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Companies Bill: Clause 260 Derivative Claims

17th October 2006

Despite amendments in the other place, which have improved clause 260, part 11 dealing with derivative claims is a complex area that still gives many much concern.

Mr. Djanogly: For the first time today, we have a decent amount of time for Opposition amendments-I suppose that I should be grateful.

Despite amendments in the other place, which have improved clause 260, part 11 dealing with derivative claims is a complex area that still gives many much concern. Currently, a shareholder can bring a claim on behalf of a company against directors only in limited circumstances. Part 11 sets out a new procedure of derivative actions that enable shareholders to bring a claim on behalf of the company for directors' breach of duty, if that breach has not been authorised or ratified by the company. Together with part 10, we believe that this has significant potential to increase liability for directors.

Before I go any further, I should like to explain the current common law position and set out what the Government aim to do in this area. Derivative claims are proceedings brought by a shareholder. Under the new Bill, they must be either

"in respect of a cause of action vested in the company and seeking relief on behalf of the company"


"brought only in respect of causes of action arising from an actual or proposed act or omission involving negligence, default, breach of duty or breach of trust by a director of the company."

This is significantly wider than the current common- law position.

There are two major concerns in relation to part 11. First, that it does not advance the common law and, secondly, that its effect, particularly when it is combined with part 10, will be detrimental to directors. We have tabled amendments that seek to deal with those concerns, which I shall discuss in due course. The leading common-law case on which this codification attempts to build is that of Foss v. Harbottle. If the Bill's intention is to enshrine in statute the well-established exceptions to the rule set out in the case of Foss v. Harbottle, our view and that of the lawyers who have advised us is that that is not immediately achieved by the current drafting. The rule in Foss v. Harbottle is that a member cannot bring an action on behalf of the company for an injury done to the company; the company is the injured party and the action vests in it.

The exceptions to the rule in Foss v. Harbottle include circumstances in which the transaction constitutes a fraud on the minority. That includes fraud proper as well as breach of fiduciary duty as a director and circumstances in which the wrongdoers are in control of the shares of the company. The non-inclusion of this fraud control test in the Bill represents a radical departure from the previous thresholds to a member making a derivative claim. The result of this non-inclusion is that it will be easier for shareholders to bring claims against directors.

Although the court will now be required to consider the evidence and merits at the earlier stage, there is a danger that this part of the Bill will simply create a more complex procedure without any corresponding reduction in the potential administrative burdens for companies. It therefore makes sense that part 11 should be amended to preserve the traditional thresholds of fraud on the minority and wrongdoer control, as that would make it clear in statute that this new regime is not intended to sweep away the existing case law.

As the new legislation does not replicate existing case law, it will take some time for a body of case law to develop. We feel that this will create uncertainty for some period as to the extent of the derivative claim provisions and the burden of this will largely fall on the company. This could, in part, be remedied by the legislation mirroring more closely existing law. In practice, derivative claims have to date been relatively rare, but any potential benefit this codification will have, which will be minimal, will be far outweighed by the possible damage that will be wrought by increased shareholder litigation and reducing the number of people who are willing to take up company directorships in the UK.

A further key change in this Bill is that the persons engaging in fraudulent conduct need not have received a benefit. Members will therefore be allowed to make claims for an honest act or omission of a director where that results in a breach of duty, regardless of whether the individual has received a benefit. Under the existing common law, it is not possible to make a derivative claim as a result of negligent action unless the person in breach of duty has received a corresponding benefit. This represents a shift from the existing position and the focus is much more on allowing member control of directors' actions.

The range of circumstances under which a derivative action may be brought will be much wider than is currently the case. This is once again an area of the law where the Government have said that the intention of putting in new clauses has been to codify the existing common law position, but this is, unfortunately, once again an area where the Government are overturning the common law position. The codification of the basis of bringing a claim and the means of bringing that claim will serve only to make it easier for claims to be brought against company directors.

Company directors also fear that increased litigation may lead to increased insurance premium costs-that is a very real fear for company directors. Should the rates that directors and officers have to pay go up, there will be a further disincentive to people becoming company directors. I am afraid that that is becoming a theme of parts 10 and 11, and it is not a happy one.

