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Shareholder Derivative Action

This paper is an analysis of the concept of Derivative Action or widely referred as a Class Action suit or a Representative Action by Shareholders. Firstly, this paper will talk about what is a Derivative Action. Then this paper will move on to shed light upon the Legal History and the development of this concept. Thirdly, this paper will discuss various Case Laws governing the principle of Derivative Action. And finally, will answer the question whether Shareholders can take a derivative Action against the Directors of the Company.

Introduction:
The concept of Derivative Action has been evolved from the principle of Rule by Majority and Minority Protection. A proper balance of the rights of majority and minority shareholder's is essential for the smooth functioning of the company[1]. In the Landmark Case Foss v Harbottle[2] it was held that, in general, the courts will not intervene in matters of internal administration at the request of shareholders, and will not interfere with a company's management by its directors as long as they are working within the authorities placed on them by the articles of incorporation. Hence, a rule was laid down in the aforementioned case stating:
"Nothing connected with the internal disputes between the shareholders is to be made the subject of an action by a shareholder."

This rule was later restated in the case of Jenkins LJ in Edwards v Halliwell [3]:
Stating, where the alleged wrong is a transaction which might be made binding on the company by a simple majority of members, no individual member of the company is allowed to maintain an action in respect of that matter for the simple reason that, if a mere majority of the members of the company is in favour of what has been done, then cadit quaestio.

The majority rule, on the other hand, does not always prevail. The rule in "Foss v Harbotile[4]" applies to circumstances in which companies have the authority to validate managerial errors. But there are certain acts which no majority of shareholders can approve or affirm. In such instances, each shareholder has the right to litigate to enforce the company's responsibilities. As a representative of the business interest, he brings the actions. A representative action of this type is known as a "derivative action" in American literature.

This type of Derivative Action can be brought by minority shareholders to protect their interests under a few exceptions in the Rule of Majority:
  1. Acts "ultra vires":
    A shareholder is entitled to bring an action against the company and its officers in respect of matters which are ultra vires the company and which no majority of shareholders can sanction. The rule in Foss v Harbottle applies only as long as the company is acting within its powers[5].
     
  2. Fraud on Minority:
    In Greenhalgh v Arderne Cinemas Ltd[6] it was adjudicated that "a special resolution would be liable to be impeached if the effect of it were to discriminate between the majority shareholders and minority shareholders, so as to give to the former an advantage of which the latter were deprived".

    As a result, the judgement implies that majority powers must be employed in good faith for the company's overall advantage. If they have not been so exercised there is a "fraud on the minority".
  3. Breach of Fiduciary Duties:
    In the case Satya Charan Lal v Rameshwar Pd. Bajoria[7], it was observed that when a director is in breach of fiduciary duty, every shareholder may be regarded as an authorised organ to bring the action.
     
Legal History of Derivative Action in India:
In 2005, the JJ Irani Committee voiced the need to introduce class-action and derivative-action in Indian company law, but these recommendations[8] remained on the back-burner till India Inc was shocked by the Satyam scam.

The legislature included specific class-action provisions in the Companies Act 2013. Section 245, which applies to all kinds of companies except banks, meets this deficit.

The company law in India still lacks clarity and is in dire need to give statutory recognition to these derivative actions. Section 245 of the Companies Act allows for the initiation of a class action suit by a member or a depositor only on behalf of the members or depositors of a company. The J.J. The Irani Committee noted that although derivative actions have been allowed by courts, they are yet to be reflected by statute. In India such cases of Derivative Suits are still governed on principles of Common Law.

The rationale behind the significance of derivative action is provided in Starlite Real Estate (ASCOT) Mauritius Ltd. & Ors. v. Jagrati Trade Services Pvt. Ltd., 2015[9] by the Callcuta High Court
"Where the wrong is being done to the company by the directors in control, the company obviously cannot take action on its own behalf. It is in these circumstances that the derivative action by some shareholders (even if they are in a minority) becomes necessary to protect the interest of the company."

The Bombay High Court (B.B.N. (UK) Limited v. Janardan Mohandas Rajan Pillai,1993[10] ) affirmed an exception to this rule that a shareholder can maintain an action when he or she is able to show that the wrongdoers are in control of the company's interests and hence, the company cannot maintain the action. It must also be noted that the inter se relationship between the plaintiffs and the beneficial owner, which the Plaintiff seeks to represent, may involve a case of deceit, fraud, inability, or incapacity

Case Laws Governing the Principle of Derivative Action:
  • Nurcombe v. Nurcombe[11] [1984]
    Facts: The action was by the wife, minority shareholder, against the wrongdoings of her husband as a director. In matrimonial proceedings she came to know of the improper profits made by the husband.

