Derivative Actions: Can the shareholders of a company take action against the directors?

We have previously written about disputes within the board of a company here and disputes between the shareholders of a company here.

But what happens where there is a dispute between the shareholders and the directors and it is the shareholders of a company who want to take action against the directors?

In most situations, the proper claimant for wrongs committed against a company, whether by directors or a third party, is the company itself . The decision whether to sue or not therefore generally lies with the directors rather than the shareholders. Shareholders are normally precluded from taking action on behalf of the company and the courts generally refuse to intervene in the internal management of a company that is acting within its powers.

However, shareholders may be able to intervene where certain specified types of wrong are committed by the directors – in such circumstances, the court has a discretion to permit shareholders to bring a claim their own name on behalf of the company. This type of claim is called a derivative action.

If the shareholders are in dispute with the directors, it is likely that the shareholders will be alleging a breach of duty by the directors. As the directors of the company are unlikely themselves to bring any action for breach of duty, the shareholders may consider bringing a derivative action. For more information on directors' duties, see our handy guide here.

When may a derivative action be brought?

The statutory provisions on how and when shareholders of company may bring a derivative action are set out in the Companies Act 2006. There are separate provisions for Scotland although they are largely similar to those applicable in England and Wales.

The Act provides that a derivative action may only be brought where the company suffers loss as a result of a director's:

• negligence;
• default;
• breach of duty; and/or
• breach of trust.

A derivative action is brought by a shareholder on behalf of the company; this means that if a derivative action is successful, any damages awarded are awarded to the company and not the shareholder(s) who brought it.

Two stage process for bringing a derivative action

To bring a derivative action to court, there are statutory hurdles that the shareholder must overcome.

The Act sets out a two-stage process for bringing a derivative claim.

Stage 1 : Permission to bring the action

Firstly, a shareholder has to seek permission from the court to commence derivative proceedings. The court must refuse to grant permission if it considers there is no prima facie case.

If permission is not refused at that stage then the court will order the application for permission to be served on the company. Orders can be made requiring the company to produce evidence and the company will then have an opportunity to make representations to the court as to whether permission should be granted.

The court must consider certain matters when deciding whether to use its discretion to allow the derivative action to be raised or continued, namely whether it is in the best interests of the company for the claim to be brought.

The Act provides that the court must refuse permission for a derivative action if it is satisfied that a person acting in accordance with the statutory duty to promote the best interests of the company would not seek to raise the claim or that the act or omission which is the subject of the derivative action has been ratified or authorised by the company.

Thereafter, when exercising its discretion, the court will consider a non-exhaustive list of factors set out in the Act, including:

• whether the member is acting in good faith;
• the importance that a person acting in accordance with the duty to promote the success of the company would attach to continuing the claim;
• whether the member has a cause of action that they may pursue in their own right rather than on behalf of the company; and
• the views of the members of the company who have no personal direct or indirect interest in the matter.

The court is obliged, at this stage, to form a view of the strength of the claim, albeit a provisional view.

Stage 2: Bringing the derivative action

If the court is persuaded to grant permission to raise/continue proceedings, then the action. for redress against the director(s), on behalf of the company, can proceed in the same way as the court action would have done if the company had decided to raise the proceedings itself.

If you would like further information on directors' duties and possible breaches, please contact a member of our Corporate team. If you need assistance for a dispute, please contact a member of our Litigation team.