Common law multiple derivative actions

The general rule when a wrong has been committed against a company is that only the company itself is entitled to bring an action against the wrongdoers: for example, against directors who siphon off the company’s assets or lose them through negligence. But how can justice be done if the wrongdoers are running the company? They are not going to let the company take proceedings against them. The common law’s solution was the derivative action, providing a route for interested parties to bypass the wrongdoers and, with the court’s permission, take an action in the name of the company if certain conditions were met.

The law on derivative actions developed over many years, adapting itself to deal with particular cases that arose. It became, according to the Law Commission, complicated, unwieldy and obscure. To clarify and simplify this area, the common law action – now called the derivative claim - was put on a statutory footing in the Companies Act 2006. But the new provisions are available only to members, or non-members to whom shares have been transferred or transmitted by operation of law. The common law was not as narrow as this.

Some influential commentators said that the changes had opened a loophole for wrongdoers: what would happen, for example, where the wrongdoers were in control of a holding company and its subsidiary, and the wrong was suffered at subsidiary level? If minority shareholders in the holding company were not also members of the subsidiary they would not meet the member qualification and not be entitled to start a derivative claim under the Companies Act. This question has now been tested in the High Court.

The facts

In Universal Project Management Services Limited v Fort Gilkicker Limited, Universal and Ian Pearce were in a joint venture to develop properties. They were equal partners in a limited liability partnership, which owned all of the shares in Fort Gilkicker Limited, a special purpose vehicle. Mr Pearce and a representative of Universal were the only directors of Fort Gilkicker.

The deadlocked structure meant that, when Universal alleged that Mr Pearce had formed a new company and used it to buy property on which Fort Gilkicker’s option had expired, there was no prospect of the board’s starting proceedings against Mr Pearce for breach of duty as a director. Similarly, the LLP needed Mr Pearce’s co-operation if it was to start a derivative claim.

The only viable route for Universal was to try what was known at common law as a multiple derivative action: in other words, to apply to court for permission to take proceedings not as a member of Fort Gilkicker, but as a member of its shareholder.

The decision

The court was faced with an invidious choice. Was it to decide that the new statutory regime under the Companies Act 2006 was not exhaustive and that those complicated, unwieldy and obscure common law rules continued to apply where the statutory regime left off? There is no consensus among the commentators as to whether the Companies Act has entirely supplanted the common law; and to decide that the old rules survive in some circumstances would leave the law in rather a mess. On the other hand, would it be worse to rule that the new regime was exhaustive and so leave a loophole for wrongdoers?

The judge decided that leaving the loophole was worse, and granted permission to proceed with the multiple derivative action. He said that there was no persuasive reason why Parliament should have wished to provide a statutory scheme for doing justice where a company was in wrongdoer control but none where its parent was in the same wrongdoer control. The Companies Act regime applies exclusively to claims by members, leaving other types of derivative action unaffected.

It made no difference that the member was not another company but a limited liability partnership. The precise nature of the corporate body that owned the wronged company’s shares was of no legal relevance, provided that it was itself in wrongdoer control and had some members at least who were interested in seeing the wrong put right.

Comment

The untidiness may be regrettable, but the case is a necessary patching up of the legal protection for minority or deadlocked investors. It could, for example, provide an important protection for joint venture parties in similar corporate structures. As the judge pointed out, Universal was not in a position to take proceedings on its own account against Mr Pearce based on the joint venture agreement, since its loss would merely have reflected Fort Gilkicker’s loss and on public policy grounds would therefore not have been recoverable by Universal.

It is not easy to obtain the court’s permission to proceed with a derivative claim under the Companies Act or a common law multiple derivative action. One factor that might make the court refuse is whether a more suitable remedy is available to the applicant – in particular, a petition under section 994 of the Companies Act for relief from unfair prejudice. This would be an action taken by the investor in its own name rather than the company’s and, if successful, would normally result in an order that the investor’s holding must be bought out at a fair value.

It would apparently have been possible for Universal to make a section 994 petition in relation to the LLP, citing Mr Pearce’s behaviour in relation to Fort Gilkicker as unfairly prejudicial at LLP level. Whether or not section 994 applies to an LLP is a matter of choice for LLP members; it is often excluded in the members’ agreement. Here the judge drew a distinction between mismanagement in running the LLP’s affairs - which was the natural territory of section 994 - and misconduct. The judge said that there might be significant difficulties in showing that Mr Pearce’s alleged conduct in setting up a new company and diverting an opportunity to it had anything to do with the management of Fort Gilkicker or the LLP, and this was one reason why the derivative action was a more suitable remedy. It must be said, however, that many successful section 994 petitions are based on just this sort of behaviour.