High Court applies common law, not statutory, test to application for permission to bring derivative claim on behalf of LLP

The High Court has ruled that where a member of an LLP seeks permission to bring a derivative claim on its behalf, it is the common law test (otherwise known as the rule in Foss v Harbottle) and not the test contained in s.263 of the Companies Act 2006 which determines whether permission should be granted: Homes for England v Nick Sellman (Holdings) Ltd [2020] EWHC 936.

The decision is unusual in that it highlights clearly the different results that might be reached under the statutory test (which applies to companies) and the common law test (which applies to LLPs). In this case, permission would have been granted under the statutory test but was refused on the common law test, with the result that the derivative claim was struck out.

Given the notorious difficulty of satisfying the common law test for permission to continue a derivative claim, members of an LLP may well find they are unable to bring derivative claims which could have been pursued had the LLP instead been a company.

Andrew Cooke, a senior associate in our dispute resolution team, considers the decision below.

Background

HoE and Holdings were each members of an LLP with a 50% interest. There was a disagreement between the parties as to how the LLP had been refinanced. HoE claimed (in outline) that it had secured alternative financing for the LLP but that, due to Holdings’ delay in executing that alternative financing, the LLP incurred an additional fee of approximately £200,000 to its previous lender.

HoE first sued Holdings for the £200,000. Holdings defended the claim on the basis that the loss had been suffered by the LLP, which was obliged to pay the additional fee. HoE then amended its claim, seeking permission to bring a derivative claim on behalf of the LLP against Holdings. HoE contended that, by delaying execution of the alternative financing, Holdings had breached a duty to act in the best interests of the LLP, to avoid a conflict of interest and to exercise reasonable skill and care when discharging management responsibilities on behalf of the LLP.

CPR 19.9C provides that, where a person seeks permission to bring a derivative claim on behalf of a body corporate (including an LLP), the procedure under sections 261, 262 or 264 of the Companies Act 2006 (“CA 2006”) applies to the permission application as if the body corporate were a company. Those sections set out the need for permission and a staged procedure through which the question of permission is considered. Section 263 of the CA 2006 sets out the test for whether permission is to be granted to bring a derivative claim on behalf of a company.

At the hearing of the application for permission to bring the derivative claim in the Central London County Court, it was common ground that the substantive question of whether permission ought to be granted in relation to a derivative claim relating to an LLP must be determined under s.263.

However, between the hearing and judgment, Holdings instructed new counsel. When the judge ruled that permission should be granted under s.263, Holdings contended for the first time that s.263 did not apply and that permission must be determined applying the common law test. Holdings sought permission to appeal on that basis.

The judge refused permission, but the High Court heard the application for permission to appeal and the appeal itself together. Holdings did not challenge the judge’s decision under s.263 but contended that, if the common law test had been applied, permission would not have been granted.

Decision

The High Court (Zacaroli J) allowed the appeal and held that the derivative claim should be struck out. In doing so, he held that the common law test applied and that, applying this test, the facts did not support the grant of permission.

Zacaroli J first referred to the Court of Appeal decision in Harris v Microfusion 2003-2 LLP [2016] EWCA Civ 1212, where it had been common ground that the common law test applied. However, HoE raised the novel argument that CPR 19.9C had modified the law in relation to LLPs so that the substantive question of whether permission ought to be granted (not merely the procedural issue of how permission was to be sought) had to be determined under CA 2006.

Zacaroli J rejected that argument as a result of close textual analysis of both CPR 19.9C and CA 2006:

• It was common ground between HoE and Holdings that the Limited Liability Partnerships (Application of Companies Act 2006) Regulations 2009, which specifies the parts of the Companies Act that apply to LLPs as if they were companies, did not apply ss.260 to 264 CA 2006 to LLPs.
• It was also common ground that CPR 19.9C did not expressly apply s.263 CA 2006 to LLPs. CPR 19.9C referred expressly to ss. 261, 262 and 264, all of which are procedural not substantive provisions. HoE argued that, by applying these procedural provisions to LLPs, CPR 19.9C must also have caused the substantive provision at s.263 to apply. Because ss. 261 and 262 created a procedure by which to answer the question under s.263, and because an LLP was required to use the procedure provided under ss.261 and 262, HoE contended that it logically followed that the question to be answered in that procedure was the question under s.263.
• Zacaroli J rejected that argument. He held that CPR 19.9C was only intended to incorporate the procedural aspects of derivative claims under CA 2006. Section 263 CA 2006 made a substantive change to the law in relation to companies, by replacing the rule in Foss v Harbottle. Had the legislature intended also to replace that rule for LLPs, it would not have done so via procedural provisions in the CPR.
• Further, the abolition of the rule in Foss v Harbottle in relation to companies took effect via s.260 CA 2006. As with s.263, CPR 19.9C did not apply s.260 to LLPs. As a result, the common law rule as it related to LLPs had not been abolished.
• Zaracoli J confirmed this analysis by reference to the court forms annexed to CPR PD 19C. The application form in relation to an LLP omits a statement that the court must take account of the factors set out in s.263. In contrast, this statement is contained in the application form relating to a company. It was clear from the difference in the forms that the drafter of CPR 19.9C had not intended to treat LLPs and companies identically from a substantive perspective, but only from a procedural perspective.

HoE further contended that, even if s.263 did not apply to LLPs via CPR 19.9C, the court could still apply the statutory test under s.263 as a result of s.261(4), which does apply to LLPs. Section 261(4) provides that:

"On hearing the application, the court may-

(a) give permission (or leave) to continue the claim on such terms as it thinks fit,

(b) refuse permission (or leave) and dismiss the claim, or

(c) adjourn the proceedings on the application and give such directions as it thinks fit."

HoE argued that this discretion was sufficiently broad as to give the court an unfettered decision whether to grant or refuse permission, such that the court could (if it wished) choose to apply the statutory test under s.263 rather than the common law test. The court rejected this argument, holding that s.261(4) is procedural and says nothing about the basis upon which the court is to determine whether to grant permission. The words relied on in s.261(4) set out what orders the court could make as to the continuation of a derivative claim if permission were granted. They did not give the court discretion to apply whichever test it chose to determine whether permission should be granted.

Having established that the common law test applied for LLPs, Zacaroli J held this test was not satisfied on the facts of the case and permission to bring the derivative claim should be refused. To succeed under the common law, HoE was required to demonstrate its application came within one of the four exceptions to the general rule against derivative claims, as established by Foss v Harbottle [1843] 67 ER 189.

Of those four exceptions, only the ‘”fraud on the minority” exception was potentially relevant to HoE’s claim. Citing Abouraya v Sigmund [2014] EWHC 227, Zacaroli J considered whether there was (a) actual fraud, ie deliberate and dishonest breaches of duty or (b) in the absence of actual fraud, whether the alleged wrongdoing resulted in loss to the LLP and personal gain by the alleged wrongdoers. While the judge accepted that Holdings' actions caused financial loss to the members of the LLP, there had been no allegations of dishonest breach of duty nor any sufficiently pleaded allegations that Holdings had acquired a personal benefit at the expense of the LLP. For this reason, HoE could not bring its claim within the relevant exception to the rule in Foss v Harbottle such that permission was refused and the derivative claim was struck out.