Essay: Minority shareholders protection

Minority shareholders protection in general meeting, and the will of the shareholders is expressed by a simple majority of votes, or such other majority as may be prescribed by the bargain between the shareholders. Due to such bargain, the concentration of power and control in voting majorities and in directors creates scope for abuse; and it is in the context of such abuse – or allegations of such abuse – that minority shareholders and their rights characteristically concern the courts.
In 1997, the Law Commission completed its task of reviewing and reforming the law on shareholders’ remedies. In its report, the Law Commission accepted the failure of the old existing ‘common law’ derivative action. The Law Commission recommended that the common law action be replaced with a statutory derivative procedure with more modern, flexible and accessible criteria for determining whether a shareholder may bring a claim. The Law Commission recommendations were endorsed and included in the Companies Act 2006 (‘CA 2006’).
Derivative claim
Derivative claims are claims brought by members of a company to enforce rights that are vested in the company and seeking relief on behalf of the company. The minority may consider that the Company has a claim against particular targets (for example, defaulting directors or even majority shareholders) which the company, under the control of its board and thus the directors (and the majority) is failing to pursue (but has not ratified such actions according to section 239 of CA 2006). In order to enable minority to protect the company’s position from those who controlled it, common law gave a right to the minority under what was known as ‘the rule in Foss v Harbottle’ in using the name of the company in certain circumstances. This judge-made rule has now been generally superseded following the Law Commission report (except for limited application covering (i) multiple derivative claims; and (ii) claims in respect of foreign registered companies ) by a statutory right for the minority to bring, or to continue, a ‘derivative action’ in the name of company under sections 260-263 of CA 2006.
Who can bring the claim?
An ordinary derivative claim, similar to petition for unfair prejudice, may be initiated by a member of the company who then requires a permission of the court to continue with it (CA 2006, section 261(1)). References to a ‘member’ include a person who is not a member but to whom shares in the company have been transferred or transmitted operation of law, section 260(5)c of CA 2006. This clause has been widely interpreted by courts. For example, in JKX Oil & Gas Plc court allowed beneficial owners to initiate the derivative claim, when they were unable to get the nominee shareholders to act quickly. No minimum shareholding is required, which in theory, means that litigious parties could purchase one share with a view to bringing a case against the directors, but whether the court would give permission to such a claimant to proceed is another matter.
On what basis can the action be brought?
A derivative claim may be brought only in respect of a cause of action arising from 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) .
The central issue under the statutory procedure is the nature of discretion vested in the court to approve or not the continuance of derivative claim. That discretion is broad but not unconstrained. A derivative claim requires two stages of permission before the claim is heard.
1st stage – Prima facie case
Although the company is a potential beneficiary of the derivative action, there is a risk that companies might find themselves subjected to overly-high levels of proposed derivative claims by shareholders who have a fanciful or even self-interested view of the likely benefits to the company from such litigation. If the court does not at this stage think the applicant has established a prima facie case for permission to be granted, the application will be refused.
2nd stage – Procedural hurdles of s263
Section 263 sets out detailed criteria as to whether permission is to be given. The court must refuse permission on the mandatory ground if it is satisfied that: (i) a director acting in accordance with s172 of CA 2006 (duty to promote the success of the company) would not seek to continue the claim; or (ii) the act or omission has been authorized by the company or ratified by the company (s 263(2) CA 2006) .
If none of the ‘mandatory grounds’ requiring court to refuse permission applies, then in deciding if permission should be given to continue the claim, the court will consider a number of factors . Factors that court will look into include are set out in a non-exhaustive list in section 263(2) of CA 2006: (i) whether the member is acting in good faith in seeking to continue the claim, (ii) the importance that a director acting to promote the success of the company would attach to continuing it, (iii) whether act or omission (still to occur) would be likely to be authorized or ratified by the company, (iv) whether the company has decided not to pursue the claim, and (v) whether the act or omission in respect of which 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.
Permission to continue the derivative claim was refused in four out of the seven post-2007 cases examined in the study conducted in 2012. In all the cases, the deciding factor was section 263 of CA 2006.
Strict interpretation of the leave procedure and the section 263 factors may leave the shareholder in a worse position than he was in at common law. A perusal of the Act and its interpretation by the court in the cases reveals an attempt to balance the need for greater protection of minority shareholders and the need to avoid a litigation culture which could be damaging for the company. But the question that arises is whether the rigorous procedural hurdles upset the balance which the Act tries to create and thus leave the minority shareholder *Comp. Law. 107 in a worse position than he was in at common law. What can be said for present purposes is that the Act has certainly simplified the law and made it more accessible.
Costs?
Litigation is expensive, and its cost is a major obstacle in the path of a minority shareholder bringing a derivative action on behalf of the company. A rational shareholder will normally prefer to sell his shares rather than litigate. In financial terms, a shareholder lacks any direct remedy that would make the action worthwhile for him or her. Even if the litigation is successful, any damages recovered accrue to the company and the shareholder will therefore receive only a pro rata share of the gains of a successful action. There is also the prospect that the shareholder may have to pay the expenses of litigation as well as the legal expenses of the defendant if the action is unsuccessful. A prospective plaintiff, being aware of this “free-riding” effect, has a strong incentive to leave it to someone else to sue. If all shareholders share the same view, then no one is likely to step forward even in situations where litigation would increase total share value.
