When will the court allow a common law derivative action on behalf of a company?

what is a derivative action

Singapore October 7 2010

The deciding mind of a company is essentially the sum of its members, and when a majority of these members are of a joint will, they can control the direction the corporate body takes. Therefore, when the minority shareholders wish to bring a derivative action on behalf of the company, they often find it a difficult task to accomplish.

The case of Sinwa SS (HK) Co Ltd v Morten Innhaug [2010] SGHC 157 demonstrates that the test for bringing a common law derivative action is not an easy one to pass. However, the Court will apply it in a balanced manner, with a view towards fairness for the parties involved.

Here, the Singapore High Court dismissed an application for leave to bring a common law derivative action on behalf of the company (For an analysis of the operation of the statutory derivative action, please refer to our previous Update of Poondy Radhakrishnon and Another v Sivapiragasam s/o Veerasingam and Another [2009] SGHC 228). In the exercise of its discretion, it found that the applicant had yet to exhaust suitable alternative remedies and – importantly – was not acting bona fide in the company’s interests.

However, in applying the ‘fraud on the minority’ test for the bringing of derivative actions, the Court also showed a degree of lenience towards the applicant in light of corporate realities. Andrew Ang J raised the proposition that ‘fraud’ need not be understood in its orthodox sense, but need only entail any wrong committed by a director, along with an improper attempt to stifle the company’s action against such wrongdoing. He also opined that the ‘minority’ need not refer to an actual numerical minority, only an inability to effect any action on the part of the company.

  1. The Defendant was initially the sole director and shareholder of company NIL. The Plaintiff later purchased 50% of the shares, making them equal shareholders.
  2. NIL owned a ship which was chartered to BGP under a Time Charter Agreement. This Agreement was later assigned to NGS, a company incorporated by the Defendant, and in which he had an interest.
  3. The Plaintiff accepted payment of the charter hire from NGS for four months. However, after this time, the Plaintiff began to insist that BGP remained liable for payment of the charter hire despite the assignment. BGP disagreed.
  4. The Plaintiff sought to commence legal proceedings against BGP, but the Defendant objected, and demanded that the Plaintiff cease from representing that it acted on behalf of NIL in relation to the proceedings.
  5. The Plaintiff then applied to the Court for leave to bring a derivative action on behalf of NIL against the Defendant, alleging numerous breaches of directors’ duties and the commission of fraud against NIL.

The Court first had to determine whether the Plaintiff had fulfilled the prerequisites to the bringing of a derivative action by a minority shareholder. Then, assuming these prerequisites were satisfied, it had to decide whether it would exercise its discretion to grant the Plaintiff leave to bring the derivative action.

Holdings Of The High Court

The Court found that most of the prerequisites for a derivative action had in fact been satisfied. However, it decided not to exercise its discretion to grant leave for a derivative action.

Prerequisites to derivative action

It was first explained that two requirements have to be satisfied before the Court will even consider granting leave for a derivative action.

  1. The company must have a reasonable case against a defendant; and
  2. The plaintiff must have locus standi to bring the action, meaning that the action must fall within the exception to the rule in Foss v Harbottle .

Under the first requirement, a plaintiff must demonstrate that the claim has a reasonable semblance of merit. It need not show that the claim will or is likely to succeed, and the Court will not undertake an extensive inquiry into the merits of the claim. This requirement is only to filter out actions taken by minority shareholders for purely extraneous reasons.

Although a number of allegations were leveled against the Defendant, the Court found that only one alleged cause of action bore any merit. The Plaintiff alleged that the Defendant had blocked the commencement of legal proceedings against BGP to recover charter hire under the Time Charter Agreement to protect its interests in NGS. On a prima facie assessment of the evidence, NIL thus had a reasonable cause of action against the Defendant.

Under the second requirement, a plaintiff must show that it has locus standi to commence a derivative action. Since the majority of a company’s members can confirm any questioned transaction, a minority shareholder can bring a derivative action if it proves the following:

  1. There has been fraud committed against the minority.
    1. The Court recognized that the meaning of ‘fraud’ here is the subject of much academic debate, but declined to adopt any one view.
    2. The orthodox view is that ‘fraud’ refers to wrongs so egregious that they cannot be ratified. However, there is no clear demarcation of what constitutes ratifiable or unratifiable wrongs.
    3. The Court also raised the alternative view, which is that ‘fraud’

      refers to a composite of the breach of director’s duties and the attempt to stifle action by the company by means of manipulation within the company.

