THE SUSCEPTIBILITY TO MEANINGFUL ATTACK OF BREACHES OF DIRECTORS DUTIES UNDER ENGLISH LAW

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T

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USCEPTIBILITY TO

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EANINGFUL

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TTACK OF

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REACHES OF

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IRECTORS

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UTIES UNDER

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AW

Louis Doyle, LLM, Barrister Kings Chambers Manchester and Leeds

INTRODUCTION

1. The central thesis of this paper is that, the theory apart, at a practical level, for the reasons identified, the procedural mechanisms available under English law for the remedy of wrongs done to a company by a director or directors make the reality of such a challenge more apparent than real. In advancing that theory it is not necessary to say anything in detail of the substance of a director’s duties to a company beyond identifying the elements prescribed in the new statutory regime under the Companies Act 2006 (to which section references hereinafter are made save where the contrary is stated):

 Duty to act within powers (s.171).

 Duty to promote the success of the company (s.172)1.  Duty to exercise independent judgment (s.173).

 Duty to exercise reasonable care, skill and diligence (s.174).  Duty to avoid conflicts of interest (s.175).

 Duty not to accept benefits from third parties (s.176).

 Duty to declare interest in proposed transaction or arrangement (s.177).

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METHODS OF DIRECT ENFORCEMENT2

2. There are three basic grounds here, none without its limitations.

Enforcement by way of litigation initiated by the board3

3. The decision to initiate litigation (on any matter) under the normal form of articles4 is given to the directors as part of the general managerial powers conferred on a company’s board. Accordingly, a board my initiate litigation in the company’s name to enforce the duties of directors even where the shareholders oppose the initiation of the litigation5. Nevertheless, the alleges wrongdoers may carry sufficient weight at board level to block the initiation of litigation, even in circumstances where a fully independent board could have formed the view that the discharge of their duty to promote the success of the company under s.172 necessitated the initiation of litigation.

4. Nothing, of course, precludes litigation where the alleged wrongdoers have been displaced6.

Enforcement by creditors7

5. Although a creditor no doubt has an interest in the competent discharge of the duties of a board, in the sense that the Courts appear to have accepted that creditors’

2 This section does not address s.44 of the Companies (Audit, Investigations and Community

Enterprise) Act 2004, applicable only to community interest companies, a personal action by a shareholder base on s.33 (effect of company’s constitution, replacing s.14 of the Companies Act 1985), fraudulent or wrongful trading claims by a liquidator under s.213 and s.214 of the Insolvency Act 1986 (“the 1986 Act”) respectively or enforcement action by the Secretary of State.

3 See Palmer’s Company Law, para.8.3702. 4 See Table A, Art.70.

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John Shaw & Sons (Salford) Ltd v. Shaw [1935] 2 KB 113, CA. The board will nonetheless be required to observe the specific provisions of the articles if those make specific provision for litigation decisions in respect of directors’ duties as can arise in practice in the case of a private company. A shareholders’ agreement may operate to like effect.

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See, for example, Regal (Hastings) Ltd v. Gulliver [1942] 1 All ER 378, HL.

7 For a useful survey of the factors relevant to the state of knowledge of creditors vis-à-vis board

operation, both formally and informally obtained, see V Finch, Company Directors: Who cares about skill and care? [1992] 55 MLR 179.

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interests have to be considered at least where a company is of doubtful solvency8, direct enforcement by a creditor would appear viable only to the extent that an independent, positive duty specifically owed to creditors can be made out9. In practice, however, such direct creditor action is almost unheard of for a number of reasons. First, a secured creditor may prefer to fall back on the appointment of an administrator10 or a receiver11. Secondly, a creditor, secured or unsecured, may, by virtue of the writing being on the wall given the company’s doubtful solvency (at least), prefer to leave remedial action to a liquidator, notwithstanding the enlightened and pragmatic self-interest which is inherent in the bringing of proceedings by a liquidator12. The actions available to a liquidator include misfeasance proceedings under s.212 of the 1986 Act which amounts to a procedural provision for the summary enforcement of breach of duty owed to the company13 and wrongful trading, the great hope of the Cork Committee, under s.214 of the 1986 Act, albeit that provision has not proved to be a powerful weapon for liquidators given the difficulties apparent in the reported authorities in meeting its stipulations and given that the provision does not envisage an attack under its terms on the mismanagement or incompetence by a director, whether leading to the insolvency of the company or not.