    Held: It is pertinent to remember, however, that a minority shareholder's action in form is nothing more than a procedural device for enabling the court to do justice to a company controlled by miscreant directors or shareholders. Since the procedural device has evolved so that justice can be done for the benefit of the company, whoever comes forward to start the proceedings must be doing so for the benefit of the company and not for some other purpose.
  • The Delhi High Court in Rajeev Saumitra vs Neetu Singh [2015][12]
    Facts:
    The plaintiff got married with defendant No.1 on 12th March, 2006. Subsequently the proprietorship concern, namely, Paramount Coaching Centre was converted into a Private Limited Company, i.e. defendant No.3. Defendant No.1 was inducted as a Director of defendant No.3 with an equal shareholding of 50%. Later into the marriage, plaintiff finds out that defendant No.1 is already married and is the founder and Director of K.D. Campus Pvt. Ltd. (defendant No.2). She just married him with an intention to conspire with her family members to hijack and divert the business, customers and revenue of defendant No.3 into defendant No.2.

    Held:
    While dealing with a derivative action, it was held that a director was liable to pay to the company any undue gains realised from breach of duties prescribed by Section 166 of the Companies Act, 2013.
  • In Prudential Assurance Co. Ltd. v. Newman Industries Ltd [1982] [13]
    Facts: The plaintiffs owned 3.2% of the issued ordinary shares in the company. Directors prepared a proposal to purchase assets and presented on the board meeting. All the directors agreed except one. CEO signed the agreement on behalf of the company for the purchase of the assets anyways.

    Held: it was noted that when such an action was brought by a minority shareholder the question whether in fact the company was controlled by the alleged wrongdoers should first be determined before the derivative action itself was allowed to proceed. Therefore, determination of the wrongdoing is placed at a higher pedestal than maintainability. The court will not allow the derivative action to proceed and the shareholder will be allowed to sue on behalf of the Company if he is bringing the action bona fide for the benefit of the Company for wrongs to the Company for which no other remedy is available.
  • In Bharat Insurance Company Ltd. v. Kanhaiya Lal[14]
    Facts: The plaintiff was a shareholder of the respondent company. One of the Objects of the company was to advance money at interest in the security of ands, houses, machinery and other property situated in India. The plaintiff complaints that several investments have been made by the company without adequate security and contrary to the provisions of the MoA and therefore prayed for a perpetual injunction to restrain such investments.

    Held: It is alleged that directors are acting ultra vires in their application of the funds of the company. Under these circumstances, a single member can maintain a suit for declaration as to the true construction of article in question.

So, Can Shareholders Take Derivative Action Against Director?
Yes if:
  1. Shareholders can maintain an action when he or she is able to show that the wrongdoers are in control of the company's interests.
  2. That the derivative action should not be permitted to be misused for individual purposes.
  3. Director of the company had any undue gains realised from breach of duties prescribed by Section 166 of the Companies Act, 2013.
  4. Action is not bona fide for the benefit of the Company.
  5. Other remedies are not available.
  6. Directors are acting ultra vires in their application of the funds of the company.
End-Notes:
  1. Clive M. Schmitthoff and Curry (Eds.), Palmer's Company Law (20th Edn 1959) 492 on Majority and Minority Rights.
  2. (1843) 2 Hare 461: 67 ER 189
  3. (1950) 2 All ER 1064,1066 (CA)
  4. Supra 2
  5. Edwards v Halliwell [1950]2 All ER 1064, 1067
  6. 1951 Ch 286 (CA).
  7. Satya Charan Lal v Rameshwar Pd. Bajoria[1950] S.C.R.394
  8. Report On Company Law F. No. 1/4/2005/CL.V
  9. Starlite Real Estate (ASCOT) Mauritius Ltd. & Ors. v. Jagrati Trade Services Pvt. Ltd., 2015 CS No.284 of 2014
  10. B.B.N. (UK) Limited v. Janardan Mohandas Rajan Pillai, 1993 (3) BomCR 228
  11. Nurcombe v. Nurcombe [1984], England & Wales EWCA Civ J0724-3
  12. CS (COMM) 935/2016
  13. Prudential Assurance Co Ltd v Newman Industries Ltd (No 2)[1982] 1 All ER 354
  14. Bharat Insurance Company Ltd. v. Kanhaiya Lal [AIR 1935 Lah74]
Footer:
  1. Edwards v Halliwell [1950]2 All ER 1064, 1067
  2. 1951 Ch 286 (CA).
  3. Satya Charan Lal v Rameshwar Pd. Bajoria[1950] S.C.R.394
  4. Report On Company Law F. No. 1/4/2005/CL.V
  5. Clive M. Schmitthoff and Curry (Eds.), Palmer's Company Law (20th Edn 1959) 492 on Majority and Minority Rights.
  6. (1843) 2 Hare 461: 67 ER 189
  7. (1950) 2 All ER 1064,1066 (CA)
  8. Supra 2

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