CORPORATION LAW IN AUSTRALIA

Under what circumstances might it be argued that the right to bring derivative actions amounts to “shareholder activism”?

SOLUTION

Derivative Actions

One of the opportunities open to the shareholders of the companies to seek to enforce the rights of the company is commonly known to have derivative actions. Derivative actions are those actions brought by the shareholders or directors of any Company on behalf of that company. This is so called derivative because it is not actually the right to bring an action of that party but it is derived from the company itself. Generally this right of bringing the action lies to the Directors of the Company because they are responsible for the management of the company, but in some cases this derivative right is also given to the shareholders. Basically the purpose behind this is to solve the wrong done to the company.[1]  Statutory Derivative Action also known as SDA is a representative litigation, enacted by the statutes across the world for the unveiling the mismanagement inside the Company and the imbalance of power among the owners of the company.

After the incorporation of the company it acquires a separate legal entity.  It has rights and duties of its own separate from its directors and shareholders.[2] It can sue and be sued separately. However it can not act on its own hence it has to rely on its representatives. Hence the entire management is bestowed with the responsibilities of the company.

Now coming to the shareholders, any one who buys the shares of the Company (even if only one share) becomes the shareholder of the company.  The shareholders, like the owner of the Company must play an active role in the management of the Company. It’s like becoming the part of the company in any of its activity.  The shareholders have been given many rights inside the Company, such as they can convene general meetings, they can speak or appoint a proxy to talk in the meeting. They can vote in general meetings and they have the right to enforce their rights as well. SDA empowers the shareholders also to bring the derivative actions on behalf of the company. The SDA enacted in Australia is very young whereas in countries like, Canada, United States, Japan, Israel, Singapore, new Zealand etc. Prior to legislature the only rule that was followed was the rule given in 1942 in the most celebrated case on the shareholders right to sue any person doing wrong to the company, of Foss v Harbottle (1842).

Foss v Harbottle (1842)

This rule of Foss v Harbottle has long been serving as barrier in the way of derivative actions of shareholders. Particularly this restricted the action of shareholders in cases of wrongdoing by companies own directors. Here in this case two shareholders of a company brought action against the directors and promoters of the Company, alleging that they are misappropriating and mishandling the assets of the Company. The courts rejected the plea on the ground that the company after its incorporation becomes a separate legal entity and it has the right and power to sue any person on its behalf.  The reasons given by the court were about the separate legal entity of the Company and the internal affairs of the Company.[3] The courts are not supposed to look into the internal matters of the Company that’s going on between their members in exercise of their powers. The rule was set out by Sir James Wigram VC in simple words that the corporation could sue in its own name or by any representative of corporate character appointed by the law.

Hence it was clear from the decision that if the action did not have the support of directors of the company or by the majority shareholders then it can never succeed. This principle was later expanded to the action of majority. It was said that if the thing which is complained is the majority of them are entitled to do then there is no use of the litigation.[4].

Exceptions to the rule

The courts laid down few exceptions to the rule of Foss v Harbottle. The action by the shareholder as derivative action must fall within any of these exceptions.

1.  If there is ultra vires or illegal act- where an act is ultra vires or illegal, a share holder could sue to restrain the action, as the majority can not rectify acts which  are ultra vires to company.
2. If the transaction requires special majority- when an act is done in breach of any requirement in the constitution requiring a special majority which has to authorize that action then a member could sue to challenge the validity of that resolution.[5]
3. If it is a personal right- whenever the personal rights of any of the shareholder had been infringed then the rule of this case will not apply, the shareholder could sue in their own name to protect their personal rights.
4. If there is a fraud on minority- where any action amounts to fraud on minority shareholders and the wrongdoers are in control of the company, in such situation the minority shareholders are permitted to bring an action against the wrongdoer on behalf of that corporation.[6] The first three right to action was the personal reasons and action brought under fraud on minority exception is the derivative one, hence it has been described as the only true exception to the rule of Foss v Harbottle.
5. The interest of justice- this exception was subjected to debate that whether in the interest of justice will be the exception to the rule of Foss v Harbottle or not. It depends on the courts to allow the action on behalf of the company by the shareholders against the wrongdoers in the interest of justice. Sealy was of the view that this is not much as the exception, it depends on the courts willingness to lend its aid to a majority members who seek redress for the corporations loss.[7]

These exceptions laid the general rule of Foss v Harbottle where it was said that generally the company has the only right to sue on behalf of it. But when the situation comes under any of the exception then the courts will allow the derivative action on behalf of the company to the shareholders. Although the common law rule in Foss v Harbottle is beneficial in reducing the multiplicity of the shareholders cases and leaving the decisions in the hands of those qualified men who are responsible to take actions on behalf of the company, it has been criticized on many grounds. As it was complex and harsh on shareholders, also it was the rule laid down by the court before a decade hence these criticisms raised many issues such as:

1. The cost of litigation issue-  it was held later in many cases that the shareholders who brought action against the wrongdoers on behalf of the company must be indemnified by the company because it is the company after all which will be benefitted by the action.[8] But subsequently many jurists also limited its efficiency. In Smith v Croft, Holten J held that the final funding to the shareholders should not be made until the final discovery or in genuine need. Australian courts are also of this opinion.[9]
2. Foss v Harbottle as uncertain rule- the rule was complex and obscure with conflicting authority leaving behind the scope of the rule.[10] The exceptions of the rule made it difficult to exactly define the law on the topic.
3. Ratification- the ratification law attached with the rule of derivative action was considered as the greatest difficulty in the application of the remedy. The derivative action could only be brought by the shareholder against the director for its breach of duty only if that breach is not rectified by the company. There is a conflict between authority that what type of act or omission by the directors may be rectified by the company or not.

In Australia, a plaintiff in derivative action has to show that the company was not willing or it was unable to sue on itself hence demands the directors. Company law and securities regulation in Australia, as they now stand, do not create a comparably simple mechanism for discovering and rectifying the use of tricky circulars and in turn the derivative actions.[11] The major impetus for Australia to adopt a statutory derivative action is the restrictive standing requirements at common law rule. Several statements at government reports seem to support this statement.

Statutory derivative Actions in Australia

Statutory derivative Actions started in Australia on 13^th march 2000. Part 2F.1A of the corporations Act 2001 (Cth) enables the current as well as former member and the officials of the corporation to take action on behalf of the company or take part in any of the proceedings in which the company is a party.[12] This SDA was based on the Ontario Business Corporations Act, 1982. For any of the civil actions, the plaintiff proceeding with the derivative actions has to satisfy the courts on the following things: It is unlikely that the company is going to commence with the proceedings or taking any responsibility for the proceedings or any steps for the proceeding.

The person applying for the derivative action is acting in very good faith

The person is doing so in the best interest of the company.

He is applying for the leave to bring proceedings because of the serious issue that is to be tried.

The applicant must give prior notice to the company at least fourteen days before taking the leave and its reasons unless the courts satisfied on the point that it is good even if the notice have not been served.

Each of the above points must be proved by the applicant before taking the leave from the courts for the derivative actions.[13]

As the other common law jurisdictions and unlike America, contingency fee arrangements are prohibited in Australia. The litigation cost issue is the major factor for the infrequent use of the statutory derivative suits in Australia. Unlike Australia, New Zealand has adopted a flexible approach to the litigation cost of SDA. Once the courts has granted the leave for the action and finds it perfect, the company is supposed to bear all the expenses and the costs arising out of the litigation.

It has been considered by many authorities that the SDA works best when it is used infrequently. Shareholder litigation in Australia is a rare issue. If we look at the numbers, it was 900 decisions were reported in the Australian corporations and securities report during September 1989 to March 1994. Prior to the introduction of SDA rule the only common way through which any one can bring a derivative action was under one of the exceptions to the rule of Foss v Harbottle. There were very few actions under the common law derivative action rule.

Perhaps the reason behind the lack of these actions in Australia is the scant judicial consideration the requirements must be satisfied before applying for the leave for taking these derivative actions.

Some disadvantages of bringing Statutory derivative actions are:

• The misconduct and mismanagement in the company comes to the knowledge of the general public through the media.
• The value of shares drop significantly
• Sale of the shares
•  The litigations damage the reputation of the company badly if the allegations are proved to be founded.
• Untimely winding up of the Company
• The cost of statutory derivative jurisdiction is very costly in Australia and the other common law jurisdiction.

Shareholders derivative action right: shareholder activism

Share holders are entitled to the rights under corporations Act 2001 (Cth). The only difference is between the majority and minority shareholders.[14] As we observed from the above discussions, that a shareholders as the owner of a company may bring suits as representative of that corporation. Such an action is allowed to prevent the wrongdoings by the powerful directors and the promoters of the corporation. These suits are brought by the shareholder when the corporation itself refuses to bring an action on the problematic issue. These actions give power to the minority shareholders also to raise their voice against the fraud in the corporation. Now it is the duty of courts to decide what amounts to fraud against minority in a company. The breach of duties of the directors which benefits them also amounts to the fraud against the company. In such situation the shareholders have the right to bring derivative action on behalf of the company. The number of shares acquire by the shareholders are insignificant in this scenario.[15] The only purpose of empowering minority shareholders with this right is to make their participation more active. These actions are often controversial but it supports and protects the rights of the shareholders and the corporation as well. The derivative actions by the shareholders may also help in the case where the directors of the company are the majority of the company and they are protecting themselves from prosecution and liabilities

CONCLUSION

To conclude the topic, it is very apt to say that the shareholder derivative suits play the role of policemen in the managerial integrity. It has a vital role in the free enterprise economy. We can see the rise in the derivative action in Australia although the SDA do not allow the contingency based payment for the derivative suit. It gives the power to minority shareholders in the company to have control over the actions of directors and managers of the company. It also provides with the action by the shareholders when the directors and the company itself can not bring actions. However the conditions lay down by the SDA to be satisfied before taking the leave for the action, minimizes the abuse of the provision and vexatious litigations. Now as the statutory derivative Action covers the entire field, it is important to compare it with the pre statutory rule. Three basic defects were identified by government reports are: cost of litigation, ratification and standing requirements which are very restrictive.