A claim for a breach of a personal right by a member

6. The legal right of a member - as opposed to a claim brought in respect of the company’s rights - is enforceable directly at the suit of the member. The enforcement of such a personal right so as to give rise to a claim for damages or other

8 See Winkworth v. Edward Baron Development Co Ltd [1986] 1 WLR 1512; West Mercier

Safetywear Ltd v. Dodd [1988] BCLC 250; Brady v. Brady [1989] AC 755.

9 See Nicholson v. Permkraft [1985] 1 NZLR 242 at 250 and Winkworth v. Edward Baron

Development Co Ltd supra at 1518.

10 Pursuant to a qualifying floating charge under Paragraph 14 of Schedule B1 to the Insolvency Act

1986.

11 Under a fixed charge, a so-called LPA receiver.

12 As commercial animals, a liquidator will have an overriding concern in the level of realisable assets

from which fees can be met and, like any other litigant, must also balance the likely time and cost of an action together with the question of whether a respondent director is worth powder and shot.

13 The provision is also available to a creditor and (with leave) a shareholder although such an action

would necessarily involve a certain altruism on the part of such a creditor or shareholder since the proceeds of the action will enure to the company to which the breached duty is owed.

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compensation is not prevented by reason of the claimant holding or having held shares in the company14.

7. Examples of such claims15 are a decision to enter into a transaction beyond the company’s objects16

and a decision by directors to allot shares for an improper purpose17.

8. So much, then, for direct action. Logically, what follows is a consideration of claims by way of petition on the part of a member alleging unfairly prejudicial conduct under s.994 (formerly s.459 of the Companies Act 1985). As will be seen, the scope of that provision in remedying wrongs done to the company, as opposed to the infringement of a member’s rights, is presently at something of a high point, a position which is unlikely to endure unchecked. Given those shortcomings the discussion must turn inevitably to the new statutory derivative claims under Part 11 of the 2006 Act.

UNFAIR PREJUDICE PETITIONS

9. In the commonly used (but not always cited) words of Hoffmann LJ (as he then was) in Saul D Harrison & Sons plc [1995] 1 BCLC 1418 at 18, “Enabling the court in an appropriate case to outflank the rule in Foss v. Harbottle was one of the purposes of the section.” The rule in Foss v. Harbottle19 featured two distinct elements. First, the proper plaintiff in respect of a wrong done to a company is the company itself. Secondly, where the alleged wrong is a transaction which might be made binding on the company by a simple majority of the members, no individual member of the company may bring a claim in respect of it20. The common law derivative action was notoriously cumbersome, however, not least on account of the heavy pleadings

14 See Prudential Assurance Co Ltd v. Newman Industries Ltd (No.2) [1982] Ch 204, CA and see now

s.655.

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For a more extensive survey see Palmer’s Company Law, para.18.4.5.

16Simpson v. Westminster Palace Hotel Co (1860) 8 HL Cas 712. 17Punt v. Symons & Co Ltd [1903] 2 Ch 506.

18 Failure of directors to act bona fide in the interests of the company. 19

(1843) 2 Hare 461.

20Prudential Assurance Co Ltd v. Newman Industries Ltd (No.2) supra at 357. A useful discussion of

the limits of the rule appears in Hannigan, Drawing boundaries between derivative claims and unfairly prejudicial petitions [2009] JBL 606.

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and costs commonly necessary to get the claim onto the starting blocks, and led to the Law Commission recommending that it be replaced with a statutory derivative procedure21. The statutory unfair prejudice action was developed by the Courts as a personal remedy for shareholders in response to either personal wrongs or in relation to corporate wrongs22 although it has been said (inaccurately, at least as matters presently stand) that the remedy is not intended to redress corporate wrongs which fall within the ambit of a derivative claim23. Academic debate has continued as to whether an unfair prejudice action can be used to deal with corporate wrongs in light of the availability of the common law and, latterly, the statutory derivative claim24. Certainly it is clear that whilst an act by a respondent which is either unlawful and/or which constitutes a breach of his fiduciary duty as a director is not automatically of itself unfairly prejudicial, a breach of a fiduciary duty may be an important fact in determining whether there has been unfair prejudice because the direct consequence of the breach may be to unfairly prejudice the petitioner’s interests25

.

