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Derivative Actions in Perspective

Derivative Actions in Perspective

A derivative action is an aggrieved minority shareholder’s right of action which essentially derives from the company, and is ordinarily available to members who may seek protection in circumstances which will be addressed in this article. Whilst a claim of this nature is governed by well-entrenched common law principles in Cyprus, it is now subject to statutory regulation under English law, per the Companies Act 2006, the relevant provisions of which have brought to the fore significant substantive and procedural changes (this will be briefly dealt with below). Although these legislative developments are not applicable in Cyprus, it is nevertheless useful to refer to the concise statutory definition of a derivative action which is given as “proceedings brought by a member of a company in respect of a cause of action vested in the company and seeking relief on behalf of the company.”

To gain a better insight of a derivative action’s mechanisms, it would be prudent, for contextual purposes, to put matters in their proper perspective, so as to facilitate a better understanding of how this equitable remedial device is accommodated in the corporate scheme of things. This approach necessarily calls for addressing the so-called rule in Foss v Harbottle (1843) 2 Hare 461, (the “Rule”), the underlying elements of which are integral components of this analysis, and emanate from the evergreen Salomon v Salomon principle of separate personality, together with the understandable reluctance of the courts to intervene in the company’s internal management issues, when it acts within its powers, or when ratification may be effected by the majority of the corporate entity’s members. As will be evident from the ensuing text, whilst the Rule essentially has procedural characteristics which deal with the issue of legal standing (“locus standi”) as to who may institute a claim, it necessarily encompasses other core aspects of the corporate governance regime which are concerned with the the notion of majority rule and minority protection, as well as the multi-party statutory contract under S.21 of the Cyprus Companies Law CAP 113, the provisions of which pertain to the nature and implications of the memorandum and articles of association, and define their legal status as key constitutional documents.

As previously stated, the position set forth above was evident in Foss v Harbottle, a landmark case which declared the inability of certain shareholders to institute a claim against the directors who had misapplied corporate property, on the basis that the matter of whether to sue or not, lay squarely on the shoulders of the company. The reasoned analysis of the court’s approach was manifested and expressed as a two-pronged rule, the essence of which is as follows:

  • When a wrong is perpetrated against the company, the proper claimant is the company itself (in effect, it will ordinarily be incumbent on the board of directors to institute proceedings, although such responsibility will lie with the majority of shareholders in the event that the directors themselves are the alleged wrongdoers).
  • In circumstances where a simple majority of the shareholders could conceivably sanction the wrong in question (i.e. is capable of being ratified), an individual member will thereby be precluded from initiating any action in relation thereto. This aspect is perhaps better explained as denying a member the opportunity to initiate a claim in circumstances where the wrong is ratifiable, and not where it has in actual fact been ratified.

 It is evident from the foregoing, that the strict implementation of the rule could conceivably have somewhat harsh implications in that, at first glance, a member would effectively be prevented from insisting that the company conducts its affairs in compliance with the articles. Furthermore, it would potentially present a corporate entity with an opportunity to promote the interests of the majority shareholders, to the ultimate detriment of the other members. By the same token, a climate would be created whereby directors’ decisions at board level (along with their ability to influence voting patterns in general meetings), could conceivably inspire or encourage them to conduct corporate matters and managerial functions in a manner tantamount to promoting their own self-interest.

The misgivings associated with the potentially adverse implications of the Rule, as revealed in the preceding paragraph, prompted the formulation of exceptions to its strict application. This development came to the fore in Edwards v Halliwell [1950] 2 All ER 1064, (and judicially endorsed by the Supreme Court of Cyprus in Aimilios Thoma v Jacob Eliades [2006]), where Jenkins J duly addressed the particular instances in which a member would not be barred from bringing forth a claim. In essence, he considered that the Rule would not preclude a shareholder from suing in the undermentioned circumstances:

  •  where the particular act complained of is illegal or wholly ultra vires the company. In such cases the majority of shareholders would be precluded from ratifying the transaction in question. Should such a transgression occur, it would be tantamount to a breach of the statutory contract (refer S.21 CAP 113), or constitute a wrong perpetrated against the company by the directors. As such, proceedings may conceivably be initiated by way of either a personal action or derivative claim.
  • where, as in the case of a special resolution, the matter called for the consensus of a special majority of the members (as opposed to a simple majority), and this was not respected.
  • where the individual rights of a member have been violated (Z&I Mediterranean Leisure Investments Limited & Others v Ioanna Iliadi-Loizou (2007). Whilst an infringement of a shareholder’s personal rights may trigger a claim under the statutory contract per S.21 CAP 113, this aspect has presented a number of conceptual difficulties which are beyond the scope of this article and would warrant separate consideration and analysis. Suffice it to say, that various problems have surfaced as regards the enforcement of outsider rights, and complications appear to have emerged in efforts to distinguish between breaches of the articles which are to be regarded as individual rights (and thereby enforceable against the company by a member in his personal capacity), and those “grey area” contraventions which could arguably be viewed as being in a shareholder’s interest in seeking to have the company’s affairs managed in conformity with the corporate constitution. Whilst McDougall v Gardiner appears to preclude an individual member from instituting a claim in the latter situation, commentators such as Professor Wedderburn, citing Quinn & Axtens v Salmon [1909] AC 442, are of the view that such an action does in fact lie in these circumstances, by virtue of the statutory contract (S.21 CAP 113) which binds the company and its members ( indeed , this aspect was viewed as a separate exception to the Rule, in its own right, in Iacovos Chimonides Investylia Public Co Ltd [2008]). However, this approach would appear to raise an additional issue for determination, to the extent that a further distinction would thereby need to be made between what may conceivably be perceived as a mere internal irregularity (whereby the company would be the appropriate claimant), and a matter which could, in essence, be treated as a contravention of the corporation’s constitution (in which case an individual member would be at liberty to sue by way of a personal action).
  • where what has been done amounts to a fraud on the minority. As to what might constitute fraud in this context, the courts would appear to have afforded the term a relatively broad meaning, to the extent that it may not only encapsulate instances of fraud in the strict/narrow sense, but could conceivably extend to embrace a breach of duty which may culminate in conferring a benefit on the directors or other wrongdoers. What can be said with some certainty is that whilst the precise boundaries of what constitutes fraud are not clear, it is evident that they go beyond the traditional common law perception of the notion initially propounded in Derry v Peek (1889) 14 App Cas 337. In essence, there would appear to be a leaning towards a more liberal interpretational position which accords with the courts approach in Eastmanco (Kilner House) Ltd v Greater London Council [1982] 1 All ER 437, which was based on the reasoning that “the essence of the matter seems to be an abuse or misuse of power”. This wider meaning of fraud more or less echoed what had previously been stated by Templeman J in Daniels v Daniels [1978] Ch 406, when he declared that an action would effectively lie, where directors could be shown to have abused their powers “intentionally or unintentionally, fraudulently or negligently, in a manner which benefits themselves at the expense of the company”. Whilst it is clear that negligence culminating in the misappropriation of the company’s assets would fall within the ambit of fraud in this context, case authority nevertheless suggests that this should not be stretched unnecessarily, and that shareholders should show tolerance in drawing a line where, for example, directors who could best be described as “an amiable set of lunatics”, did not (despite their undoubted negligence), derive any benefit from their actions (Pavlides v Jensen [1956] Ch 565.)

The foregoing affords a contextual indication of the circumstances in which a derivative action may come into play. In essence, where a member’s individual rights are involved, he is at liberty to institute a personal action, whereas if the right of action effectively lies in the company’s hands, but the wrongdoers themselves control the company, a member would thereby be entitled to initiate a derivative action – so called by virtue of the fact that the claimant’s right to sue, “derives” from the company. Such action would lie in circumstances where there has been fraud on the minority which, in reality, and despite the use of somewhat misleading terminology, is a fraud committed on the company (and not on the minority as such), which would entitle a shareholder to sue by way of derivative procedural mechanisms. Needless to say, the fraud which constitutes the bulk of minority complaints, in the context of derivative actions, usually emanates from directors’ actions during the course of undertaking their managerial functions. In view of the fact that such directors may themselves enjoy a controlling shareholding or, alternatively, are capable of harnessing the support of controlling shareholders, a further qualification necessarily comes into play, to the effect that a derivative action would only be permissible in the undermentioned circumstances:

  • The wrongdoers are in control, in the sense that they are in a position to obstruct any initiative to institute proceedings against the company.
  • The majority of independent shareholders are in favour of proceeding with such action. In effect, the majority of the minority ought to have a say in whether the path to litigation should be pursued.

