Double derivative actions: challenging wrongs done to subsidiary companies

A recent High Court decision provides a useful reminder that the common law "double derivative" action remains available. This gives minority shareholders the option of challenging wrongs done to companies further down the chain, even if they are unable directly to take advantage of the statutory derivative mechanism under the Companies Act 2006: Bhullar v Bhullar [2015] EWHC 1943 (Ch).

The case is also of note as the court departed from the ordinary principle of making a pre-emptive order granting a costs indemnity to a claimant with permission to pursue a derivative action.  Instead, as the derivative proceedings were viewed as a stepping stone towards the negotiation of a formal split or for an unfair prejudice petition, the court held that all parties should be on risk as to costs.

Earlier this month Gary Milner-Moore and Tom Henderson, a partner and senior associate in our dispute resolution team, published an article in the July – September 2015 edition of Corporate Disputes magazine (see post) which looked at how judges have sought to limit derivative claims since the introduction of the statutory regime. The Bhullar decision is particularly interesting in the context of the courts having kept the statutory derivative claim within measured bounds. Gary and Tom consider the decision further below.

Background

Double Derivative Claims

Derivative claims were originally developed by the common law as an exception to the rule in Foss v Harbottle (1843) 2 Hare 461 that only the company itself has standing to pursue a claim for loss suffered by it. The Foss v Harbottle jurisprudence was problematic as it meant that wrongs committed against a company by its directors would rarely reach court as the wrongdoer directors were in control and would not allow the company to litigate. However, in a derivative action, a minority shareholder of the company is able pursue a claim in the name of the company. Common law also evolved to permit a minority shareholder of a parent company to pursue a cause of action vested in a subsidiary of the parent company, the "double derivative" or "multiple derivative" claim.

While sections 260 to 264 of the Act have since provided an exclusive statutory regime for claims pursued by members of the wronged company, it did not address double derivative claims.  However, in Universal Project Management Services Ltd v Fort Gilkicker Ltd & ors [2013] All Er (D) 313, Briggs J held that double derivative claims survived and were governed by common law principles.

The facts

The claimant, "Inder", was a minority shareholder (22%) in a family company, "BL", alongside the first defendant, his brother, "Jat" (41%), and their mother "Rajinder" (37%). BL's wholly owned subsidiaries "BDL" and "BBL" were the second and third defendants (the "Subsidiaries"). Jat and Rajinder were directors of BL and the Subsidiaries at all times.  Crucially, Inder was not a shareholder in the Subsidiaries and could not rely on the Act to pursue his claim.

Inder applied for permission to continue a common law double derivative claim comprising two allegations of wrongdoing by Jat. First, Inder alleged that various payments made by the Subsidiaries to another company, which was wholly owned by Jat, amounted to gifts which caused the Subsidiaries to suffer loss (the "Payments"). Jat contended that the payments were loans which had already been partially repaid. Secondly, Inder claimed that a property transferred from BDL to Jat personally at a price of £115,000 amounted to wrongdoing as the transfer was at an undervalue (the "Property"), denying BDL the opportunity to develop the property itself and make a profit. Inder also requested a pre-emptive indemnity as to costs so that he would be indemnified out of the assets of the relevant companies in relation to his costs of bringing the claim.

Decision

The court (Morgan J) found in favour of Inder and permitted him to continue the double derivative action with respect to the Payments, but not the Property.  In coming to that decision, four key issues needed to be examined.

1. Did the court have jurisdiction in relation to a double derivative claim following the enactment of sections 260 to 264 of the Companies Act 2006?

Morgan J was able swiftly to determine this question in Inder's favour following the Universal Project Management decision cited above. 

2. Had Inder established a prima facie case that BDL and BBL were entitled to relief and that Jat could not successfully rely on a limitation defence?

Morgan J expressed some surprise that there was not complete clarity as to what the phrase "a prima facie case" actually means, albeit it did not cause real difficulty in this case.

With respect to the Payments, Jat accepted that there was a prima facie case of breach of duty but argued that  this claim was time barred, as the payments were made more than six years before Inder's claim was issued. However, Morgan J found that as Jat was a director and the beneficiary of the alleged dishonesty, Jat had prima facie committed a dishonest breach of fiduciary duty. This enabled Inder to argue that section 21(1) of the Limitation Act 1980 was available, which establishes that there is no relevant period of limitation in the event of fraudulent breach of trust.

With respect to the Property, Jat accepted that there was a prima facie case and no limitation defence was raised.

