CORPORATE COUP D’ETAT: Derivative Actions under the Companies Act
In companies, like democratic societies, the majority rules. The majority shareholders pass resolutions in general meetings in accordance with the company’s articles of association to authorize certain actions, including, for example, the appointment of directors. The majority directors in board meetings in turn pass resolutions to take decisions relevant to the daily management and operation of the company. The minorities in those settings, who would like to see the affairs of the company conducted in some other way, are usually bound to accept the position of the majority. The Companies Act, however, provides means for these minorities to challenge the will of the majority, namely through (1) the derivative action and (2) the oppression remedy. Unlike the oppression remedy, which is an action a complainant brings in his or her personal capacity, the derivative action enables a minority stakeholder to usurp the power of those controlling the company for the purpose of bringing an action in the name and on behalf of the company.
The derivative action is an exception to a seminal principle of company law, established over 170 years ago, that where a wrong is done to the company, the company is the party that should sue. This principle arises because a company, upon incorporation, becomes a separate legal personality with the capacity to sue and be sued in its own name. Individual shareholders and stakeholders have no personal right to sue on behalf of the company. The controlling majority, however, can compel the company to act for itself. What happens, then, when a wrong is done to the company, to the detriment of the company and all its shareholders, and the controlling majority refuses to seek redress for the company?
Shareholders/former shareholders and directors/former directors are among the limited classes of “complainants” who can bring a derivative action. Therefore, in circumstances where wrongdoers have assumed control of the company, or those in control are not taking the requisite steps to protect the company, minority shareholders or directors may apply to the Supreme Court for leave to bring a derivative action in the name and on behalf of the company or any of its subsidiaries. Again, complainants who bring derivative actions tend to belong to the minority because the majority could compel the company to act for itself. The action is called ‘derivative’ because it is the company’s right to sue for itself that is being licensed by the Court to the minority shareholder/stakeholder. The complainant’s ability to sue on behalf of the company and in the company’s name derives from the company itself.
Since minority shareholders and/or directors are unable to compel corporate action, a complainant seeking to bring a derivative action must first obtain the court’s permission. To do so, the complainant must satisfy the Court of three conditions. First, he must give reasonable notice to the directors of the company of his intention to apply to the Court for leave to bring a derivative action if the directors do not take specified remedial steps. Fairness mandates that the company be given an opportunity to remedy the wrong before derivative action proceedings commence. If the notice issued does not advise the company of what exactly needs to be done, then it may be deemed inadequate and leave accordingly refused. Second, the complainant must be acting in good faith. Third, the bringing of the action must appear to be in the interests of the company or its subsidiary.
Possible Court Orders
If a complainant successfully obtains leave to bring a derivative action, then he/she can also ask the Court to make orders in relation to how the claim initiated is to be conducted. In those circumstances, the Court may appoint a person to control the litigation for the company and give directions for the conduct of the action. The Court may also order that the company, which was forced to sue against its will, pay all reasonable legal fees incurred by the complainant in the action. If the company ultimately succeeds in the derivative action, the Court may even order that any money to be paid to the company be paid instead to former and present shareholders or debenture holders.
From the perspective of a company’s majority shareholders and/or directors, derivative actions may seem an excessive and anti-democratic infringement on the rights and entitlements of the corporate majority. On the other hand, from the viewpoint of minority shareholders and stakeholders, they may represent a desirable check and balance on corporate power, ensuring that the company and the corporate minorities it houses are not without defences. On applications for leave to bring a derivative action, the Court will have to decide, having regard to the company’s interests, whether the derivative action should proceed. As in all cases, the outcome of derivative actions will turn on the specific facts.
Jacob Phillips is an Associate at Myers, Fletcher and Gordon and a member of the firm’s Litigation Department. He may be contacted at firstname.lastname@example.org or through the firm's website www.myersfletcher.com. This article is for general information purposes only and does not constitute legal advice.