Prior to addressing these aspects, mention should be made of an apparent procedural oddity that is characteristic of derivative actions, to the effect that the company, on whose behalf the claim is instituted, is to be duly designated as a nominal defendant (along with the wrongdoers), in order to ensure that it is bound by the judgment from which it may thereby benefit. Small wonder therefore that Paul L Davies declares it to be “highly misleading to find that an action to enforce the company’s rights, takes the form, apparently of an action against the company” (Gower and Davies’ Principles of Company Law, at p454). Nevertheless, whilst on the face of it, this would appear to be a somewhat peculiar requirement, it does stand to reason that the company itself may not be designated as plaintiff in the absence of such action being sanctioned by the general meeting or board of directors. It is also pertinent to mention that any moneys recovered pursuant to a derivative action shall be for the company’s account and not for the benefit of the individual aggrieved minority member who instituted the proceedings.  

Returning to the issue of wrongdoer control, it is incumbent on the claimant to substantiate the fact that the perpetrators of the alleged fraud enjoyed a sufficient measure of control, so as to effectively obstruct the prospect of initiating legal proceedings on behalf of the company. This aspect does however give rise to the question of whether “de jure” control would be necessary to satisfy the requirement, or whether it would suffice to establish “de facto” control in this regard. In the former sense, the element of control would necessarily be determined by whether the wrongdoers actually own or control the majority of shares (as in the Pavlides case where the register of members reflected a clear numerical majority), whereas in the latter sense, the issue would hinge on whether the perpetrators are able to wield sufficient influence to secure control and thereby prevent proceedings from being instituted (a point that was aptly stated by the Court of Appeal in Prudential Assurance Co Ltd v Newman Industries Co Ltd (No 2) (1988), in declaring that it would in fact suffice if such control emanated from votes “cast by the delinquent himself plus those voting with him as a result of influence or apathy”). The principle of control in the latter sense, was duly adopted by the Supreme Court of Cyprus in Theodoros Pirillis v Eleftherios Kouis (2004), which identified the determining criterion for control as being the company’s ability or otherwise of bringing forth a claim itself. As previously mentioned, the control factor appears to have been further qualified to narrow down its scope, with the supplemental requirement that the claimant would only be afforded the requisite locus standi to sue, if the views “of the majority inside the minority” were to be sought – the idea here being that if the majority of these so-called independent minority shareholders should oppose proceedings, the claimant would thereby be precluded from initiating a derivative action to enforce the company’s rights. (per Knox J in Smith v Croft (No 2) [1988] Ch 114).

In addition to the foregoing, further procedural obstacles appear to have emerged to hamper a disenchanted shareholder’s ability to commence a derivative action. These somewhat restrictive factors initially came to light in Barnett v Duckett and Others [1955] BCC 362, where the Court of Appeal declined to sanction such proceedings on the basis that it could not be shown that these were being pursued bona fide for the benefit of the company. Furthermore, the court expressed its reluctance to allow the claim to proceed, having regard to the fact that there was an alternative remedy available to the aggrieved shareholder. This judicial approach may be seen as being inspired by equitable considerations from which the derivative action originally emanated, so that its availability to an aggrieved member was essentially a matter to be left to the discretion of the court. In addition to determining whether any other remedial options might have been open for the complainant, due cognisance would also be taken of other material circumstances such as the claimant’s motives, and his overall conduct throughout the process of pursuing a claim of this nature. In this regard, it should be pointed out that any moneys recovered pursuant to a derivative action, shall be for the company’s account and not that of the member who instituted the claim.

In the event that a company has gone into liquidation, a minority shareholder will be denied the opportunity to bring a derivative action, by virtue of the fact that the right to do so is properly vested in the liquidator who effectively takes over the reins of corporate control from the board of directors and general meeting (Fargo Ltd Godfrey [1986] 2 BCC 99, 167). Should the liquidator decline to initiate such action, the members are at liberty to ask the court that he should do so, or that they themselves may institute a claim on the company’s behalf.

As previously stated, in the event that money is recovered pursuant to a derivative action, payment thereof shall be made to the company and not to the aggrieved shareholder. This stands to reason in that the wrong which is alleged to have been perpetrated, essentially culminates in a loss to the corporate entity and not the individual member concerned. Accordingly, a shareholder would be denied a personal action in such circumstances. Indeed, this would be so, despite the likelihood of any contention on his part, that the wrong perpetrated against the company, occasioned a diminution in the market value of his shares, or a consequential reduction in dividend levels. This aspect was explained by the Court of Appeal in Prudential Assurance Company v Newman Industries (No 2) (1982) which considered same as “merely a reflection of the loss suffered by the company”, in that the shareholders’ only loss was effectively that which was sustained “through the company, in the diminution of the value of the net assets of the company”. Notwithstanding this, an individual member would nevertheless be at liberty to institute a personal claim in circumstances where he can establish that the wrongdoer was in breach of a tortious, contractual or other legal duty owed him, with the result that his loss was entirely unconnected with that incurred by the company (refer Walker v Stones (2001) 2 WLR 623 CA, where such a duty stemmed from a trust situation).