10. The starting point is the decision of Millett J (as he then was) in Re Charnley Davies Ltd (No.2) [1990] BCLC 760 where the relationship between an unfair prejudice and a derivative claim was considered26. In identifying that the distinction between misconduct (in the derivative claim sense) and unfairly prejudicial management (in the s.994 sense) lies not in the acts or omissions of which complaint is made but, rather, in the nature of the complaint and the remedy necessary to meet it27, Millett J drew the conclusion that if the substance of the complaint was a breach of duty or some other misconduct actionable by the company, as opposed to mismanagement,

21 Law Commission, Shareholder Remedies, Cmnd 3769, 1997, Pt 6, para.6.15. This proposal was

adopted by the Company Law Review, Modern company law for a competitive economy, developing framework, 2000, paras.4.112 to4.139 and see also Final Report, 2001, paras.7.46 to 7.51.

22 R Cheung, Corporate wrongs litigated in the context of unfair prejudice claims: Reforming the

unfair prejudice remedy for the redress of corporate wrongs (2008) 29 Comp Law 98 and the cases cited therein.

23 J Zeigel, Corporate governance and directors’ duties to creditors: Two contrasting philosophies,

University of Toronto, April 2004 at 10.

24 See, for example, J Poole and P Roberts, Shareholder remedies: Corporate wrongs and the

derivative action [1999] JBL 99 and E Iacobucci and K Davis, Reconciling derivative claims and the oppression remedy (2000) 12 SCLR (2d) 87.

25 V Joffe et al, Minority Shareholders: Law, practice and Procedure (OUP, Oxford 2007, paras.5.121

and 5.122).

26

The unfair prejudice provision in question in that case was that in the formerly operative s.27(1) of the Insolvency Act 1986 which includes wording similar to that found in s.459 of the Companies Act 1985 and now in s.994.

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then the claim was appropriately actioned by way of a derivative claim and not as an unfair prejudice complaint. The dicta of Millett J in Re Charnley Davies was considered at length and adopted by the Hong Kong Court of Final Appeal in Re Chime Corp (2004) 7 HKCFAR 546 in which Lord Scott, sitting as a Judge of that Court, held that it was an abuse of process to seek, in effect, to circumvent the rule in Foss v. Harbottle by way of an unfair prejudice petition where the substance of the complaint so actioned was misconduct (or breach of duty) rather than mismanagement. The nature of such a claim and its remedy existed and enured for the benefit of the company and should properly be actioned by way of a derivative claim subject to two important conditions28.

11. Very significantly, in Gamlestaden Fastigheter AB v. Baltic Partners Ltd [2008] 1 BCLC 468 the Privy Council overturned a decision of the Jersey Court of Appeal and, in considering the Jersey equivalent of ss.994 – 996, held that a cause of action vested in a company was capable of being prosecuted to judgment by way of an unfair prejudice petition on which the Court had jurisdiction to order damages be paid by the respondent directors to the company29. In other words, an unfair prejudice petition was not limited to benefiting a complainant shareholder qua shareholder. Neither is it necessary that the matters complained of must be shown to have reduced the value of the complainant shareholder’s shares30.

12. What is notable from the judgment in Gamlestaden is that the judgment of Lord Scott makes no reference to the two conditions identified by him in Re Chime Corp (see footnote 28). As such, Gamlestaden appears to stand as authority for the Court having power to make an order for the payment of damages or compensation to the company on an unfair prejudice application without reference to those criteria identified in Chime Corp. If that is correct, then the decision is of some significance

28Re Chime Corp supra at [63]. Noting the dictum of Hoffmann LJ in Saul D Harrison, Lord Scott

reformulated the “outflanking” observation in that case in holding that it would be appropriate to allow the rule to be outflanked only if two conditions were satisfied, namely (a) the order sought in the unfair prejudice petition corresponded with the order that would have been made if obtained in a derivative claim, and (b) it was clear from the outset that the issue could conveniently be dealt with at the hearing of the petition: at [63]. In any other case, the appropriate relief would be an order permitting a derivative action to be brought for the recovery of the sums claimed.

29 See R Goddard, The Unfair Prejudice Remedy (2008) 12 Edin LR 93 for further comment.

30 The Privy Council did not, however, establish a general rule that shareholders who were also

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because it means that a shareholder may bring a s.994 petition even where his complaints could be dealt with by means of a statutory derivative action although it should be noted that there is no authority which holds that a statutory unfair prejudice claim may not proceed by reason of the availability of a derivative action31. Gamlestaden may (indeed, it is submitted, will) prove to be a high water mark which requires subsequent modification and proviso. The correct approach, it is submitted, is likely to be found to be that expounded in the Court of Final Appeal in Hong Kong in Re Chime Corp where, to use the language of Bokhary PJ (whose judgment largely concurred with that of Lord Scott), the grant of a remedy in the company’s favour (as opposed to the complainant shareholder’s favour) on an unfair prejudice petition will be “rare and exceptional” and that, in the ordinary course, the petitioner should seek an order in the petition to bring a derivative action on behalf of the company or, alternatively, pursue a statutory derivative action as now contained in Part 11.

