Examining Foss under the Companies Act - Essay Example

? Introduction Minority shareholders in the UK have traditionally been constrained from bring causes of actions against directors, due to the common law rule established by Foss v. Harbottle (1840) 67 ER 189. In this case, the Foss court held that actions may only be brought by the company itself, subject to certain exceptions. Since then, the Companies Act (2006) has established the right to a shareholder derivative action, subject to severe constraints on when actions may be brought, and has also established, in a different section, the right for company members to bring action if the directors are acting in a way that is prejudicial to the shareholder, or, alternatively, does a certain action which is considered to be unfairly prejudicial. Since “unfairly prejudicial” is not defined by the Act, this means that there are broad reasons why a minority shareholder may bring a cause of action against a corporation, which effectively negates the constraints established by Foss. This paper will examine Foss, will examine derivative actions, and will examine the Companies Act (2006), concluding that, while Section 260 of the Act does not provide shareholders with any more protection than what was had under Foss, section 994 does provide this protection. Foss v. Harbottle Even though shareholders are effective in holding directors accountable, the UK courts have a common law rule, delineated in Foss v. Harbottle (1840) 67 ER 189. In this case, two minority shareholders accused the defendants, who were the directors of a company called “Victoria Park Company,” of misapplying land, wasting land and obtaining improper mortgages, without the permission of the shareholders. The court in the Foss case dismissed the shareholders case, stating that only the company itself has a right to sue the directors. The reasoning for this might be best stated by the court in a subsequent case, Edwards v. Halliwell [1950] 2 All ER 1064. The judge in this case states that the sound reason why minority shareholders cannot bring an action against directors is that, if there is only a minority bringing the case, it would mean that the majority of the company is in favor of what was done. Ramsay & Saunders (2006) state that there are two prongs to the Foss case – one, it established the “proper plaintiff” who is the company itself; two, it established the principle that directors should be independent and not subject to shareholder meddling into business affairs (Ramsay & Saunders, 2006). There are exceptions to the Foss rule. One is that the company did an illegal or ultra vires act. A shareholder can bring an action on this basis, because the majority cannot ratify an illegal or ultra vires act (Wedderburn, 1957; Cockburn v. Newbridge Sanitary Steam Laundry Co. [1915] 1 IR 237). Another exception is that, if the company takes an action which, in the company’s constitution, requires a “special majority” to take this action, then a minority shareholder may sue if the company takes this action in contravention to its own constitution (Black, 1983; Edwards v Halliwell [1950] 2 All ER 1064). Berkahn (1998) states that another exception is that a shareholder’s “personal rights” have somehow been infringed by the corporation, therefore that shareholder has a right to sue for his personal rights infringement (Berkahn, 1998; Pender v Lushington (1877) 6 Ch D 70). Another exception is the “fraud on the minority” exception, which means that the wrong-doers actions amounts to fraud (Lo, 2004; Atwool v Merryweather (1867) LR 5 EQ 464n). Buckley (1976) states that this last action is the only derivative action of the exceptions, as the first three exceptions involve personal actions. Therefore, according to Maloney (1986), this action is the only true exception to Foss (Maloney, 1986). Statutory Actions Although Foss limited the actions that minority shareholders can take, statutory actions have restored many of the rights of the minority. One is that the Companies Act (2006) has given shareholder permission to bring a shareholder derivative action. Ramsay & Saunders (2006) state that shareholder derivative actions are necessary to the concept of corporate governance, because it gives investors confidence by punishing bad actors in the company. Moreover, the possibility that these actions might be brought are an effective deterrence to directors who might, otherwise, perform acts which are detrimental to the company. That said, shareholder actions are a balancing act – on the one hand, they are effective, in that they deter wrong-doing and hold wrong-doers accountable. On the other hand, they might be a nuisance and be an obstacle to director independence. Directors need freedom from shareholder interference, which is an argument against allowing minority shareholders the right to sue the company (Ramsay & Saunders, 2006). The part of the Companies Act (2006) which gives minority shareholders the right to bring an action against the company is Section 260 of this Act. Section 260 states that shareholders may bring a derivative action against the company if the company is negligent, or breaches its duty or breaches trust (Companies Act 2006 § 260). The derivative action may be brought if a court allows it, and, in order for the court to allow the case to proceed, the shareholders must demonstrate that they have a prima facie case, which means that, on its face, without any other evidence, the plaintiffs can present an actionable case to the court (Companies Act 2006 § 261). Courts must refuse the application to bring a case if it is shown that the act has been ratified by the company, or authorized by the company before the act occurred; or that a person who has been appointed to promote the company would not have pursued the claim (Companies Act 2006 § 263). Ohrenstein (2007) states that this section of the Companies Act is important, because it gives shareholders the right to bring a cause of action for negligence, even if the directors did not benefit from the negligence, and this, according to Ohrenstein (2007), is a significant change from the common law. In addition to the provisions set forth in Companies Act 2006 § 260, there is also another provision in the Companies Act (2006), and this is Companies Act 2006 § 994. In this provision, the members of the company may bring an action against the company if the company has conducted its affairs in a manner which is prejudicial to the members. It may also be brought if there is an actual act that the company has taken that would be prejudicial to the members (Companies Act 2006 § 994). What is interesting about this provision is that, unlike the Section 260 provision, there is not the burden of proving a prima facie case to the court, and there also is not a provision stating that the court