The UK Company Law: The Rule in Foss v Harbottle - Assignment Example

The rule in Foss v Harbottle has been a very familiar part of company law for over 150 years. The rule is twofold: (a) It reinforces the democratic principle of ‘majority rule’. In other words, the rule precludes a minority shareholder from bringing an action to pursue wrongs done to the company; and (b) It supports the ‘proper claimant’ principle, that where the company has suffered harm, or where there has been a breach of duty owed to the company, then the proper plaintiff in those circumstances is the company itself. In other words, it reinforces the concept that the company is a separate legal entity. This rule means that, for good or bad, the decision-making power within a company lies with those in control of more than half of the votes in general meetings or boards of directors. (Though if you refer back to earlier lectures then many resolutions require a special resolution). Consequently, at common law, if the minority shareholder disagrees with the majority, he has little room to complain. In many instances, the unhappy shareholder in a public limited company is encouraged to use his ‘power of exit’ – in other words to sell his shares on the Stock Market. However, consider the position of a minority shareholder within a private limited company: Where is the market available? Is the shareholder able to sell his shares to individuals external to the company? - Consider pre-emption clauses in the articles. How will the shares be valued? The main exception to this restriction on the ability of the minority shareholder to object to the actions of the majority arises in instances where there is a ‘fraud on the minority’. However, even in these circumstances success is not guaranteed. The obscure nature of the rule in Foss v Harbottle has meant that in the past individuals have been refused a remedy – despite the merits of the case. However, since October 2007, minority shareholders have been allowed a new statutory derivative action. The two rules in Foss v Harbottle will continue to apply, although the absence of one or the other will no longer be a bar to commence proceedings. Before exploring the new statutory derivative action, it is necessary to provide some context for the rule (and the exceptions to the rule contained in Edwards v Halliwell) in Foss v Harbottle. In 1997, the Law Commission recommended that derivative actions at common law be replaced with statutory derivative actions with more modern, flexible and accessible criteria for determining whether a shareholder may bring a claim. (Law Commission Report, Shareholder Remedies, LC 246, 1997, para 6.15). The statutory derivative action was introduced by the Companies Act 2006; nevertheless, despite such codification the role of derivative actions is still overshadowed by the unfair prejudice remedies under s.994 of the Companies Act 2006. Section 994, Company Act 2006 - the unfair prejudice remedy As noted above, a petition under s994(1) CA 2006 is made on the ground that the company’s affairs are being or have been conducted in a manner which is unfairly prejudicial to the interests of its members generally or of some part of its members (including at least the petitioner) or that any actual or proposed act or omission of the company is or would be so prejudicial. History of the unfair prejudice remedy Originally, s210 of the Companies Act 1948 was intended to provide more flexible remedies free from the restrictions of the rule in Foss v Harbottle and the harshness of s122(1)(g) – (a winding up order). The Cohen Committee had recommended this development in the area of minority shareholder protection. The new remedy was to be based on the concept of ‘oppression’. In other words, a member could bring an action where the affairs of the company were being conducted in a manner oppressive to some of the members (including the petitioner). However, the wording s210 proved to be a problem, resulting in the fact that there were only two successful cases under the section in the UK. Critically analysis of shareholder analysis Shareholder disputes present one of the most prevalent and destructive problems encountered by the privately-owned business.1 Shareholder conflicts appear to be universal.2 Minority shareholder allegations against the majority reverberate in courtrooms throughout the world.3 Common accusations are that the majority has excluded the minority from active participation in the business or has mismanaged or misappropriated assets.( http://www.allbusiness.com/government/business-regulations/319808-1.html4) Complaints that the majority has taken excessive remuneration or has failed to pay dividends cross geographical barriers.( http://www.allbusiness.com/government/business-regulations/319808-1.html)5The small business has made great strides in harnessing the benefits of technological advances in our computer age. (http://www.allbusiness.com/government/business-regulations/319808-1.html)Yet difficulties abound in the non-technical realm of human business relationships.( http://www.allbusiness.com/government/business-regulations/319808-1.html) Indeed, conflicts among shareholders continue to pose among the most difficult challenges to businesses, and in turn, to business law.( http://www.allbusiness.com/government/business-regulations/319808-1.html)6 The United Kingdom and the United States have developed somewhat similar legal remedies for the minority shareholder of the private company. The law in the United Kingdom recognizes an action for "unfairly prejudicial" conduct,( .( http://www.allbusiness.com/government/business-regulations/319808-1.html)7 while many U.S. state statutes provide the machinery for corporate dissolution in certain situations involving shareholder deadlock or where there has been "illegal, oppressive, or fraudulent" conduct.8 Under the U.K. company law, the court has broad discretion to make remedial orders if there has been unfairly prejudicial conduct (including orders to regulate corporate conduct or purchase a shareholder's stock) .9Although a court may order a purchase of a shareholder's stock in an effort to resolve a dispute, the buy-out remedy lies entirely within the discretion of the U.K. court.