In the context of corporate group structures, mention should be made of multiple derivative claims which entail a process by which a shareholder of a holding company may institute proceedings on behalf of a wronged subsidiary entity. Aside from a single derivative claim which is addressed herein, it is conceivable that a so-called multiple derivative action, may be brought forth by an aggrieved minority shareholder. Pursuant to this, a member of a parent company who has been exposed to the same wrongdoer control as its subsidiary, is at liberty to initiate proceedings in respect of a cause of action which, in essence, accrues to the parent company’s subsidiary. As is evident, taking this somewhat unorthodox remedial path is permissible, notwithstanding the fact that the individual claimant is a member of the subsidiary’s holding company, as opposed to being a direct shareholder of the subsidiary (on whose behalf he is suing derivatively), which would ordinarily be called for in conventional “single” proceedings of this nature. Where it can be established that the directors of the holding company and its subsidiary are capable of obstructing a claim which is in fact vested in the latter entity, a shareholder of the former may nevertheless bring a double-derivative action on behalf of the latter “first tier” concern (or indeed, a so-called triple derivative action where the alleged wrongdoing complained of encompasses a “second tier” subsidiary). Such a scenario is likely to arise where a shareholder may have invested in a parent company, in circumstances where assets are held, and actual business operations and activities are conducted by, its subsidiary entity which lies further down the group’s corporate structure. A point of interest in this regard, is that whilst single derivative actions under English law have been placed on a statutory footing (refer below), matters concerning multiple derivative actions continue to be governed by common law principles (as is currently the case in Cyprus), which appear to have survived the applicability of sweeping legislative intervention (Universal Project Management Services v Fort Gilkicker Ltd [2013] EWHC 348).       

It remains to be seen as to whether derivative actions in Cyprus will continue to retain their present form, particularly in light of statutory intervention (by way of the Companies Act 2006), which has significantly altered the landscape under English law, in recognition of the prohibitive costs involved, as well as substantive ambiguities and procedural complexities encountered in such proceedings. Importantly, the scope of these actions has been widened, so that fraud on the minority and the element of wrongdoer control need no longer be established. In essence, the previous common law requirements have been simplified, whilst the parameters of such actions have been extended to encapsulate instances of negligence, default, breach of duty, breach of trust by former or current directors or shadow directors of the company. Following an application by a member, a two-stage process ensues which initially calls for establishing a prima facie case for preliminary permission to continue the derivative claim, whereupon the matter will thereafter proceed with final permission proceedings. Suffice it to say that no conceptual changes have been effected in terms of regarding the company as the proper claimant, a position which, as before, would `mean that shareholders shall continue to pursue matters derivatively, and that any ensuing award made would continue to be placed solely in the hands of the corporation - a state of affairs which commentators see as a potential disincentive for member s to institute such actions.

The upshot of the foregoing is that there are certain procedural and substantive complexities in coming to grips with the constituent elements of a derivative action which call for appropriate expert advice to be had. With this firmly in mind, a systematic analytical approach may be pursued, with a view to ensuring that any initiative taken by a disenchanted minority shareholder is not unnecessarily hampered by conceptual obstacles, or legal pitfalls, which might otherwise emerge in ensuing proceedings.

This content is solely for general information purposes. None of the information herein should be relied on or substituted for specific professional advice regarding a particular matter or situation and no person should act or refrain from acting on the basis of the information contained in this brochure without first obtaining advice from an attorney. A.G. Erotocritou LLC is not engaged in rendering legal services or advice by providing the information contained in this brochure. © A.G. Erotocritou LLC, a Cyprus lawyers’ limited liability company regulated by the Cyprus Bar Association, with registration number HE 326006. Address: 1 Arch. Kyprianou and Ayiou Andreou Str, Loucaides Building, 6th floor, 3036 Limassol Cyprus I website: www.erotocritou.com I Telephone: +35725370101 I Fax: +35725370102 I email: info@erotocritou.com

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