The concern that part 11 will increase potential liabilities for directors and the chance of tactical and vexatious litigation by activist shareholders has been raised by many others. The City law firm, Lovells, says:

"The Explanatory Notes to the Bill explain that 'the'"

derivative action

"'clauses do not formulate a substantive rule to replace the rule in Foss v Harbottle, but rather a new procedure for bringing such an action which set down criteria for the Court distilled from the Foss v Harbottle jurisprudence'. It is hard to see how this can be correct. As the Explanatory Notes themselves make clear, the rule in Foss v Harbottle is that is for the company to bring proceedings where a 'wrong has been done to the company', and that an exception can be made where there is conduct amounting to a fraud on the minority. The case of Estmanco (Kilner House) Ltd v Greater London Council made clear that 'fraud' in this context extends beyond fraud at common law to include 'the equitable concept of fraud on a power', including an abuse or misuse of power. It is generally considered that fraud, in this sense, does not include negligence. Other grounds include where the director's act is illegal, ultra vires and not ratifiable, or where the shareholder has acquired a personal right against a relevant director.

Whilst the Explanatory Notes say that Part 11 does not seek to overturn these previous 'well established principles', it is hard to see how this can be. If Part 11 comes into law, individual shareholders will be able to bring proceedings against directors, including in respect of negligence, which cannot be summarily struck out for want of locus standii, but only under a brand new test, which is unconnected to these common law factors. As a result, there is a clear risk that multiple stakeholders might make good use of Part 11 to further their own various platforms, at the expense of companies' time and money, and their directors time and money, personal stress, and claims upon their D&O insurance. It may even be possible for such a shareholder to use the provisions of this Part to apply for an order that the company pay his costs of bringing the proceedings, along the lines of the application upheld in Wallersteiner...If so, this could produce the very odd result that a number of activists could each buy a single share in the company, and each bring separate proceedings against directors, in respect of conduct predating their shareholding, at the company's expense. Such claims may well, however, be struck out by the Court under the first stage of section 242 referred to above."

We hope that that would be the case, but clearly the risks are there.

Let me turn to our amendments, which seek to rectify the problems that I have highlighted. Clause 260(3) states:

"A derivative claim...may be brought only in respect of a cause of action arising from an actual or proposed act or omission involving negligence, default, breach of duty or breach of trust by a director of the company."

That wording is not sufficiently precise and is too wide. In particular, the use of the words, "or proposed", go too far. A member should not have the statutory right to make a derivative claim to restrain some proposed act or omission. The intention should be to provide a remedy for a member where there has been an actual act or omission. To include the words, "or proposed", may be a charter for members at any time to take action to restrain what they thought was a potential future breach of the relevant duties. We therefore propose to amend the wording of the clause as set out in amendment No. 412. In Committee, the Solicitor-General said that this approach is too restrictive, but we are yet to be convinced by his arguments.

Amendments Nos. 413 and 414 were brought to us by the Institute of Chartered Accountants, which sets out its position in its brief of 10 October:

"We are concerned that the draft clauses do not reflect the Government's intention, as stated in its explanatory material and agreed to in the House of Lords Committee stage debate, of codifying existing common law principles on derivative actions. These clauses create new rights for members to bring a derivative action against persons other than directors. An actual or alleged breach of duty by a director"-

The Solicitor-General: I am interested that the briefing from the outside body suggests that we are codifying. The aim is to deal with some of the exceptions in part 11, not to replace the whole rule in Foss v. Harbottle. The case remains as part of common law.

Mr. Djanogly: Yes, but as I explained to the Solicitor-General, although the Government are maintaining that the case remains, the clause as drafted will significantly alter the application of the case.

Action against a director for breach of duty could, therefore, be effectively used as a springboard for a member to bring a derivative action against others. The Institute of Chartered Accountants believes that it will encourage nuisance claims against directors. We therefore tabled amendment No. 413. In Committee, the Solicitor-General stated that clause 260 was drafted on Law Society recommendations. He gave examples of third parties who hold money, transferred in breach of trust from the company, and who should be permitted to be pursued by a member of the company. Although that may be true in limited circumstances, we remain concerned about the growing scope of the clause and support the position of the Institute of Chartered Accountants.

8.45 pm

The City law firm Allen and Overy brought the substance of amendment No. 415 to us. It aims to ensure that the company retains an opportunity to exercise its primary right to sue the directors. Although it is easy to get carried away with arguments for and against members being able to seek relief on the company's behalf, we should not forget that the primary right is for the company to initiate the action. The amendment would embed that right in primary legislation.

Amendment No. 416 is aimed at resolving some of the problems that I have highlighted. The Law Society has been a great help in drafting the amendment, which was first tabled by Lord Hodgson in the other place. It would insert in clause 263 three new provisions, which oblige the court to refuse permission to continue a claim.