(10) The remedy of corporate dissolution may be sought under a separate statutory provision pursuant to the U.K. Insolvency Act.11 In England and Wales there are two courses open to shareholders to seek redress: a minority prejudice action whereby a shareholder sues the majority shareholder or shareholders who control the company or a derivative action where the shareholder sues the company directors on behalf of the company. Derivative actions A derivative action is an action by a shareholder against a director. Prior to the Companies Act 2006, derivative actions were often threatened but rarely actioned. Under the rule in Foss v Harbottle, the company was the proper claimant for any wrongs done to it, and companies were not required to act at the request of their shareholders even to pursue the company's rights in relation to an alleged wrong. In order to bring a derivative claim a shareholder had to fit his case into one of the exceptions to the rule in Foss v Harbottle namely: 1) that the company was controlled by the wrongdoers causing fraud on a minority; or 2) that the actions of the majority were ultra vires; or 3) that the personal rights of the members had been infringed and that the breach could not be rectified by a simple majority vote. Both U.K. and U.S. minority shareholders of private companies face similar obstacles when a conflict arises with the majority owners. Under both U.K. and U.S. law, the minority shareholder's investment in a private company is an illiquid asset. In both countries, when a serious and irreconcilable dispute occurs between the minority and majority shareholders, a common legal remedy sought by the minority shareholder is a court order to obtain a buy-out.( http://www.allbusiness.com/government/business-regulations/319808-1.html)12 Shareholder remedies in the case Ebrahimi v. Westbourne Galleries Ltd., [1973] A.C. 360 (H.L.) In this case the company had started with a partnership between two directors and then it has been extended to three directors.The directors had got the salaries in these periods but has not received the dividends normally meant for directors. There was removal of one of the director and there was an order to purchase the shares held by the director. The company had promised to begin to pay dividends.13 Held: In the case of a small company the rights and obligations went beyond that of bare company law requirements.14 The applicant had been excluded from being involved in the management of the company against his reasonable expectations and this equated to him being effectively unable to dispose of his interest. Equitable considerations can come to be applied where the association has personal characteristics and rests on a relationship of trust and confidence, and all members are expected to take an active part and share transfers are restricted thus the company should be wound up.15 Lord Wilberforce: "A limited company is more than a mere legal entity, with a personality in law of its own: that there is room in company law for recognition of the fact that behind it, or amongst it, there are individuals, with rights, expectations and obligations inter se which are not necessarily submerged in the company structure. That structure is defined by the Companies Act and by the articles of association by which shareholders agree to be bound. In most companies and in most contexts, this definition is sufficient and exhaustive, equally so whether the company is large or small. The most major case that has been reported after the 2006 act has been the Franbar Holdings Ltd v Patel and ors (2008).16The high court had refused the application and that has been under the section 261 of the 2006 act and that has been under the derivative claim.There has been a series of disputes that has been between Franbar holdings and they were having 25 % of the shares in medic enters and Casualty Plus Ltd (C Ltd) (the holder of75% of the shares in M Ltd), F Ltd issued three sets of proceedings: 17 • A claim against C Ltd for breach of the shareholders' agreement between the parties.18 • A petition under section 994 of the 2006 Act by F Ltd against C Ltd seeking an order that C Ltd purchase F Ltd's shares in M Ltd.19 • A claim by F Ltd against the directors nominated by C Ltd and M Ltd, which F Ltd sought permission to continue as a derivative claim as it sought a remedy on behalf of M Ltd.20 The court refused permission to continue the derivative claim. The judge stated that a person acting in accordance with the duty to promote the success of the company would be unlikely to attach very much importance to continuing the derivative claim (section 263(3)(b)).21 The hypothetical director acting in accordance with section 172 would take into account a wide range of considerations when assessing the importance of continuing the claim. These would include matters such as the prospects of success of the claim, the ability of the company to recover any award of damages, the disruption which would be caused to the company's business by having to concentrate on the proceedings, the cost, and any damage to the company's reputation and business if the proceedings were to fail. A director would often be in the position of having to make what was no more than a partially informed decision on continuation without a clear idea of how the proceedings might turn out. The judge considered that the hypothetical director would be inclined to regard pursuing the derivative claim as less important given that several of the complaints were more naturally formulated as breaches of the shareholders' agreement or were acts of unfair prejudice which were already the subject of proceedings. The other reported case is Mission Capital v Sinclair (also 2008).22 In this case the applicants constituted a minority on the board of Mission Capital. Three non-executive directors were in the majority. The board purported to