In what circumstances, breach or dispute, can shareholders take action against the director?

In the realm of corporate governance and disputes, we’ve extensively discussed board conflicts and shareholder disagreements. But what ensues when a dispute erupts between shareholders and directors, leading shareholders to seek legal recourse against the directors? This blog dives into the intricacies of derivative actions, a tool that allows shareholders to challenge directors’ actions on behalf of the company itself.

Understanding Derivative Actions: Enabling Shareholders to Act on the Company’s Behalf

Typically, when a company experiences harm due to the actions of its directors or external entities, the company itself is the rightful claimant. The decision to initiate legal proceedings lies primarily with the company’s directors rather than its shareholders. Moreover, shareholders are usually barred from pursuing legal action on the company’s behalf, and the courts are generally reluctant to interfere in a company’s internal management, as long as it remains within its legal boundaries.

Nevertheless, a scenario arises wherein shareholders can step in when specific categories of wrongdoing are perpetrated by the directors. In such instances, the court possesses discretionary authority to permit shareholders to initiate legal action in their own names on behalf of the company. This legal avenue is known as a derivative action.

When Can a Derivative Action Be Initiated?

The framework for shareholders to pursue a derivative action is enshrined in the Companies Act 2006, with separate provisions existing for Scotland, though closely aligned with the English and Welsh regulations.

According to the Act, a derivative action can be commenced when the company incurs loss due to the director’s:

  • Negligence
  • Default
  • Breach of duty
  • Breach of trust

A derivative action involves a shareholder taking legal action on behalf of the company. This signifies that if the derivative action proves successful, any damages awarded are channeled to the company, not the initiating shareholder(s).

Navigating the Two-Stage Process of Derivative Actions

Bringing a derivative action to court entails navigating through statutory prerequisites.

Stage 1: Securing Permission for Legal Action

The initial step involves the shareholder seeking court authorization to initiate the derivative proceedings. The court must reject permission if there’s no prima facie case.

Should permission not be denied at this stage, the court orders the application to be served on the company. The company can be compelled to present evidence and can subsequently present its own arguments to the court regarding permission.

In determining whether to allow the derivative action, the court considers the company’s best interests as a primary factor. The Act mandates the court to decline permission if a person fulfilling the duty to promote the company’s best interests wouldn’t pursue the claim, or if the action or omission in question has been ratified or authorized by the company.

Additionally, the court evaluates several factors, such as:

  • The shareholder’s good faith
  • The significance attached to the claim by a person promoting the company’s success
  • The shareholder’s potential to bring a personal claim
  • The views of members with no vested interest in the matter

At this juncture, the court must form a preliminary assessment of the claim’s strength.

Stage 2: Instituting the Derivative Action

If the court grants permission to proceed with the proceedings, the action for redress against the director(s) on behalf of the company proceeds akin to a regular court action initiated by the company.

In Conclusion: Remedy for breach or dispute 

In the complex world of corporate governance, derivative actions stand as a formidable tool, offering minority shareholders a pathway to ensure that directors fulfill their fiduciary duties and act in the best interests of the company. If you need to delve deeper into directors’ duties and potential breaches or require guidance in commercial litigation, reach out to our seasoned Corporate and Litigation teams at Clarity Simplicity. We’re here to navigate the intricate terrain of shareholder disputes and ensure the accountability of company directors.