must refuse application to the court if the adverse action was ratified or authorized by the company. Analysis Foss v. Harbottle restricted shareholders from bringing actions against a company’s directors, stating that only the company itself may bring actions against the directors. This is presumably because majority shareholders approve of the action taken, or else the majority shareholders would bring an action against the directors. It is also because directors should have freedom to act without interference from shareholders. The Companies Act (2006) restored some rights to minority shareholders, although Section 260 appears to give shareholders no more rights than what they had under the Foss rule. Theoretically, under Section 260, minority shareholders may bring actions against directors if they are negligent or if they breached a duty or breached trust. They may also bring actions against directors if they have defaulted in some way. However, the court must deny the application if the promoter of the company is not a part of the action, and would not have brought an action. The court must also deny application if the company ratified the act or authorized the act. Therefore, the minority shareholders have, under Section 260, virtually the same rights that they have under Foss. This is because, under Foss, only the company may bring actions against the directors, which means that the majority shareholders must be in agreement to bring the action against the directors. If the majority is for the lawsuit, the lawsuit may go forward. If the majority is in favor of the company action, and does not want to sue, then the action may not go forward. Under Section 260, the results are virtually the same – if the majority approves of the actions of the company, then the lawsuit may not go forward, just like in the rule under Foss. Moreover, just one person may block the lawsuit, and that is the promoter. If the promoter does not approve of the lawsuit, then the lawsuit may not go forward, either. Therefore, under Section 260, shareholders do not have more rights than they did under the Foss rule. However, Section 994 does not have the same conditions for allowing an application to go forward. This section states that any actions of the directors, which have prejudiced the company members, may be the subject of a suit. There is not the requirement to show that the suit may not go forward if the prejudicial action is ratified by the company. Therefore, under Section 994, the shareholders do have considerably more rights than what they had under Foss. Moreover, the Companies Act (2006) does not define what “unfairly prejudiced” means, which means that the minority shareholders are relatively unconstrained on what actions they might bring. Because of Section 994, the Foss rule has basically been negated, as “unfairly prejudicial” is a broad term, which would encompass a number of different suits that shareholders might bring. There have been a few cases in the UK which have defined the “unfairly prejudicial” exception. One of these is the case of Re Saul D Harrison & Sons plc [1995] 1 BCLC 14, in which a shareholder brought an action against a company, stating that the company should have liquidated and distributed dividends to the shareholders. Instead, the directors were keeping the business going, so that they could unjustly enrich themselves. The Saul court sided with the shareholder in this case. Another case is that of Rock Nominees Ltd v RCO (Holdings) plc [2004] EWCA Civ 118. In this case, minority shareholders attempted to hold the company accountable because the company transferred shares which were undervalued. Although the court did not allow the petition to go through, it was not because the shareholders did not have a right to bring an action, but, rather, because the petitioners could not show that the transferred shares were undervalued. Conclusion The Foss rule created an untenable situations for minority shareholders, and that is that they were made powerless to bring actions against directors of companies. The only exception is if the wrong-doing amounted to fraud, or if the company was engaged in ultra vires or illegal acts. The other exceptions were that the shareholders were personally affected by the wrongdoing, or if the act required a special majority for ratification, and the company did not obtain this special majority. The Companies Act (2006) helped, however, in that, in Section 994, company members are free to bring a suit against the directors if they were unfairly prejudiced in some way. “Unfairly prejudiced” is deliberately broad term, so that minority shareholders are less constrained to bring suits. Section 260 is another section which ostensibly protects minority shareholders, and allows them to bring derivative suits. However, due to other sections in The Companies Act (2006), Section 260 really does not provide any protection. The directors simply have to show that the act was ratified or authorized, or that the promoter would not have brought the suit. This would mean, in effect, that the majority can crush the minority, assuming that the company’s bylaws allows for ratification of acts by a simple majority. Therefore, Section 260 does not provide protection for minority shareholders, any more than Foss did. Word Count (Excluding Bibliography) – 1992. Bibliography Wedderburn, K (1957) ‘Shareholders’ Rights and the Rule in Foss v. Harbottle’ Cambridge Law Journal, pp. 194-198 Black, P. The Rule in Foss v. Harbottle, Corporate Governance and the Derivative Action (LLM Thesis, University of Melbourne, 1983) 1-10. Berkahn, M. (1998) ‘The Derivative Action in Australia and New Zealand: Will the Statutory Provisions Improve Shareholders’ Enforcement Rights?’Bond Law Review, vol. 10, pp. 74-85. Lo, S. (2004) ‘The Continuing Role of Equity in Restraining Majority Shareholder Power’ Australian Journal of Corporate Law, vol. 16, pp. 96-105. Buckley, FH (1976) ‘Ratification and the Derivative Action under the Ontario Business Corporations Act’ McGill Law Journal, vol. 22, pp. 167-179. Maloney, M. (1986) ‘Whither the Statutory Derivative Action?’ Canadian Bar Review, vol. 64, pp. 309-324. Ohrenstein, D. (2007) Derivative Action. New Law Journal, vol. 5, pp. 1372-1373. Ramsay, I. & Saunders, B. (2006) Litigation By Shareholders and Directors: An Empirical Study of the Statutory Derivative Action. Available at: http://cclsr.law.unimelb.edu.au/files/Statutory_Derivative_Action_Research_Report__15_03_06_.pdf Cockburn v. Newbridge Sanitary Steam Laundry Co. [1915] 1 IR 237 Edwards v Halliwell [1950] 2 All ER 1064 Pender v Lushington (1877) 6 Ch D 70 Atwool v Merryweather (1867) LR 5 EQ 464 Re Saul D Harrison & Sons plc [1995] 1 BCLC 14 Rock Nominees Ltd v RCO (Holdings) plc [2004] EWCA Civ 118. Foss v. Harbottle (1840) 67 ER 189 Read More