STATUTORY DERIVATIVE CLAIMS32

13. Under the common law derivative claim - that is, by which the common law provided certain exceptions to the rule in Foss v. Harbottle - a derivative claim could be brought by an individual shareholder on behalf of the company in order to remedy a wrong that would otherwise go without redress. As indicated above, the common law derivative claim was only available, however, where (a) the wrong was a fraud on the minority not capable of being cured by the majority, and (b) the wrongdoer’s control of the company in general meeting prevented the company pursuing an action in its name33. Even where those exceptions could be made out, however, in giving effect to the commercial considerations of the company in deciding whether or not to litigate, the Court would not allow a derivative action

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See Clark v. Cutland [2004] 1 WLR 783.

32 For excellent surveys of the new statutory regime see A Keay and J Loughrey, Derivative

proceedings in a brave new world for company management and shareholders [2010] JBL 151-178 and B Hannigan, Drawing boundaries between derivative claims and unfairly prejudicial petitions

[2009] JBL 606-626. For a detailed assessment of the procedural requirements see B Pettet, J Lowry and A Reisberg, Pettet’s Company Law: Company and capital markets law (3rd Edn, Longman, Harlow, 2009) pp.233-234.

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where that ran contrary to the wishes of the majority of the disinterested shareholders who were independent of the wrongdoers34.

14. Under the new statutory scheme, a member may bring a derivative claim against any director (including former and shadow directors) in respect of negligence, default, breach of duty and breach of trust35. A claim, however, then requires the permission of the Court in order to continue36. The permission stage involves two hurdles. First, the Court must dismiss the claim unless a prima facie case can be made out37. Secondly, the Court must consider a number of factors38. Certain of those factors require the Court to refuse permission39. It seems likely, however broad the language in which those provisions are cast, that the Government intended to strike a balance in favour of management - as opposed to investor protection - given the clear policy that derivative claims should be “exceptional”40

and subject to “tight judicial control at all stages”41

. It remains, nevertheless, that the question of whether it is in the interests of the company to litigate by way of the statutory derivative claim lies in the hands of the Court and not within the confines of the company structure itself. This contrasts with the position under the derivative claim at common law where the Court’s role was limited to ensuring that the claimant had standing to sue without consideration (indeed, jurisdiction) to take account of whether or not it was in the best interests of the company for the litigation to be pursued42.

34Smith v. Croft [1987] 3 All ER 909. 35 s.260(3).

36 s.261(1). 37

s.261(2).

38 s.263(3): namely, whether the member is acting in good faith, the importance that a person acting in

accordance with s.172 would attach to continuing the claim, whether the cause of action results from an act or omission which is yet to occur and whether in the circumstances the act or omission would be likely to be authorised or ratified by the company before or after it occurs, whether the company has decided not to pursue the claim and whether the act or omission in respect of which the claim is brought gives rise to a cause of action that the member could pursue in his own right rather than on behalf of the company

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s.263(2).

40 Hansard HL, vol.679 (official report) (27th February 2006) Cols GC4-5 (Lord Goldsmith). 41 Ibid, Cols GC4-5 and see also the Consultation Paper at para.4.6 and Report at para.6.4.

42 See P L Davies, Gower and Davies, Principles of Modern Company Law (8th edn, London, 2008) at

614. The practical effect of the new statutory regime is that a shareholder can obtain a decision on the key issue as to whether it is in the interests of the company for the litigation to be brought as opposed to the previous position where the Court could do no more than decide that the decision to litigate was one for the shareholders generally rather than the individual shareholder.

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15. As a result of the implementation of Part 11 of the 2006 Act “the rule in Foss v. Harbottle is thus consigned to the dustbin”43. The new statutory provisions are not, however, an all-encompassing regime since ss.260(3) and 265(3) contemplate claims only “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”44

. Where a company has a cause of action outside of the scope of the new statutory regime45 the decision whether or not to litigate will necessarily be determined in accordance with the company’s articles of association which, in practice, will ordinarily leave the decision to the board, although a defective decision by the board in that regard might lend itself to a claim under the statutory regime by a disgruntled shareholder.