The first provision would apply when the directors had decided not to pursue the claim. The second would apply when the shareholders had decided not to pursue the claim. The third would apply when the court concluded that pursuing a claim was not in the company's best interests.

The first provision would apply when a company's directors had decided not to pursue the claim, unless the court considered them to be in breach of their duties in making the decision. The purpose is to ensure that the court does not second-guess the directors' commercial judgment unless it considers that, by deciding not to proceed, they are in breach of their duties. In Committee, the Solicitor-General maintained that that should be a relevant factor for the court in reaching its decision but not a bar. He said that the amendment would prevent meritorious claims from being granted permission for leave. However, we urge the Government to trust directors and accept the amendment.

The second provision, for when shareholders had decided not to proceed, would apply when the court believed that the majority of shareholders, excluding those with a personal interest in the decision, did not wish to proceed with a claim.

I hope that the third provision is self-explanatory and constitutes common sense.

Although the Government gave explanations about the amendment in Committee, we do not believe that they have merit. The amendment would improve the drafting considerably. We emphasise that its purpose is to introduce a threshold test that does not involve expense.

The Government have added new reasons for the court to reject a derivative claim. Are the tests strong enough? We contend that they will not be in practice. There is a concern that it will be possible for firm advice to be given on the court's approach to the exercise of its unfettered discretion only after years of jurisprudence. Uncertainties will be damaging to business.

Amendment No. 417 would reintroduce the fraud on the minority and wrongdoer control tests that existing common law contains. I have already spoken about the way in which the radical departure from common law has worried several stakeholders to whom we have spoken. From the way that the hon. Member for Cambridge (David Howarth) is shifting in his seat, I have a feeling that he, too, will cover the matter.

I thank the Solicitor-General for his letter of 25 July on derivative claims, which set out the legal position about fraud on the minority following implementation. Although we acknowledge that the Government are attempting to clarify a difficult matter, we believe that the common law position should prevail and have tabled amendment No. 417 on that basis.

The issue is important to us. We have been lobbied significantly by companies, accountants, solicitors, the CBI and many interest groups, including many City solicitors. The Government need to reconsider the matter, because if we get it wrong, we open up the possibility of a culture of litigation, which exists in the United States, but that we do not want to experience in this country.


Mr. Djanogly: Under these provisions, there will be a wider variety of people who can be sued, it will be possible to sue people for a greater variety of offences, and there will be a more straightforward procedure by which to sue people, which I think the Minister called a clearer and more accessible procedure. I foresee that the net result will be that more people will, indeed, be sued, as my hon. Friend the Member for North Wiltshire (Mr. Gray) suggested.

The Government have introduced certain amendments to tighten this part of the Bill, introducing the two-stage process, which in itself could be contentious-I have doubts that it will, in the event, save costs. While we note the requirement for the claimant to establish a prima facie case in order to obtain permission to continue a derivative claim, the introduction of the threshold does not entirely address the concerns about frivolous litigation. For certain categories of claim, it will be easy to establish a prima facie case, and the threshold might not act as a deterrent. The best example that I can give is where directors or the company have been fined for regulatory breaches. Evidence of the conviction will itself amount to a prima facie case of breach of duty under clause 243(3). The threshold is also no answer to the concerns that arise from allowing shareholders to bypass the board when commencing a derivative claim.

We remain concerned that part 11 empowers shareholders to commence litigation against the directors without consulting or informing the board. That increases the chances of tactical litigation, as I have made clear. Secondly, it will create the capacity for disruption. Thirdly, it will give the shareholder a primary, rather than a derived, right to bring a claim in the company's name. On that point, we have common ground with the Liberal Democrats; it comes to the fore in relation to amendment No. 415.

9.30 pm

It is a fundamental principle of company law that directors owe their duties to the company, and the company thus has the primary right to sue them in respect of wrongdoing. At present, a shareholder derives a right to sue in a company's name in particular circumstances, including because the wrongdoers who control the company will not exercise the company's primary right to sue. By failing to include a requirement that the board be consulted on, or informed about, a shareholder's intention to sue the directors in the company's name, the company will be deprived of an opportunity to exercise its primary right to sue in any circumstances in which the shareholder chooses not to consult the board. We were not convinced by the Minister's response to that point, so although I will not press amendments Nos. 412 to 414 to a Division, I will press amendment No. 415. I beg to ask leave to withdraw the amendment.

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