“THIS COURT,” declared Lord Eldon in 1817, “is not to be required on each Occasion to take the Management of every Playhouse and Brewhouse in the Kingdom.” Lord Eldon reflected the judiciary’s reluctance to interfere with a company’s internal management.
But some critics contend that the Companies Bill now going through Parliament will lead to more lawsuits against directors — so requiring the courts to become more involved in disputes over the internal management of business ventures. The Bill, they say, will deter people from becoming board members.
Their concerns arise from one of the most controversial measures in the first important company law Bill for more than 20 years: the creation of a statutory “derivative claim”.
A derivative claim is a claim made by a shareholder on behalf of, and for the benefit of, the company; typically, for breach of duty against a director (or former director) of a company. If the claim succeeds, a remedy will be awarded to the company itself, rather than to the shareholder bringing the claim on its behalf.
The derivative claim has existed for centuries at common law — a typical example is where a fraud has taken place which the company is improperly prevented from redressing because it is controlled by the wrongdoers. But the Law Commission has described the scope of the claim as “obscure, complex and old-fashioned” and in 1997 it proposed a new procedure. “In an age of increasing globalisation of investment and growing international interest in corporate governance,” it argued, “greater transparency in the requirements for a derivative action is in our view highly desirable.”
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The Bill seeks to implement the Law Commission’s recommendation that the common law derivative claim be replaced with a new statutory procedure with “more modern, flexible and accessible criteria for determining whether a shareholder can pursue an action”.
Under the Bill, a derivative claim may be brought by a shareholder only in respect of “an actual or proposed act or omission involving negligence, default, breach of duty or breach of trust” by a director, former director or shadow director of the company. The cause of action may be against the director or another person (or both).
Critics of the Bill have two main concerns: first, the statutory derivative claim will apply to a broader range of conduct than is now possible at common law, since it applies to any breach of duty or negligence, even if the act or omission has not benefited the director and he or she has acted in good faith. The scope of directors’ duties is itself widened by the Bill, which puts them on a statutory footing for the first time. Clause 173 imposes on the directors a duty “to promote the success of the company for the benefit of its members as a whole”. They are specifically required to have regard to (among other matters) the interests of the company’s employees, the impact of the company’s operations on the community and the environment, and the desirability of the company maintaining a reputation for high standards of business conduct.
This widening of the scope of directors’ duties, and the fact that the claimant does not need to show that the company would suffer any financial loss if the derivative claim was not brought, has led to fears of opportunistic claims by such diverse potential shareholders as disgruntled employees, environmental activists, lobby groups, institutional investors unhappy with management performance, or vulture funds.
The Bill’s defenders counter that this danger is more apparent than real. It is a prerequisite of a derivative claim that the company has a claim against the director. The claims that a company would have against its directors for breaches of their duties to have regard to (say) the impact of the company’s operations on the environment appear to be limited. And there will be tight judicial control of derivative claims. The Bill imposes a two-stage filter to prevent unmeritorious claims from being allowed to proceed. Only claims that a director acting in good faith in the company’s interests would seek to continue will be allowed to proceed. The court has a wide discretion to dismiss claims at an early stage on grounds which include that the shareholder bringing the claim is not acting in good faith and independent shareholders are opposed to the claim being brought.
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The second concern is that the Bill does not require the derivative claimant to obtain the court’s permission to settle or discontinue a derivative claim — even though the Law Commission pointed out that this “could give rise to serious possibilities of collusion, with the directors buying off the” claimant “in disregard of the rights of the company and its members.”
There is a possible judge-made solution to this difficulty. The courts could adopt a practice of giving permission to continue derivative claims only on condition that the claim would not be settled or discontinued without the sanction of the court. But courts would have to take a pro-active stance in imposing this requirement, as parties to the claim who are contemplating a collusive arrangement would be most unlikely to request its imposition.
It is not too late for the Government to close this lacuna in the Bill, and so prevent the new statutory derivative claim from being abused for personal gain.
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The author is a barrister practising from Serle Court, Lincoln’s Inn