Derivative Actions Under the Companies Act

A derivative action is a powerful legal mechanism that allows shareholders to bring a claim on behalf of the company against directors or third parties who have wronged the company. Governed by Sections 260–264 of the Companies Act 2006, this remedy is designed to hold those responsible accountable for misconduct or negligence while protecting the company’s interests. This article explains the key aspects of derivative actions, including when they are applicable, how to initiate them, and what remedies they provide.

What Is a Derivative Action?

Unlike personal claims, a derivative action is initiated by a shareholder but seeks to redress harm done to the company itself. The shareholder acts in a representative capacity, aiming to benefit the company rather than their personal interests. This type of claim often involves allegations such as:

• Breach of fiduciary duties by directors.
• Fraudulent activities or misappropriation of company funds.
• Negligence or failure to exercise reasonable care in managing the company.

Derivative actions are particularly relevant when directors, who typically act on behalf of the company, are the ones accused of misconduct, creating a conflict of interest.

When Can a Derivative Action Be Brought?

Under Section 260(3) of the Companies Act, a derivative action can only be brought in respect of a cause of action arising from:

• Negligence.
• Default.
• Breach of duty.
• Breach of trust by a director.

The wrongdoing must harm the company, and the shareholder must demonstrate that pursuing the claim is in the company’s best interest. Claims cannot address purely personal grievances, such as unfair prejudice to the shareholder’s individual interests.

Procedure for Bringing a Derivative Action

Initiating a derivative action involves several procedural steps:

1. Obtain Court Permission

The shareholder must seek the court’s permission to proceed with the claim. The court will evaluate factors such as:

• Whether the claim has merit and is brought in good faith.
• The likelihood of success and whether continuing the action is in the company’s best interest.
• Whether a director acting in accordance with their duties would pursue the claim.

2. File a Claim

In practice, the claim form is issued first and the application for permission is filed at the same time; the shareholder cannot take further steps in the claim (other than those the rules allow) until permission is granted. This involves presenting evidence of the alleged misconduct and its impact on the company.

3. Conduct of the Action

Once the action proceeds, the shareholder acts as the representative claimant, but the benefits of the claim (e.g., compensation) accrue to the company.

Remedies Available Through Derivative Actions

The remedies in derivative actions are intended to rectify the harm caused to the company. Common outcomes include:

• Compensation or Damages: Directors or third parties may be ordered to compensate the company for financial losses.
• Restitution: Restoring misappropriated assets to the company.
• Injunctions: Preventing further harmful actions by the directors or other parties.
• Rescission of Contracts: Voiding agreements entered into under fraudulent or negligent circumstances.

The goal is to restore the company’s position rather than provide personal compensation to the shareholder who initiated the action.

Key Case Law on Derivative Actions

Several important cases have shaped the understanding and application of derivative actions:

• Foss v Harbottle [1843]: Established the rule that only the company itself can sue for wrongs done to it, laying the foundation for derivative actions as an exception.
• Franbar Holdings Ltd v Patel [2008]: Clarified the factors courts consider when granting permission to proceed with a derivative action, such as the company’s best interests and the merits of the claim.
• Kiani v Cooper [2010]: One of the first reported cases in which the court granted permission to continue a derivative claim under the new statutory regime, after weighing the statutory factors, including the claimant’s good faith.

Derivative Actions vs. Unfair Prejudice Claims

While derivative actions focus on harm to the company, unfair prejudice claims address personal grievances of shareholders. A derivative action is appropriate when the misconduct affects the company as a whole, whereas unfair prejudice claims target unfair treatment of individual shareholders.

Challenges in Derivative Actions

Derivative actions can be complex and costly. Challenges include:

• High Burden of Proof: The shareholder must demonstrate clear wrongdoing and its impact on the company.
• Costs and Risks: The claimant may be liable for legal costs if the action is unsuccessful.
• Court Permission: The requirement to obtain permission adds an extra layer of scrutiny.

These challenges make it essential for shareholders to seek professional legal advice before pursuing a derivative action.

Key Takeaways

• Derivative actions allow shareholders to hold directors accountable for harm to the company: They focus on rectifying misconduct that affects the company as a whole.
• Strict procedural requirements apply: Shareholders must obtain court permission and demonstrate that the action is in the company’s best interest.
• Remedies benefit the company, not the shareholder: Outcomes such as compensation or asset recovery are aimed at restoring the company’s position.