SHAREHOLDERS' RIGHTS - PART I - COMMON LAW DERIVATIVE ACTION
It is a general principle of company law that an individual shareholder cannot sue for wrongs done to a company or complain of any internal irregularities. This principle is commonly known as the rule in Foss v Harbottle.
Rule in Foss v Harbottle
In Foss v Harbottle (1842), two shareholders commenced legal action against the promoters and directors of the company alleging that they had misapplied the company assets and had improperly mortgaged the company property. The Court rejected the two shareholders' claim and held that a breach of duty by the directors of the company was a wrong done to the company for which it alone could sue. In other words, the proper plaintiff in that case was the company and not the two individual shareholders.
This rule is derived from two general legal principles of company law. Firstly, a company is a legal entity separate from its shareholders. Secondly, the Court will not interfere with the internal management of companies acting within their powers. Where an ordinary majority of members can ratify the act, the Court will not interfere. This simply means, if the majority can ratify an act, the minority cannot sue.
However, there are four exceptions to the rule in Foss v Harbottle, namely :-
- ultra vices or illegal acts;
- transactions requiring special majorities;
- personal rights; and
- the “fraud on the minority” exception.
For the purpose of this article, I will concentrate on the last exception, that is, fraud on the minority, which is the most common ground for derivative actions.
The fraud on the minority
Under this exception, a minority shareholder can bring an action on behalf of the company, where he can show :-
- the wrong constitutes a "fraud against the minority"; and
- the "wrongdoers are in control of the company" and will not allow the company to sue.
Fraud against the minority
The Court has interpreted the term "fraud" loosely to include fraud in a strict sense as well as a breach of duty which results in conferring some benefit on the directors or third parties.
It has been held that gross negligence may also amount to fraud against the minority. The Court will allow a derivative claim where the wrongdoers have benefited personally from their self-serving negligence. Typical examples include, diverting business from the company to themselves in breach of fiduciary duty, causing the company to sell assets to themselves at an undervalue, or selling worthless assets to the company.
Wrongdoers are in control of the company
Control of a majority of the voting shares was believed to be necessary to bring a derivative action. However, the Court of Appeal in Waddington Limited v Chan Chun Hoo Thomas and others [2006] adopted the more flexible concept of de facto control. In that case, a minority shareholder in a listed company brought an action against a director in respect of wrongs done to various subsidiaries. Although the director did not have voting control, the Court found that he was in de facto control of each of the subsidiary companies in the group.
Restrictions
The major restrictions to a successful derivative action relate to the obscurity of the law and the costs of the proceedings.
Owing to the ambiguity surrounding the notions of "fraud against the minority" and "control by the majority", the Court has in the past held that the question of the locus standi of minority shareholders should be dealt with first as a preliminary issue before the trial of the action.
It must also be borne in mind that if a derivative action is successful all recovery flows to the company and the plaintiff shareholder only receives a small pro-rata benefit. Only in appropriate cases will the unsuccessful plaintiff/shareholder's costs be indemnified by the company.
In view of the above restrictions, I shall look at the new statutory provisions in Part II of this article.
Albert Lam
March 2012