  2. The alleged wrongdoers are themselves in control of the company.
    1. The Court here adopted a ‘substance over form’ approach when assessing whether control existed.
    2. Control can obviously exist when the wrongdoer is the majority shareholder.
    3. However, it can also exist where the wrongdoer is able to prevent an action from being brought against him, such as through a monopoly of information or the use of managerial vetoes over litigation.
    4. Therefore, a shareholder who holds 50% of the shares of a company may still be able to bring a derivative action under the Foss v Harbottle exception.

Here, the Court found that ‘fraud’ had been made out as the Defendant had, prima facie. prevented legal action from being taken out against BGP to protect his own interest in NGS.

However, it was unable to decide on the issue of control. The Plaintiff was not, strictly speaking, a minority shareholder as it held 50% of NIL’s shares. It was also unclear whether the Plaintiff and its appointed directors actually had the authority to compel NIL to bring an action against the Defendant.

Exercise of discretion

The Court found that it was unnecessary to decide on the issue of control as it would not be exercising its discretion to allow a derivative action in any event.

First, the Plaintiff’s application for leave to bring a derivative action was premature as it had failed to exhaust all alternative remedies.

  1. If there is an adequate remedy available to the minority shareholder, it should generally not be allowed to resort to a derivative action.
  2. This alternative must be a viable remedy, though it need not necessarily be a better option.
  3. Here, it was unclear who had the power to determine whether to bring an action against the Defendant. The Shareholders’ Agreement provided for arbitration to decide such disputes.
  4. The Plaintiff would only be unable to bring an action against the Defendant if the arbitrator’s decision had gone against the Plaintiff. Therefore, the Plaintiff should have brought this question for determination under the arbitration clause before applying for a derivative action.

Second, the Court found that the Plaintiff was not acting bona fide in bringing the action against the Defendant.

  1. The derivative action is an equitable device, and anyone seeking to use it must do so in the best interests of the company and not for some ulterior purpose.
  2. The Court determined that the Plaintiff had not disclosed its real motive for the derivative action. NGS had been faithfully paying its charter hire, and it was difficult to understand why the Plaintiff should insist on being paid by BGP instead.
  3. Further, the Plaintiff threw numerous unjustified and unsupported accusations at the Defendant, and its actions were inconsistent with the interests of NIL.

Therefore, the Court declined to exercise its discretion to grant leave for the Plaintiff to bring a derivative action on behalf of NIL.

Concluding Words

A company is controlled by its shareholders, and the Court will not override the will of the majority in favour of the will of the minority unless the circumstances truly warrant it. Therefore, parties applying for a derivative action cannot do so in haste, and certainly cannot do so with any underlying ulterior motive. Derivative actions are not tools to allow “backseat drivers” to steer the corporate vehicle.

Nonetheless, the Court has also demonstrated that it is aware of the difficulties of the minority in bringing derivative actions, and of the corporate realities behind such situations. Andrew Ang J recognized that the ‘majority controllers’ of a company need not be an actual numerical majority, and could exert control in other ways. He also raised the view that ‘fraud against the minority’ could refer to a breach of director’s duties combined with an attempt to stifle any action. This is in keeping with the spirit of derivative actions, which is to allow a corporate entity to protect itself where its decision makers are acting against its interests.

Note that this case considers common law derivative actions, as opposed to statutory derivative actions, as provided for under section 216A of the Companies Act. The elements of the tests for both forms of derivative actions are largely similar, such as the essential requirements of good faith and a reasonable case against the defendant. For an analysis of the operation of the statutory derivative action, please refer to our previous Update of Poondy Radhakrishnon and Another v Sivapiragasam s/o Veerasingam and Anot her [2009] SGHC 228.

The statutory derivative action has a number of additional benefits: it provides that the Court may order the company to pay all reasonable legal fees and disbursements, and also avoids the difficult question of standing encountered in Foss v Harbottle. Therefore, it appears to be the preferred form of derivative action in Singapore today. However, this option is not available to companies incorporated outside of Singapore, for which the recourse of common law derivative actions must be sought.

Source: www.lexology.com

Category: Bank

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