Indemnity cost order – recognizing the problem of the impecunious shareholder
The above mentioned financial considerations will usually be the first factor which informs a shareholder as to whether it is worth pursuing a derivative claim. Regardless of how strong a claim and aggrieved a shareholder, this is negligible without a strong financial footing for shareholders to pursue a derivative claim. Indemnity costs orders have been assumed to be the answer to providing financial incentives to shareholders. The important case of Wallersteiner v Moir (No.2) established that a consequence where permission is given to the derivative claim by court, the company should normally be liable for the costs of the claim, even, in fact especially where the litigation is ultimately unsuccessful. This decision is now reflected in the Civil Procedure Rules which provide that ‘the court may order company … to indemnify the claimant against any liability for costs incurred in the permission application or in the derivative claim or both’ . This is very important provision because, without it, the financial disincentive for a shareholder to bring a derivative claim would be very strong, no matter how relaxed the standing rules.
All things considered, the mere introduction of the statutory derivative claim has not dramatically increased the litigation risk to the directors, nor indeed significantly enhanced the protection of shareholders.
Unfair Prejudice petition
The most valuable shareholder remedy is that contained in the Companies Act 2006, s 994(1) , which provides:
‘A member of a company may apply to the court by petition for an order on the ground
(a) that the company’s affairs are being or have been conducted in a manner that is unfairly prejudicial to the interests of members generally or of some part of its members (including at least himself), or
(b) that an actual or proposed act or omission of the company (including an act or omission on its behalf) is or would be so prejudicial.’
This provision repeats rather than reforms the provisions previously found in section 459 of the Companies Act 1985, so the older cases remain relevant. Controlling shareholders are not in terms excluded from using the section, but this section operates primarily as a mechanism for minority protection – or, at least, for the protection of non-controlling shareholders.
What ‘rights’ are protected by unfair prejudice petition?
The important steps taken by the courts can be characterized by saying that the courts recognised that section 994 of CA 2006 also protects expectations, not just rights. It is sometimes said that the section protects ‘legitimate expectations’ of the petitioner, as endorsed in by the Court of Appeal in Re Saul D Harrison & Sons Plc per Hoffmann LJ; thought more recently the courts have preferred the phrase ‘equitable considerations’ as endorsed also by Lord Hoffmann (as he had by then become) in decision of House of Lords in O’Neill v Philips . In his judgment, he stated that for the purposes of section 994 of CA 2006, ‘a member of a company will not ordinarily be entitled to complain of unfairness unless there has been some breach of the terms on which he agreed that the affairs of the company should be conducted’. However, ‘there will be cases in which equitable considerations make it unfair for those conducting the affairs of the company to rely upon their strict legal powers’. This would be so where the exercise of powers in question would conflict with the promises the parties had exchanged; such promises need not necessarily be contractually enforceable. However, the mere fact that trust and confidence had broken down was not sufficient.
What is unfair prejudice?
It has been held that the test for unfair prejudice is an objective test, not a subjective one . It would not therefore be necessary to show that the majority acted in the knowledge that the conduct would prejudice the petitioner. The question is whether a reasonable man would regard the conduct as having unfairly prejudiced the minority’s interests. An unfair prejudice petition will succeed if the two constituent parts of unfair prejudice are established, namely unfairness and prejudice as established in Re R A Noble (Clothing) Ltd and Re Saul D Harrisson . Please note that conduct may be prejudicial but not unfair, for example if petitioner has acquiesced in the breaches of which he now complains as in Re Metropolis Motorcycles Ltd, Hale v Waldock where court found it was prejudicial not to consult a minority shareholder, but not unfair, if the petitioner has chosen to withdraw from active involvement in the business. Vice versa, conduct may be unfair but not prejudicial, as in Irvine v Irvine (No1) where the court found that there had been a failure to meet the statutory requirements as to approving the accounts and holding of annual general meetings, but the failures could not be said to have caused the petitioner any material prejudice.
Examples of the forms of conduct which courts have in certain circumstances held to amount to unfairly prejudicial conduct for this purpose include: (i) breach of fiduciary duty which results in real prejudice, such as damage to the parties’ relationship of trust and confidence, the misuse or misappropriation of company assets or the procurement of an allotment of shares to dilute a minority’s interests; (ii) serious mismanagement as in Re Macro (Ipswich) Ltd ; (iii) failure to pay dividends as in Grace v Biagioli ; (iv) payment of excessive remuneration as recently confirmed in Re Booth Limited ; (v) diluting the minority’s shareholding; (vi) failure to abide by the company’s articles, any shareholders’ agreements, or CA 2006; and (vii) exclusion from management where participation was part of the bargain as in Re a Company No 00477 of 1986 , or failure to consult with, or provide information to, a petitioner where it was agreed that the petitioner would be consulted or provided with such information.
Who has right of petition?
