Court of Appeal decision confirms high threshold for fraud requirement in a common law derivative action in the LLP context

A recent Court of Appeal decision provides a useful reminder of the limited scope of the exceptions to the rule in Foss v Harbottle in common law derivative actions, which continue to apply to limited liability partnerships (LLPs) as they are not subject to the statutory regime for derivative actions under the Companies Act 2006. The Court of Appeal's decision confirms that common law derivative actions should only proceed on the basis of the "fraud on the minority" exception in cases of actual fraud or where wrongdoers have improperly benefitted themselves at the expense of the LLP: Harris v Microfusion 2003-2 LLP & ors [2016] EWCA Civ 1212.

While the continued existence of a common law derivative claim is, in theory, a powerful tool at the disposal of members of an LLP, this case further demonstrates that the reality is that such claims will likely succeed only in exceptional circumstances.

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

Legal background

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 the company has suffered. 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, derivative actions developed in certain exceptional circumstances to permit a minority shareholder of the company to pursue a claim in the name of the company.   

Common law has also evolved to permit a derivative claim to be brought in respect of an LLP (see Re Fort Gilkicker Ltd [2013] EWHC 348 (Ch)). While sections 260 to 264 of the Companies Act 2006 have since provided an exclusive statutory regime for claims pursued by members of a wronged company, it did not address LLPs. As such, the common law rules on derivative actions continue to apply to LLPs. 

To pursue a derivative claim at common law, it is necessary to fall within one of the four exceptions to the rule in Foss v Harbottle. These exceptions are as follows:

1. A shareholder can sue in respect of some attack on his individual rights as a shareholder;
2. If the company is purporting to do by ordinary resolution that which its constitution requires to be done by special resolution;
3. If the company has acted or is about to act ultra vires; or
4. If there is "fraud on the minority" and there is no other remedy.

In the present case, the Court of Appeal was required to examine the scope of the fourth of these, the "fraud on the minority" exception.

Factual background

Mr Harris was a member of a limited liability partnership, Microfusion 2003-2 LLP ("the LLP"), who wished to pursue a derivative claim against two companies (referred to collectively as "Future Films"), who were the "Designated Members" of the LLP, for the benefit of the other members of the LLP. The allegation was that Future Films had control over the day to day management of the LLP, owing fiduciary duties which were breached as a result of three matters:

1. Future Films made improper payments from the LLP to LMI Investments Limited for administrative services;
2. Future Films made payments from the LLP to Alcon Entertainment LLC for marketing services without commercial reason; and
3. Future Films made rebate payments from the LLP to two companies, Trademark and Etic, for no real commercial reason. 

Mr Harris was successful in securing permission to bring a derivative action in respect of the first two issues but not the third. The appellant sought to reverse this decision in the Court of Appeal. Future Films cross appealed on the first two issues. 

Decision

The Court of Appeal (Lord Justice McCombe giving the leading judgment with which Jackson and Christopher Clarke LJJ agreed) dismissed Mr Harris's appeal and allowed Future Films' cross appeal: none of the claims were permitted to proceed.  The key issue before the Court of Appeal was the scope of the "fraud on the minority" exception to Foss v Harbottle. 

Mr Harris sought to argue that the "fraud on the minority" exception had been too narrowly stated at first instance. He argued that the definition of fraud in this context is wider and thus more accessible than fraud at common law as established in Derry v Peek (1889) 14 App Cas 337, and was satisfied where there had been allegations of breach of fiduciary duty and/or abuse/misuse of power.

However, the Court of Appeal disagreed.  It adopted the analysis of Richards J (as he then was) in Abouraya v Sigmund [2014] EWHC 227 that the "fraud on the minority" exception applies to (a) cases of actual fraud, ie deliberate and dishonest breaches of duty; or (b) in the absence of actual fraud, the alleged wrongdoing must have resulted in loss to the company (LLP in this instance) and personal gain by the wrongdoers. 

As there were no allegations of deliberate or dishonest breaches of duty in respect any of the three issues in dispute, and the Court of Appeal was not persuaded that there was sufficient averment of "benefit" to Future Films, the exception to Foss v Harbottle was not satisfied for any of the issues. 

The Court of Appeal refused to expand this approach in the interests of "justice" even though there had likely been breaches of duty by Future Films. Instead, it agreed with Future Films that principle meant that the Foss v Harbottle exception should remain exceptional.  People are free to join LLPs on whatever terms they choose and, if majority rule is provided for, the minority is bound by the wishes of the majority.  The majority is free to excuse breaches of duty, unless they have used their power to confer benefits on themselves in breach of duty and prevent the company from recovering loss caused to it as a result. The "fraud on the minority" exception is intended to prevent directors from improperly benefiting themselves at the expense of the company.