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Company Law Reform Bill: Derivative Claims

13th July 2006

Will it become easier to sue company directors?

9.30 am

Mr. Djanogly: We move on to part 11, another significant new area of the Bill, which is complex and has brought much interest and no little concern from the City among others. I should especially like to thank Farrar and Co solicitors for the advice they have given us on the analysis of this part. Let me set the scene. It applies equally to all clauses in this part, but I shall not repeat it.

A shareholder can only bring a claim on behalf of a company in limited circumstances. Part 11 sets out a new procedure of derivative actions that enables shareholders to bring a claim on behalf of the company for breach of duty if that breach has not been authorised or ratified by the company. Together with part 10, we believe that that has significant potential to increase the liability of 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.

Derivative claims are proceedings brought by a shareholder. Under the Bill, they must be in respect of a course of action vested in the company, for the purposes of seeking relief on behalf of the company, and brought only in respect of courses 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.

To bring a derivative claim, a shareholder must commence proceedings in the usual way and then apply to the court for permission to continue the claim. In determining whether to grant permission, the court is required to take into account the series of factors set out. There are two major concerns. The first is that it advances the common law in undesirable ways. The second is that the effect of the clause, particularly when combined with part 10, will be detrimental to directors generally. We have tabled amendments to address those concerns, but the leading common law case on which codification attempts to build and on which the hon. Member for Cambridge (David Howarth) is clearly dying to speak, is that of Foss v. Harbottle. If the Bill's intention is to enshrine in statute the well established exception to the rules set out in that case, our view and that of the lawyers who have advised us is that this is not immediately achieved by the current drafting.

The rule in Foss v. Harbottle is that a member cannot bring in 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 are, broadly speaking: an infringement of personal rights of members; ultra vires or illegal transactions on the basis that the majority cannot ratify such transactions; transactions requiring the sanction of a special majority; and, importantly, the fraud and control test whereby the transaction constitutes a fraud on the minority. This includes fraud proper as well as breach of fiduciary duty as a director and when the wrongdoers are in control of the shares of the company.

The non-inclusion of the fraud and control test in the Bill represents a radical departure from the previous thresholds to a member making a derivative claim. The result of that non-inclusion is that it will be easier for shareholders to bring claims against directors. Furthermore, it is the view of many law firms that the current form of part 11 does not address concerns about the court having an unlimited discretion in deciding whether to allow derivative actions to proceed. The non-inclusion of the fraud and control test represents a fairly radical departure from the previous thresholds to a member making a derivative claim.

The court will still be required to consider the evidence and merits at the earliest stage, and there is a danger that that part of the Companies Bill will simply create a more complex procedure without any corresponding reduction in the potential administrative burdens for companies. It therefore makes sense to amend part 11 to preserve the traditional thresholds of fraud on the minority and wrongdoer control, as that would make it clear in statute that the 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. Although of persuasive nature, the previous rules in Foss v. Harbottle and other case law will not be directly relevant in determining whether the provisions of the legislation have been applied. That will create uncertainty for some period as to the extent of the derivative claim provisions, and the burden of that will largely fall on the company. That could, in part, be remedied by the Bill more closely mirroring existing law.

In practice, derivative claims have been relatively rare to date. It has been pointed out to us that the Government will achieve relatively little by enshrining this rare bit of case law into statute. Granted, they will have codified a part of the common law, but any potential benefit that that will have-it will be minimal-will be far outweighed by the possible damage that will be wrought by increased shareholder litigation and by reducing the number of people who are willing to take up company directorships in the UK.

A further key change in the 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 if it results in a breach of duty, regardless of whether they received a benefit. Under Foss v. Harbottle, it is not permissible to make a derivative claim as a result of negligent action unless the person in breach of duty receives a corresponding benefit. The Bill represents a shift from the existing position, in that 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. A shareholder who brings proceedings must apply to the court for permission to continue the claim. If the court judges that a person seeking to promote the success of the company for the benefit of the shareholders would not continue the claim, permission must be refused. Permission must also be refused if the conduct complained of has been authorised or ratified by the company-that is, by the shareholders.

The Chairman: Order. The Committee is suspended for one minute. We are inquorate; there is not a sufficient number of Members in the room.

9.37 am

Sitting suspended.

9.38 am

On resuming-

The Solicitor-General: On a point of order, Mr. Illsley. The speech by the hon. Member for Huntingdon has cleared his own Back Benches. It has cleared all but one Liberal Democrat and many Labour people from the room, and even encouraged some to get out their newspaper. He may feel slightly aggrieved, but I assure him that it is a fascinating speech. I was listening to him with great care, as I am sure you were, Mr. Illsley, although I saw your head start to droop slightly.

The Chairman: I call Mr. Djanogly to respond.

Mr. Djanogly: I am delighted by that reassuring point of order from the Solicitor-General. I shall do my best to keep up the heightened tension.

As we debated earlier, there will also be a significant tightening in the law in relation to the ratification procedure which will make it more difficult for a director's act to be ratified. On any resolution to ratify a director's negligence, default, breach of trust or breach of duty, the votes of shareholders who are personally interested in the ratification must be disregarded. The consequence of that is that ratification will be more difficult to achieve and that there are therefore likely to be more derivative actions. The consequences of the prospect of more derivative actions for company directors is grave, especially when the prospect is made more likely by the extension of possible liabilities that face directors under part 10. This is once again an area of law about which the Government have said that the intention is to codify the existing common law position. Unfortunately, once again they are overturning the common law position.

Parts 10 and 11 in effect create what my noble Friend Lord Hodgson referred to as a “double whammy

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