Corporate fraud - how do minority shareholders obtain redress?

In a case of corporate fraud, where directors have diverted or misappropriated company assets, how are the minority shareholders to obtain redress if the same directors have majority control and can thus block a civil claim by their company?

It is the rule in Foss v Harbottle (1843) 2 Hare 461 (if a wrong is done to a company, the proper claimant is the company itself) which erects the wall which the minority shareholder must clamber over. There is an exception which can help - where there has been a “fraud on the minority” coupled with “wrongdoer control.” Fraud here involves more than just common law fraud and will also include fraud in an equitable sense of abuse or misuse of powers by directors. Examples will include non-ratifiable breaches of duty by directors resulting from misappropriation of company assets. And where the wrongdoers are also in control, the court will allow the minority to bring a derivative claim against the miscreant directors in the name of or for the benefit of the company.

In order to make coherent doubts and uncertainties produced by evolving case law, the Law Commission recommended a more modern and flexible derivative procedure. The result lies in the Companies Act 2006. However, the relevant provisions concerning shareholder actions (sections 260-264) only come into force on 1 October 2007.

Broadened scope

Section 260(3) broadens the scope of a derivative claim. A claim may be brought arising from an actual or proposed act or omission involving negligence, default, breach of duty or trust by a director. Thus, an alleged breach of any of the new general duties of directors contained in Chapter 2 of Part 10 of the Act will be able to be the subject of a derivative claim. This includes the duty to exercise reasonable care and skill (section 174) – this removes the previous doubt where it was unclear whether actions could be brought for negligent actions or omissions of directors, particularly where the negligence was not self-serving.

It is probable that a derivative claim against a person other than a director will only be possible where that person has secondary liability (eg for knowing receipt) resulting from a primary breach by a director.

New requirement – showing a prima facie case

Before seeking permission, as now, to bring a derivative claim on behalf of the company, there is a new hurdle. If the court believes no prima facie case for giving permission is disclosed, it must dismiss the application and may make any consequential order it considers appropriate (section 261(2)).

If the derivative claimant leaps this hurdle, the court may then give directions on the evidence to be provided by the company (section 261(3). Permission will then be sought at a full hearing.

Factors concerning permission

Section 263 sets out several circumstances in which permission must be refused – where a person acting in accordance with a duty to promote the success of the company would not seek to continue the claim, or where the conduct has been authorized or ratified by the company (section 263(2)).

There has also been a change regarding the ability of a company to ratify acts or omissions by directors. Section 239(2) says that a company’s decision to ratify conduct amounting to negligence, default, breach of duty or breach of trust in relation to the company must be made by a resolution of the members. Further, a perhaps logically, however the resolution is proposed – in writing or at a meeting – none of the votes of any director concerned, or any connected person, can be counted. So it is no longer possible for a simple majority of shareholders to ratify the conduct of directors, thus creating a bar on any derivative claim. This is a marked variation from the general principle of majority control.

Importantly, in the context of fraud, this new qualification does not affect the existing law concerning acts which are incapable of being ratified by the company. Examples include a bad faith abuse of power or a misappropriation of assets. Bona fide incidental profit making is ratifiable. Self serving negligence is not ratifiable traditionally, but negligence conferring no benefit on the director may be – even if such negligence causes loss to the company. It also does not affect the existing law regarding decisions taken by unanimous consent of the members and the power of directors to compromise claims on behalf of the company.

When assessing whether to grant permission, the court will take into account:-

(a)    Whether the member is acting in good faith in seeking to continue the claim

(b)   The importance that a person acting in accordance with the duty to promote the success of the company would attach to continuing it

(c)    Where the cause of action results from an act or omission which is yet to occur, whether such could be, and in the circumstances would be likely to be authorized before it occurs, or ratified after it occurs

(d)   Where the cause of action arises from an act or omission that has already occurred, whether the act or omission could be, and in the circumstances would be likely to be, ratified by the company

(e)   Whether the company has decided not to pursue the claim

(f)     Whether the act or omission gives rise to a cause of action that the member could pursue in his own right rather than on behalf of the company

Factor (a) should act as a safeguard in stopping a claim by a protester purchasing a single share solely to bring a derivative claim. The result might be different where the shareholder had held shares for some time and was a genuine investor.

The wording of factor (b) suggests an objective test: the court itself will assess the importance such a person would attach to continuing the claim. However, the views of members with no personal interest, direct or indirect, will be likely to be influential. This reflects the existing law where a members’ majority independent of the miscreant directors not wishing proceedings to continue may prevail upon the court to prevent a derivative claim. However, it is likely that a disaffected shareholder, with the benefit of hindsight, could put together a credible argument that a corporate decision was taken negligently because the directors failed to assess relevant factors or placed undue weight on others.

A derivative claim being continued by another

Section 264 allows another shareholder to apply for permission to continue a derivative claim brought by another if:-

(a)    The manner in which the proceedings have been commenced or continued amounts to an abuse of process

(b)   The claimant has failed to prosecute the claim diligently

(c)    It is appropriate for the applicant to continue the claim as a derivative claim

In making this application, the new claimant must show a prima facie case before going on to a full permission hearing. An identical requirement exists in section 262(3)) regarding a derivative claimant seeking permission to adopt a claim already being pursued by the company.

Conclusion

Where directors are guilty of fraud involving misappropriation of company assets and opportunities, the new Act is unlikely to lead to a different result from the existing law. But the increased scope and simplicity means that, at the margins, members may be more encouraged to bring derivative claims than previously. Moreover, shareholder activism may cause an increase in derivative claims challenging mainstream business decisions by directors. Finally, all the above rights are, of course, in addition to any rights under shareholders agreements.