3. Had Inder established a prima facie case that the case fell within the exception to the rule in Foss v Harbottle? In relation to this issue, a number of sub-issues were raised, as follows:

• a) was this a case of actual fraud?
• b) did Jat benefit from the alleged wrongdoing?
• c) was there “wrongdoer control” of BBL and BDL?
• d) could (not would or should) a reasonable board of directors of the relevant company consider it appropriate to bring these claims?

Morgan J had to be satisfied that this case should fall within the exception to the rule in Foss v Harbottle as concerning a "fraud on the minority" which a reasonable board of directors could consider pursuing.

With respect to the Payments, in answering question 2 above, Morgan J had already reached the view that there was a prima facie case of dishonesty and a clear benefit to Jat as sole owner of the recipient.  Morgan J was also satisfied that there was a prima facie case of wrongdoer control exercised by Jat and Rajinder as collectively 78% shareholders in BL and effective controllers of BBL and BDL.

Having answered questions (a) to (c) in Inder's favour, it was common ground following Airey v Cordell [2007] BCC 785 that Morgan J also needed to consider the likely attitude of reasonable independent boards of directors of BBL and of BDL to the claim for the Payments against Jat.  Bearing in mind the size and strength of this claim and the likely level of costs involved, Morgan J concluded that an independent board could reasonably decide that that it was appropriate to sue Jat for the outstanding sums.

It was also submitted that permission to continue a derivative claim with respect to the Payments should be refused as it was open to Inder to pursue an unfair prejudice petition under section 994 of the Act. While this was certainly possible, Morgan J recognised that the derivative claim would be relatively narrow and self-contained whereas an unfair prejudice petition could involve significantly wider issues, resulting in a slower and more expensive trial. As Inder had made it clear that he could not engage in negotiations to achieve a fair overall settlement without resolving the issues raised in the derivative claim, there was a real advantage to permitting Inder the opportunity to establish what he alleged fairly swiftly with a view to facilitating negotiations.

With respect to the Property, Morgan J was not able to conclude that there had been a prima facie case of dishonesty or that there was a benefit to Jat as a result of the transaction. Inder was unable to support his allegation that the land had been sold at an undervalue as he did not adduce any evidence as to the value of the land other than his own views. Moreover, if Jat had paid market value for the property, there was no relevant benefit to him. Until detailed advice was taken on the value of the land at the time of the sale to Jat, a reasonable board could not have considered it appropriate to bring proceedings against Jat in relation to this transaction.

4. Should the court direct that Inder was to be indemnified out of the assets of the relevant company and/or BL for his costs in bringing these claims, such costs to include any adverse orders for costs made against him?

Morgan J also refused Inder's request for an indemnity out of the assets of BBL or BDL to cover his own costs and any adverse order for costs made against him. Morgan J considered the leading case of Wallersteiner v Moir (No. 2) [1975] QB 373 and later authorities and came to the view that the court needs to exercise considerable care when deciding whether to order a pre-emptive indemnity. Morgan J did not think it was obvious on the facts that if Inder lost at trial, the trial judge would order a costs indemnity. Also, as the derivative proceedings were considered a stepping stone to negotiations for a formal split of the business or separate section 994 unfair prejudice petition, Morgan J considered that the costs position should be the same as it would be in a section 994 petition: there should be a cost risk to both sides.

Comment

The risk of wrongdoing occurring where fraudsters choose to defraud a subsidiary rather than a parent company was widely regarded as undesirable and the decision in the Universal Project Management case a welcome one. Bhullar v Bhullar further underlines the rights of shareholders to challenge wrongdoing, regardless of the precise nature of the overall corporate structure.

It is also helpful to note that the court will not resolve factual disputes when deciding whether to grant permission to pursue a derivative claim but will consider the strength of the case. Having sufficient evidence even at this early stage of the proceedings is plainly essential. Had Inder adduced evidence of the value of the Property at the time that it was transferred to Jat, it is possible that he would have been granted permission to continue with that claim as well as the claim in relation to the Payments.

Additionally, Morgan J's approach to the possibility of Inder pursuing an unfair prejudice petition as an alternative remedy is of interest. The courts tend to refuse permission to continue a derivative claim where an unfair prejudice petition is available (see for instance, Franbar Holdings v Patel and Kleanthous v Paphitis). However, in Bhullar v Bhullar, Morgan J took the most pragmatic approach by preferring the course most likely to result in overall settlement.

Shareholders also need to be alive to their own cost risk in pursuing a derivative claim. While the costs indemnity is often described as the usual order in derivative actions, Morgan J's judgment demonstrates that this will be carefully considered on the basis of the matters in issue. If Inder continues this derivative claim he will need to bear his costs and, potentially, the adverse costs of Jat should his claim ultimately prove to be unsuccessful.