also by the court’s power to make any settlement conditional upon its consent. However, if the aim of the derivative action is publicity, these factors are unlikely to be much of a deterrent and the opportunity for the shareholder to participate in an oral hearing at the permission stage may even be an incentive to shareholders seeking to air a grievance.

Whether an increase in the number of derivative actions being launched will translate into an increase in the number of claims making it past the permission stage remains to be seen and will depend very much on the court’s application of the new provisions.

Further reading: Directors’ Duties under the Companies Act 2006