16. It has to be said that the implementation of Part 11 of the new statutory regime brought with it certain harbingers of doom, law firms included, who predicted a shift to floodgates US-style litigation46. Few directors of large companies and in-house counsel will have missed the level of concern expressed both in the press and in law firm client briefings during the course of the companies bill passing through Parliament to the effect that the new derivative action would increase litigation47.

17. To date, and contrary to those early fears, two cases bear out what appears to be the continued conservative approach on the part of the Courts towards allowing continued pursuit of derivative claims48. First, in Mission Plc v. Sinclair [2008] EWHC 1339 two executive directors constituting the minority of a board commenced a claim when their employment and directorships were terminated on the grounds

43

P L Davies, Gower and Davies supra at p.615.

44 That is, where the directors themselves are in breach of duty since it is in that instance that the risk

of conflicted decision-making by board or shareholders has been shown to have arisen most commonly on the authorities.

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Eg, a claim against a non-director employee.

46 J Loughrey, A Keay and L Seroni, Legal Practitioners: Enlightened shareholder value and the

shaping of corporate governance (2008) 8 JCLC 79 at 97 provides extensive detail of the literature, including website addresses for a number of high profile firms of solicitors.

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Clifford Chance, for example, has suggested that, where directors recommend a takeover bid which would lead to job cuts, employee shareholders could initiate derivative litigation claiming that the directors failed to give sufficient weight to the s.172 statutory factors. The fact that such an action would be likely to be struck out would make no difference to the intended consequence of the lapse of the takeover offer.

48 A Reisberg, Shadows of the Past and Back to the Future: Part II of the Companies Act 2006

(in)action (2009) 6 ECFR 209 at 225: see also D Arsalidou, Litigation Culture and the New Statutory Derivative Claim (2009) 30 Comp Law 205 at 207.

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that they had failed to meet financial forecasts and to submit important financial information to the company. The two directors’ contracts for services provided that the board could terminate the contracts on the basis of conduct unacceptable in the reasonable opinion of the board. Apart from an interim injunction seeking to restore their positions, the Court had to consider granting permission for the continuation of a derivative action under s.263. On the facts it was held that, whilst mandatory refusal was not necessary under s.263(2), a proper consideration of the discretionary factors in s.263(3) and the circumstances of the case justified refusal for permission for the claim to continue. The key point was that, despite the fact that the former directors had brought the action in good faith, the Court did not think that a notional director would attach much importance to it given that the damage suffered by the company as a result of the wrongful dismissals was, at best, speculative.

18. Permission was also refused in Franbar Holdings Ltd v. Patel [2008] EWHC 1534 (Ch) which involved a number of applications including a petition under s.994 alleging unfairly prejudicial conduct and an application to continue a derivative action. The claimant had a minority stake in the company with the balance of the shares being held by a third party. The claimant alleged that the directors of the company appointed by the third party had wrongly suspended one of the claimant’s nominated directors, had not provided adequate financial information and had diverted business opportunities away from the company to the third party. In considering the application, the Court identified several factors which the hypothetical director would take into account, including the prospects of success, any damage to the company’s reputation and business in the event of the action failing and the cost of the proceedings. Some importance was also placed on whether the shareholder bringing the derivative action would be able to obtain relief under s.994. In fact, the principal reason for the Court’s decision to refuse permission was the existence of the s.994 remedy. Whilst there was substance in some of the allegations made by the claimant shareholder, and prima facie breaches of duty on the part of the directors could be established, the Court made clear that the shareholder would be able to obtain appropriate remedies by pursuing the s.994 action alone and that, for the purposes of permission on a derivative claim, more was required to establish a clear route for a claim of breach of duty leading to a significant recovery on the part

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of the company. It was therefore open to a hypothetical director to decline to proceed with the derivative action.

19. The robust approach taken in both Mission and Franbar suggests that, in substance, and despite the apparent rationalisation by way of the new statutory code, little might, in fact, have changed by way of the new statutory regime. Neither is there anything in the new Part 11 procedure which could reasonably convince a rational shareholder that he might be better off litigating his case on behalf of the company rather than simply selling his shares. With the potential for the scope of s.994 claims being liable to be clipped back, as identified above, the conclusion must be that s.994 is likely to remain a remedy available, other than perhaps in the most exceptional of circumstances, in respect of personal shareholder (as opposed to company) grievances whilst the new statutory derivative regime may offer little, if anything, new.

LOUIS DOYLE Barrister

Kings Chambers,

36-38 Young Street, Manchester, M3 3FT 5 Park Square East, Leeds, LS1 2NE ldoyle@kingschambers.com

www.kingschambers.com September 2010

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