Lastly SDA is the response to the shortcoming of the earlier remedies available to the share holders who wanted to pursue an action against the company officers, involved in the breach of their fiduciary or statutory duties where the corporation itself was not willing to take any action against them.

BIBLIOGRAPHY

1. Mathew Berckhan, The Derivative Actions in Australia and New Zealand, [75]-[76], Massey University, [1998], viewed on 26^th April 2012,  http://www.sc.com.my/eng/html/resources/inhouse/shareholders.pdf
2. Peter Lawrence Black, The rule in Foss v Harbottle’, Corporation Governance and derivative action, University of Melbourne, 1983 at 7-8
   1. Stefan Lo, ‘The continuing role of equity in restraining majority shareholder power’[2006] 16 Australian journal of corporate  law 96 at 105
   2. L S Sealy, Foss v Harbottle- A marathon where nobody Wins’, (1981), Modern Law review, Cambridge Law Journal, 202.
   3. Brian R Cheffins, ‘Reforming the Derivative Action: The Canadian Experience and British Prospects’ (1997), 2 Company, Financial and Insolvency Law Review 227 at 229-231.
   4. Deborah A. Demott, Share holders litigations in Australia and united states: common problems uncommon solutions, Sydney Law review, [268] March 1987, viewed on 26^th April, http://scholarship.law.duke.edu/cgi/viewcontent.cgi?article=1581&context=faculty_scholarship&seiredir=1&referer=http%3A%2F%2Fwww.google.co.in%2Furl%3Fsa%3Dt%26rct%3Dj%26q%3Devolution%2Bof%2Bderivative%2Bactions%2Bin%2BAustralia%26source%3Dweb%26cd%3D10%26ved%3D0CGUQFjAJ%26url%3Dhttp%253A%252F%252Fscholarship.law.duke.edu%252Fcgi%252Fviewcontent.cgi%253Farticle%253D1581%2526context%253Dfaculty_scholarship%26ei%3D2N6YT-SXINDNrQexiL2sAQ%26usg%3DAFQjCNGoDE19eoK-A7vgrL855YaBM4lrKw%26cad%3Drja
   5. Ian M Ramsay, ‘Litigation by the Shareholders and directors: empirical study of empirical derivative Action, University of Melbourne’, [2006], viewed on 26^th April 2012, http://www.google.co.in/url?sa=t&rct=j&q=derivative+action+of+shareholders&source=web&cd=8&ved=0CFUQFjAH&url=http%3A%2F%2Fwww.alfainternational.com%2Ffiles%2Ftbl_s12Publications%2FFileUpload92%2F265%2FSHAREHOLDER%2520ACTIONS%2520IN%2520ENGLAND%2520%26%2520WALES%2520-%2520%2520New%2520Rules%2520but%2520Little%2520Action.pdf&ei=AoKZT8fSBse8rAfxz6i7AQ&usg=AFQjCNH2dtNrma3Hd4IUvLTHM96CRUow-A&cad=rja

1. Melissa Holfmann, The Statutory derivative actions in Australia: empirical study,[2004],    viewed on 26^th April, http://epublications.bond.edu.au/cgi/viewcontent.cgi?article=1012&context=cgej&sei-redir=1&referer=http%3A%2F%2Fwww.google.co.in%2Furl%3Fsa%3Dt%26rct%3Dj%26q%3Devolution%2Bof%2Bderivative%2Bactions%2Bin%2BAustralia%26source%3Dweb%26cd%3D5%26ved%3D0CEMQFjAE%26url%3Dhttp%253A%252F%252Fepublications.bond.edu.au%252Fcgi%252Fviewcontent.cgi%253Farticle%253D1012%2526context%253Dcgej%26ei%3D2N6YT-SXINDNrQexiL2sAQ%26usg%3DAFQjCNElkQ2TDIx-7Ii5GF7Gs9PTZ5LLJw%26cad%3Drja
2. E-notes, Shareholders rights, Business Law, [2012] viewed on 26^th April 2012, http://www.enotes.com/business-law-reference/shareholder-rights

1. Albert Lam, Share holders right: the Derivative Action, Hampton, Winter and gleynn, [2011],  viewed on 26^th April 2012, http://www.hwg-law.com/articles/shareholders-rights-part-i-common-law-derivative-action

Case laws

1. Salomon v Salomon & Co. (1897) AC 22-29
2. Foss V Harbottle (1843) 67 ER 189
3. Burland v Earle [1902] AC 83 at 93.
4. Mac Dougall v  Gardinger, [1875]1ChD 13, [25]
5. Wallersteiner v Moir, [1975] QB 373
6. Smith V Croft, [1986] 2 All ER 551.