terminate the applicants' employment and required them to resign from the board. Mission Capital obtained an interim injunction excluding the applicants from its premises and requiring delivery up of certain documents. The applicants both counterclaimed and brought a separate derivative claim against the non-executive directors and their replacement director. In their counterclaim, the applicants argued that their employment contracts were still subsisting and that their purported resignations were invalid. They claimed injunctive relief equating to specific performance of their service contracts and reinstatement to the board. By the derivative claim, they argued that Mission Capital would suffer damage from their wrongful dismissal and the replacement director would act improperly. They claimed the same heads of relief as in the counterclaim. On the application for permission to continue the derivative claim, the judge looked at the question whether a notional director, under section 263(2)(a), would seek to continue the claim. The debate focussed on whether the derivative action was purely duplicative of the counterclaim. The judge accepted that it was arguable that the derivative claim might succeed where the counterclaim failed and that Mission Capital would be able to claim damages against the directors for the damage it had suffered as a result of the applicants' wrongful dismissal, which would not be available to the applicants as shareholders. However, he then went on to consider how to exercise his discretion under s. 263(3). He refused permission. He held that although he could not be satisfied that the notional s.172 director would not continue the claim, he did not believe that he would attach that much importance to it. He stated: "Would a company which had wrongfully dismissed a director normally takes action against those responsible for the damage that it has suffered? It would depend, but I suspect that the action it would take in preference would be to replace the directors. Moreover, on the evidence before me the damage...[Mission Capital] will suffer is somewhat speculative - another reason why the section 172 director would not attach great weight to it". A second ground was that he was not satisfied that there was anything sought by the applicants whom they could not recover by means of an unfair prejudice petition under s. 994 of the 2006 Act. Directors would be considering how they would deal with shareholder requests and that would be true in relation to wide disputed and contentious matters and the shareholders would be trying to use the information to launch a derivative claim. The following types of conduct have been held not to be oppressive or unfairly prejudicial: • A company not postponing a validly requisitioned annual general meeting to permit the requisitioning shareholder more time to contact beneficial shareholders in preparation for the meeting (Nalcap Holdings Inc. v. Equity Preservation Corp., [1989] B.C.J. No. 1842 (S.C.)). • A company excluding a minority shareholder from management, there has been permitted by the company’s articles and the personal relationship with the majority shareholder and president had deteriorated so they could not work together (Safarik v. Ocean Fisheries Ltd. (1995), 12 B.C.L.R. (3d) 342, reversing in part 10 B.L.R. (2d) 246 (C.A.)). • A president would be terminating a minority shareholder as employee and removing him as director, where permitted by employment agreements (Grant v. A.W.Sessions Ltd., [1998] B.C.J. No. 1970 (S.C.)). • A company would be ceasing to pay dividends to one shareholder and effectively blocking the redemption of his shares, and there has been permitted by its articles (Saunders v. Tidewater Development Corp., [1998] B.C.J. No. 1871 (S.C.)). • A company’s preferential treatment of its majority shareholder that has been also its main customer (Sentinel Estates Ltd. v. Inland Fibre Specialists Ltd.,[1987] B.C.J. No. 1073). • Shareholders would be making decisions to improve the company’s financial performance that had been made it more difficult for a minority shareholder to sell his shares (Tkatch v. Dr. Heide Dr. Tkatch Dr. Climenhaga Dr. Fietz Inc.(1996), 29 B.L.R. (2d) 266 (B.C.S.C.) [In Chambers]), aff’d [1998] B.C.J. No. 2613 (C.A.)). • Shareholders not accepting a minority shareholder’s business views (Bosman v. Doric Hldg. Ltd. (1978), 6 B.C.L.R. 189 (S.C.)). • One director not signing monthly shareholder loan cheques to any shareholders (Bianco v. Apple Valley Trailer Park Ltd., [1985] B.C.W.L.D. 633 (S.C.)). A company not issuing to a minority shareholder shares for which he could not pay (McMurchie v. Locke, [1990] B.C.J. No. 664 (C.A.)). • Shareholders of a closely held company passing a special resolution allowing the directors to redeem shares issued to the majority shareholder’s family without consideration (Re Giroday Sawmills Ltd.; De La Giroday v. Giroday Sawmills Ltd. (1983), 49 B.C.L.R. 378 (S.C.)). • Directors arranging a private placement diluting the majority shareholders and resulting in the undervaluing of their shares, where issuing shares was in the discretion of the directors (Re Goldstream Resources Ltd.; Dicore Resources Ltd. v. Goldstream Resources Ltd., supra). • Shareholders suspending share dividend payments to finance repairs to the company’s premises and management salaries (Lafaille v. Amorous Oyster Restaurant Ltd., [1991] B.C.J. No. 1091 (S.C.)). • Shareholders not re-electing a representative of a corporate competitor as a director and terminating payments to that competitor, while paying management fees to themselves (Chiu v. Aero Heat Exchanger Inc., [1990] B.C.J. No. 1217 (S.C.)). The directors of a company deciding not to begin a doubtful lawsuit against a contractor (H.J. Rai Ltd. v. Reed Point Marina Ltd., [1981] B.C.J. No. 786 (S.C.)). • Shareholders deadlock (Cariboo Western Lumber Ltd. v. Mochizuki, [2001] B.C.J. No. 1556 (S.C.)). • Directors being in a conflict of interest (Bruneau v. Irwin Industries (1978) Ltd., [2002] B.C.J. No. 1095 (S.C. Master)). Read More