Court of Appeal rejects second major attempt at a climate-related derivative action

In July 2023, the Court of Appeal upheld the first instance decision in McGaughey & Anor v Universities Superannuation Scheme Limited [2023] EWCA Civ 873 ("McGaughey"), dismissing the application by members of a pension scheme to bring a derivative action against the directors of the scheme's trustee company.

McGaughey and ClientEarth v Shell, taken together, confirm that the courts of England and Wales remain wary of challenging reasonably made decisions of company directors. In McGaughey, the Court of Appeal also made clear that derivative actions are not appropriate when direct challenges are available. For more on ClientEarth v Shell, see our blog post here.

So, while derivative actions may continue to be brought as a disruptive tactic by activist shareholders, there is likewise continued judicial reluctance to second-guess corporate decision-making. The Courts are aware that climate risks are just one of the many risks which executives consider when deciding on strategy. In the absence of evidence of egregious disregard for climate risks, the courts seem unwilling to find that directors have the balance wrong.

Factual background to McGaughey

Two academics (the "Applicants"), members of the Universities Superannuation Scheme (the "Scheme"), one of the largest private occupational pension schemes in the UK, appealed the High Court's rejection of their attempt to bring a derivative action against the directors of the Scheme's trustee company.

The directors had approved resolutions amending Scheme benefits by making changes to salary threshold, accrual rate and inflationary increases and increased member contributions. They had also obtained an actuarial valuation as at 31 March 2020, when they were not required to do so until a year later. The Applicants challenged these decisions.

The Applicants also argued that the directors had breached their duties under the Companies Act 2006 by continuing to invest in fossil fuels despite the Scheme's ambition to be carbon neutral by 2050. They argued the directors had not adequately considered the attendant financial risks. These breaches were therefore said to cause current and future loss to Scheme members, in the form of lost assets, increased deficit and other knock-on future losses.

As the trustee company of the Scheme is a company limited by guarantee, it has no shareholders. The statutory derivative action under the Companies Act 2006 was therefore not available and the Applicants consequently framed their claim at common law.

A common law derivative action must satisfy four requirements:

1. sufficient interest or standing to pursue the claim on behalf of the company;
2. a prima facie case that the claim falls within an exception to the rule in Foss v Harbottle;
3. a prima facie case on the merits; and
4. that it is appropriate in all the circumstances to permit the derivative claim(s).

The test for standing

The appeal in McGaughey failed at the first hurdle. The Court highlighted two key aspects to the Applicants' lack of standing:

1. Under the 'Reflective Loss' principle, the Applicants had to show they had suffered a loss. Also, importantly, they had to show this loss related to (or at least correlated with) the Scheme's loss. The Applicants were unable to make out either of these. In particular, they could not prove any substantive loss suffered by the company on account of the directors' actions (including in relation to fossil fuels claims).
2. Further, because changes made by the directors to the Scheme benefits were not uniformly detrimental (ie the changes affected different classes of Scheme members differently), the Applicants were not able to bring the claim on behalf of all the members of the Scheme. Contrast this to the position of shareholders in a company, who all enjoy the same benefits.

Directors' duties and other obligations

McGaughey makes clear that directors' duties must be considered separately from their other obligations.

The rule in Foss v Harbottle is that, generally, the Company is the correct party to bring an action against its directors. There are, however, a number of exceptions to this rule, including where a fraud has been committed and the minority (ie shareholders) are prevented from remedying the fraud because the company is controlled by the wrongdoers (ie the directors).

The Applicants claimed that the directors knew or believed that the changes to Scheme benefits involved indirect discrimination and were nonetheless prepared to tolerate it for their own ends.

However, the Court of Appeal found this attempted to elide the directors' statutory duties, owed to the company, with the objects of the trust. Mere allegations of directors acting in bad faith or having conflicts of interest are insufficient to fall under an exception. Claimants must specifically identify the fraud on minority stakeholders and the wrongfully obtained benefits of that fraud. The Applicants' vague allegations were given short shrift, with Lady Justice Asplin commenting that "it was entirely inappropriate that the[se] allegations [of fraud] should have been made."

Direct claims rather than derivative actions

Both the High Court and Court of Appeal showed a preference for direct claims over derivative claims. The derivative action mechanism is "not intended to enable would be claimants to avoid other procedural hurdles".

The Court of Appeal noted that because of this, even if the Applicants had a prima facie case, the derivative action would not have been allowed to continue. In particular, the Court of Appeal noted it was "surprised" that the claim had been brought in this form, noting there was "no reason, save perhaps a desire to avoid the difficulties in relation to costs and representation," for bringing it as a derivative action. Instead, the Applicants should have brought a claim which challenged the Scheme's investment policy directly, here most simply in breach of trust.

The importance of internal governance to climate claims

While clearly a success for the Scheme's directors, McGaughey also shows the importance of shareholder resolutions in corporate governance.

Leech J, deciding at first instance in McGaughey, considered a survey of members in finding that the directors had complied with their obligations to diversify and manage the Scheme's assets.

Similarly, in deciding not to grant ClientEarth leave to pursue its derivative action, the High Court explicitly had regard to a shareholders' vote of approval for Shell's Energy Transition Strategy at previous Annual General Meetings.

Both the McGaughey and ClientEarth decisions highlight the courts' consideration of these resolutions, signalling that proactive shareholder involvement can shape corporate climate strategy and that companies should consider their internal controls when assessing litigation risk.