Only members (in certain circumstances, the Secretary of State may petition on the same grounds under Companies Act 2006, s995, but this power is never used) have a right to petition and the definition of ‘member’ is extended to include persons to whom the shares have been transferred or transmitted by law (Companies Act 2006, s 994(2)) which extends standing to petition to persons such as personal representatives and trustees in bankruptcy. A petition may also be brought by a nominee shareholder as confirmed in Atlas View Ltd v Brightview Ltd .
Remedies?
Section 996(1) gives the court a wide remedial discretion to ‘make such order as it thinks for giving relief in respect of the matters complained of’. In addition to this general grant, five specific non-exhaustive powers are given to the court by s.996(2) of which undoubtedly the most commonly used is an order that the petitioner’s shares be purchased by the controllers or the company. The wide discretion has been held to include a right to refuse any specific relief if no appropriate remedy could be devised (Re Full Cup International Trading Ltd, Antonides v Wong and Others ). Having satisfied section 994, the usual course for the claimant to take is to seek an order that his shares should be purchased from him at a fair value which normally requires shares to be valued as if wrongdoing had not occurred so ensuring that the shareholder recovers any diminution in the value of his shares cause by the wrongdoing .
Given that most attractive remedy for dissenting minority shareholder is usually exit from the company, we will look in more details rules followed with regard to purchase of such shares. In O’Neill v Phillips , Lord Hoffmann set out guidelines with regard to an offer to purchase a petitioner’s shares in a case where unfair prejudice is alleged: (i) the offer must be to purchase shares at a fair value; (ii) the value, if not agreed, should be determined by a competent expert acting as such (rather than as an arbitrator); (iii) the offer should provide for ‘equality of arms’ between the parties, ie equal rights to information about the company which affects the value of the shares, and to make submissions to the expert; and (iv) in the event of a breakdown in relations, the majority shareholder should be given a reasonable opportunity to make an offer before he becomes obliged to pay costs.
The advantage of proceeding by way of a petition under Companies Act 2006 s994 is that it avoids the procedural obstacles surrounding the derivative claim which require a claimant to obtain the permission of the court to continue the claim. A petition also secures a personal remedy for the petitioner rather than a remedy for the company, as is the case with a derivative claim. On the other hand, a derivative claim may be attractive where the shareholder does not wish to have his shares purchased by the respondents but wants a remedy for misconduct and the recovery of assets belonging to the company and he wishes to take advantage of the indemnity for costs which is available with respect to derivative claim.
WINDING UP ON JUST AND EQUITABLE GROUND
Legal protection for minority shareholders is now dominated by the unfair prejudice remedy, but, despite its remedial flexibility, the court cannot thereby order the winding-up of the company in question. There is a separate provision contained in s.122(1)(g) of the Insolvency Act 1986, by which a minority shareholder may seek to have the company wound up. A winding-up petition triggers section127 of the Insolvency Act 1986, which requires the court’s consent for any disposition of the company’s property after the petition is presented. The ability to paralyse, or at least disrupt, the normal running of the company’s business adds to the negotiating strength of the claimant, but is hardly legitimate if an unfair prejudice petition could give him or her all that is wanted. In practice, it is unlikely that a petitioner does want a winding-up order. As discussed, the successful petitioner is able under section 996 of the CA 2006 to obtain a purchase order and exit the company and has no reason to pursue a winding-up order. Having said that, there may be a circumstance, such as deadlock, in which a claim cannot be brought within section 994 of the CA 2006, but would fall within the just and equitable winding-up jurisdiction. It is possible therefore that the claim for a winding-up order will be instead of or additional to a claim under section 994.
Conclusion
The armory that minority shareholders have in respect to misadministration contains of 3 crucial components – unfair prejudice petition, Just and equitable winding up and derivative claim. Derivative claim as it stands has a lot of inadequacies and the threshold and risk of litigating is so high that will put of most of vexatious individuals from that kind of litigation, due to relatively small gains that they could have and exhausting path in succeeding in one. The approach of the courts in giving the green light to proceed with the derivative claim has been fairly strict. Unfair prejudice petition seems like a more appropriate way of trying to enforce the minority shareholders rights, the remedies afforded are much more generous and are giving a wide discretion to courts to respond to diverse factual situations. The procedural hurdles are not as onerous as with the derivative claims and the claimant will be able to secure a personal remedy rather than rather than a remedy for the company.
So far, the courts appear to have trodden carefully but it remains to be seen how future cases covering new situations will be treated, particularly by the higher courts. However, this also raises the question of whether maintaining the balance between these two competing interests is a matter to be decided by the court in individual cases or whether this could have been taken care of more effectively in the Act itself.
The goal of the legislation in the area of minority shareholder protection is to strike a balance between the need to uphold the majority rule principle and the need to protect minority shareholders from abuse by the majority.
Bibliography:
Books:
V. Joffe, D. Drake, G. Richardson, D. Lightman and T. Collingwood, Minority Shareholders – Law, Practice and Procedure (Oxford 2015, 5th edition)
B. Hannigan, Company Law (Oxford YEAR, 4th edition)
P.L. Davies and S. Worthington, Gower Principles of Modern Company Law (Sweet & Maxwell YEAR, 10th edition)