The kilt doesn't quite fit

The Petition of Alexander Marshall Wishart [2009] CSOH 20 was the first application to the Court of Session for an order under s 266 of the Companies Act 2006 granting leave to bring a derivative claim. Lord Glennie’s opinion of 12 February, granting leave, offers guidance to practitioners as to how the new rules will be implemented. (The decision has been reclaimed.)

The general rule is that a shareholder buys into a company in the knowledge that it is run by majority rule. The company, which is controlled by its board of directors and, residually, by the shareholders at general meeting, is the correct pursuer in any action seeking restitution to the company. If the company decides not to take action, a minority shareholder cannot go around that to raise an action: Foss v Harbottle (1843) 2 Hare 416.

The derivative action is an exception to this rule. Where a wrong (or a “fraud”, given an extended meaning) has been committed against the company, and the wrongdoers or those connected with them exercise control of the company to prevent remedial action being taken, shareholders may raise a court action on behalf of the company. This is referred to as a “derivative action”, as the rights the shareholder seeks to enforce are derived from the company.

The Companies Act 2006 (“CA 2006”) put this type of action on a statutory footing. The rules for Scotland and England differ slightly, but significantly. It appears that the aim was to “kilt” the English provisions, tweaking them to take into account the peculiarities of Scottish procedure. However, the Wishart application has thrown up a number of issues suggesting that the “kilting” process may not yet be complete.

In England & Wales the derivative action was well established prior to CA 2006. Under special procedural rules adopted in 1994 a plaintiff who raised a derivative claim required to apply to the court for leave to continue the action (CPR 19 r9).

In contrast, very few derivative claims had been raised in the Scottish courts and there was even doubt as to whether or not such an action was competent. That was resolved in Anderson v Hogg 2000 SLT 634 and Wilson v Inverness Retail and Business Park, 2003 SLT 301, which confirmed that derivative actions were competent in Scotland and in fact dated back as far as 1898.

Divergent approaches

Derivative claims must now be brought under the rules set out in CA 2006, Part 11. Following the existing rules of procedure, in England a member who brings a derivative claim must apply for permission to continue that claim (s 261(1)). In Scotland the derivative action cannot be raised without the leave of the court, making the application for leave a separate procedure from the action itself. The thinking behind the different procedure in Scotland is not clear, and the Wishart application raised a number of concerns as to how this will work in practice.

The substantive rules, as to who can bring a derivative action and for what, are essentially the same in both jurisdictions. The claim may be brought by a member (shareholder) of the company in respect of a cause of action vested in the company 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 (ss 260(3) and 265(3)).

Suitable for enquiry

When leave is applied for, the court considers ex parte whether on the face of the application it appears that it does not disclose a prima facie case, in which case it must be dismissed (ss 261(2); 266(3)). Lord Glennie noted that in addition to a prima facie case of a relevant act or omission, the court requires to look for a prima facie case of wrongdoer control. This is not specifically referred to in CA 2006, but Lord Glennie held that it was implicit in the nature of derivative proceedings.

If the petition survives the ex parte stage it is served on the company, which can enter the proceedings if it chooses. Lord Glennie clarified that the alleged wrongdoer directors do not have any right to do so.

The court goes on to consider a number of factors, first those which, if found, require that leave is refused. If the court determines that a person acting in accordance with a duty to promote the success of the company would not seek to bring the derivative claim, or that the act or omission has been authorised or ratified by the company, leave must be refused (ss 263(2); 268(1)). (In considering ratification the votes of the wrongdoers and those connected with them are discounted: s 239.)

If these factors are not found, the court may grant leave. In determining whether to do so it must consider whether the member is acting in good faith, the importance a person acting in accordance with a duty to promote the success of the company would attach to the action, whether it is likely the act or omission could be and in the circumstances would be likely to be ratified by the company, whether the company has decided not to pursue the claim, and whether the claim is one that the member could pursue in his own right (ss 263(3); 268(2)). The court is to have particular regard to the views of members of the company who have no personal interest in the matter (ss 263(4); 268(3)).

