Court refuses permission for derivative action to proceed following risk/benefit analysis

The High Court has refused permission for two members of a company to continue a derivative action despite there being (at least) a prima facie case against one of the company's directors. The court conducted a risk/benefit analysis and concluded that it was not sensible or proportionate to proceed with the derivative action:  Zavahir & anor v Shankleman & ors [2016] EWHC 2772 (Ch).

While the statutory derivative claim is, in theory, a powerful tool at the disposal of a shareholder, this judgment is a useful reminder that the court will exercise caution when considering whether to grant a shareholder permission to advance such a claim. A good case is not enough. The decision to bring a claim in the name of a company is much more complex and requires consideration of a number of different factors, including the costs that will be incurred and the likely reward if a company is successful. 

Judgments of this type will be welcomed by companies which do not wish to see uncommercial claims brought in their name. The court has shown willingness to place limits on such claims. 

Gary Milner-Moore and Tom Henderson, a partner and senior associate in our dispute resolution team, consider the decision further below.

Background

Derivative Claims

Derivative claims are actions which are initiated by a shareholder but brought in the name of the company in order to address wrongs done to the company, often by its directors. The court's permission is required to continue the claim. Sections 260 to 264 of the Companies Act 2006 provide the statutory footing. 

To obtain the court's permission to advance a derivative claim, the applicant must first demonstrate a prima facie case (section 261(2)). This is considered on the basis of the applicant's evidence only, and usually without a hearing. The court will then consider the strength of the overall case in more detail, usually in a hearing, taking into account the pre-conditions for permission under section 263(2) and the six non-exclusive factors under 263(3) of the Act. 

Relevant to this case is section 263(2)(a), which provides that the court must refuse permission if no person acting in accordance with section 172 of the Act (duty to promote the success of the company for the benefit of its members as a whole) would seek to continue the claim.  If some would and some would not, the court is obliged to consider the discretionary factors under section 263(3), which include the need to consider the importance that a person acting in accordance with the duty to promote the success of the company under section 172 of the Act would accord to the proposed claim (section 263(3)(b)).   

The facts

The claimants were shareholders in 89/93 York Street Limited ("YSL") a company incorporated for the purpose of ownership and management of the freehold of four flats in a property in London.  They alleged that YSL, through its director, Mr Shankleman, had granted lease extensions of substantial value for nominal consideration to shareholders or their successors in title in circumstances where it was known that YSL had no profits available for distribution. The lease extensions were valued at £136,000 in the aggregate with the implication that the value of YSL had diminished by the same amount. This was said to be a breach of section 830 of the Act: "Distributions to be made only out of profits available for the purpose". The claimants sought permission to bring a derivative claim in the name of YSL for breach of section 830. 

Decision

The court (Mr John Baldwin QC sitting as a Deputy Judge) rejected the claimants' application for permission to continue a derivative claim. Looking at the strength of the claim, the court concluded that the claimants had at least a "prima facie" case: "I am satisfied that the Claimants have a prima facie case and indeed, something more than that…". However, the court was not satisfied that any person acting in accordance with section 172 of the Act would seek to continue the claim and therefore the claimants failed to pass the threshold under section 263(2)(a) of the Act. 

In reaching this conclusion the court undertook a risk/benefit analysis. YSL was not a trading business. It had £20,000 of cash assets. The costs incurred in the application for permission to continue a derivative action amounted to £156,000 at the time of the hearing, when the action had barely started. An entirely successful action on behalf of the claimants would result in only £136,500 plus interest and, probably, a favourable order for costs – which might, optimistically, result in 80% recovery. Any leftover monies in a successful action would likely be distributed amongst the shareholders with 25% going to each. If the action failed or settled on a walk away basis it would be a "complete disaster as far as YSL is concerned".  In the circumstances, the court found that no prudent director would advance the claim.  Simply put, the legal merits of the claimants' claim were outweighed by the downsides and costs.

As the claimants had failed to pass the section 263(2) gateway, there was no need for the court to consider the factors under section 263(3) of the Act.  Nonetheless, it was noted by the court that the application of section 236(3)(b) of the Act would have led to the same conclusion had it been necessary to consider it.