Derivative Claims

How to bring a director to account for a company's loss - the derivative action

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Derivative Claims

A company will suffer if a director acts badly but the shareholders do not have enough voting power to force a solution. But, there are actions that the shareholders can take. One being the derivative claim. If a derivative claim is successful, the court can force the director to account to the company for its loss.

We bring and defend claims brought by shareholders against directors.

The problem for most shareholders is that a company can only decide to take action if the board of directors approves it. If the board is in the wrong, then they will not take action against themselves. The shareholders can then step in. We act for private companies and represent shareholders or defend directors.

Our service is to find the quickest and easiest solution. There are steps to work through before litigation as we explain.

Derivative claims used against directors by shareholders

There are a variety of routes to consider. The best route will depend upon the facts.

There is a procedure under the Companies Act for the dismissal of a director. The problem is it requires more than 50% of the shareholders to vote in favour. The voting threshold can be increased under the company’s articles – the starting point is to review the articles and any shareholders’ agreement. In many cases, we can suggest solutions to overcome this statutory voting threshold.

We set out below an outline of the claims that can be advanced by shareholders against directors. We also address what orders the court can make.

Derivative action taken by shareholders against directors   

A derivative claim can be considered where the director has abused his position in some way. The director may have breached his duties to the company.

Or, the director may be negligent or dishonest. Situations where the director diverts company clients to another company in which he has an interest would be a fairly typical case of dishonesty.

A shareholder can indirectly bring a claim against the director. The derivative action is seen as indirect because the shareholder claims on behalf of the company. The company usually seeks damages from the director, or an account of profits for any gain made.

A useful point for shareholders to note is that there is no obligation to show the director in default has benefited. A shareholder claiming against a director under the derivative claim route merely has to show that the company has suffered loss.

Derivative claims are fairly rare in practice. However, the threat can be effective. If the director is ordered to pay damages he will also have to pay the legal costs of the shareholder(s) bringing the derivative claim and the legal costs of the company.

What is a derivative claim?

If a shareholder pursues a derivative claim, then the court has to give permission for it to continue. This is on the basis that the claim can rip apart the company. The court will consider, in granting permission, whether:

  1. The claim is for the benefit of the company’s shareholders as a whole;
  2. The shareholder bringing the claim has any personal vendetta;
  3. The shareholder bringing the claim has the support of other shareholders;
  4. Unnecessary costs will be incurred.

The court can order for the shareholder to be indemnified for its costs in bringing the claim. The company satisfies this indemnity.

Company law – derivative action used to bring directors to account

The unfair prejudice petition route is one of the most common claims. It is brought by a minority shareholder, against a majority shareholder. An unfair prejudice petition can have teeth when the majority shareholder is the director in default. The minority shareholder has to show that the majority shareholder(s) have conducted the company’s affairs in a way that is unfair and prejudicial to the minority shareholders. This will often relate to finances, poor decision making and or unfair payment of dividends.

Unfair prejudice claim – remedies

Again, the threat of an unfair prejudice petition can be effective.

If the unfair prejudice petition is successful, the court can order for the sale of the minority’s shares for fair value. The court has a wide discretion when making such orders. For example, directions can be given on the method for valuation of shares and who is required to buy them. The court can order a company buy back which is a neat solution in many cases.

Shareholder claims against the director via a just and equitable winding up

A shareholder can apply to court for an order for the company’s winding up. This is a drastic route, but one that can be used to gain leverage to strike a deal. The court will consider whether it is just and equitable for the company to be wound up. The court will not make an order unless a winding up is the only solution. If the company is deadlocked, then the court may order a winding up.

If shareholders oppose the application for a winding up order they are likely to try and argue that the shareholder is himself at fault in some way. Before commencing with a winding up order alternative means of resolving the shareholder dispute should have been attempted. And, the shareholder making the application needs to have “clean hands”.

A successful winding up order means the company’s assets are sold by the liquidator to the highest bidder. Goodwill is destroyed. This means that the shareholders may be better off agreeing a sale of the shares. On a sale of shares goodwill can be largely preserved which supports the share value.

Shareholder claims against the director via a declaration

A shareholder can apply to court for a declaration as to facts. For example, a director may have removed another from office without power or consent. The court can confirm that the removal was void and had no effect, i.e. reinstate the removed director.

How to resolve a dispute without forcing a derivative action

In practice, most disputes do not end up with a full trial. This is because we can usually find a workable solution. Solutions include:

  1. Use of “letters before action”. These are required under protocol. However, a well drafted one can open a path to settlement.
  2. Phasing an exit – whereby the director leaves over a period of time.
  3. Agreeing to wind up the company.
  4. Initiating a process whereby the company buys back the director’s shares to procure an exit.
  5. Mediation – John Deane is our mediator at Gannons. John has resolved many disputes over the years.
  6. Splitting up the business assets by a spin off or reorganisation.
  7. Agreeing a trade sale of the company.

All will depend on the circumstances. We do offer creative solutions that can be attractive to all parties. That is the trick to securing settlement.

Track record in resolving disputes relating to directors and derivative claims

Our recent instructions include:

  • Acting for a consortium of shareholders of a large recruitment firm pursuing the derivative claim to hold a director who received commission fees in his sole name accountable. The director was ordered to return the commission fees to the company to which he owed the duty.
  • Advising the shareholders of a professional services firm on a derivative claim taken on behalf of the company, to prevent a director from damaging the company’s revenue stream by directing clients to a competitor firm in which he had an indirect financial interest.
  • Successfully bringing a derivative claim on behalf of an institutional investor in a hedge fund following a director’s clear breach of duty by acting in a position of conflict in managing the fund.
  • Successfully acting for a director of a technology company, on his defence to the derivative claim, where the claim was brought for a personal interest rather than with the interests of the company as the basis of the claim.

Alex Kleanthous is the partner charged with running the commercial litigation team. Alex brings and defends claims against directors. Please do get in touch if we can be of assistance.