What level of enquiry should the court enter into in considering these factors? The threshold procedure is intended to weed out frivolous actions at an early stage; however, consideration of the factors requires that the court consider the substance of the proposed action and the petitioner’s motives, which raises the prospect of a mini or even a full proof. In Wishart the defenders sought an evidential hearing on good faith. This would potentially have involved leading evidence on the whole substance of the derivative claim.

In England the courts have discouraged lengthy preliminary trials on the question of leave, noting that this would allow a shareholder who has yet to establish the right to bring a derivative claim, to subject the company to a lengthy evidential hearing (e.g. Prudential Assurance Co v Newman Industries [1982] 1 Ch 204). Lord Glennie found some middle ground and allowed affidavits to be lodged in relation to good faith, but excluding issues he considered to be going to the merits of the derivative claim.

Indemnity from the company

In Wishart, in addition to seeking leave to bring a derivative claim, the petitioner also sought an order that the company be responsible for the expenses of bringing the action.

In a derivative action a shareholder is suing on behalf of the company. The benefit, if they are successful, will go to the company (the shareholders may benefit indirectly if the value of their shares increases). Should a shareholder face the burden of having to fund the action themselves? If they are ultimately unsuccessful, should they be liable for the expenses of the defender?

In England a shareholder may obtain an order for indemnification for costs from the company. In Wallersteiner v Moir (no 2) [1975] QB 373 Lord Denning noted that the shareholder raising a derivative action is acting as agent of the company and therefore ought to be indemnified in the same way that a trustee is entitled to be indemnified from a trust. If the action succeeds, the wrongdoers will have to pay costs, but if there is a difference between judicial costs and the shareholder’s actual costs or payment cannot be obtained from the defender, the company ought to pay. If the action fails, provided it was raised reasonably and in the interests of the company, the company ought to pay the shareholder’s costs and any award in favour of the defender. Wallersteiner has been applied in subsequent cases in England, and power to make this award now appears in CPR 19 r9E.

Application for indemnity in England is made at the same time as the application for leave to continue, and is incidental to the derivative action itself. Orders are often initially made for a limited period, on the basis that further applications can be made as the case progresses, allowing the court to reconsider the reasonableness of the shareholder continuing with the action. Since in Scotland the application for leave is a separate court action, a judge asked for a Wallersteiner order is being asked to issue an interlocutor determining liability for expenses in another proceeding. As the court considering the leave petition is not the court that will hear the derivative action, how is the shareholder to seek further Wallersteiner orders?

Lord Glennie considered these matters and granted a Wallersteiner type order that the petitioner be indemnified by the company for the expenses of bringing the derivative action up to the procedural hearing (the action was to be raised as a commercial action). Further applications can be made as the case progresses, as the petition for leave has been continued. Lord Glennie foresaw potential difficulties with the tandem proceedings and recommended that the judge hearing the petition have both processes before him.

A way forward?

CA 2006 has put it beyond any doubt that derivative actions are competent in Scotland and has provided some clarity in terms of the threshold tests. However, the two stage procedure devised for Scotland has created difficulties. Lord Glennie has encouraged the Rules Committee, in a postscript to his opinion, to devise a mechanism whereby the application for leave can be made by note or some similar ancillary proceeding to the derivative action, so that the order granting leave is an order of the main action. This could resolve the issue of prescription and address the difficulty related to Wallersteiner awards of expenses.

Stopping the clock

Where it is close to five years since the act or omission complained of, the shareholder seeking to raise derivative proceedings in Scotland faces a potential difficulty. They first require to raise the application for leave to bring the derivative claim. The length of time this takes will depend on the facts and the approach taken by the judge as to the level of enquiry necessary. Assuming a decision on leave can be obtained in time, if that is reclaimed there is a further prospect of the claim prescribing before the question of leave is resolved.