A better fitting kilt

Earlier this year (“The kilt doesn’t quite fit”, Journal, March, 22) I discussed a test case under the Companies Act 2006 (“CA 2006”), in which a shareholder successfully asked the court for leave to bring an action against a company director (and a third party) on behalf of the company: Petition of Alexander Wishart [2009] CSOH 20. Lord Glennie granted leave to raise the action and ordered that the company pay the expenses of bringing the action (insofar as they were not recovered from the defending director and/or third party).

The respondents appealed to the Inner House, whose decision was issued on 21 July 2009: [2009] CSIH 65. The court upheld both elements of Lord Glennie’s decision. The shareholder can now proceed to raise a court action against the director and third party for breach of directors’ duties and a return of profit to the company.

Flexible remedy

In its discussion of the relevant law the Inner House confirmed a number of points. It agreed that the application for leave should be a summary procedure; a hearing with documents and affidavit evidence is appropriate. It was correct that only the company should be served with the application; the allegedly wrongdoing director has no right to enter into the process at that stage. The onus is not on the shareholder to show that he has a prima facie case: it is for the opposing company to persuade the court that leave should not be granted. However, the strength of the case is relevant in considering the importance a shareholder acting in the interests of the company would give to the action.

The court rejected the submission that as the applicant had the alternative of raising unfair prejudice proceedings, he should not be permitted to raise a derivative action. The unfair prejudice action (CA 2006, s 994) primarily covers the situation where the shareholder wishes to be bought out of the company. There is scope for diverted profit to be taken into account in assessing the value of his shares; however, he may not wish to be bought out, and the derivative action offers a more direct route to the remedy of recovering diverted profit for the company.

The Inner House made an important obiter comment. Although CA 2006 makes no mention of wrongdoer control, Lord Glennie held that it remained an essential feature of the derivative action. If there was no prima facie case that the alleged wrongdoers were in control of the company, and so in a position to prevent the company from taking action, the application for leave would be refused. The Inner House disagreed. It held that while wrongdoer control will often exist in this type of situation, it is not a requirement: CA 2006 was intended to introduce a more flexible approach to derivative actions.

This could have important implications. A shareholder contemplating derivative proceedings in relation to decisions taken within one of the rescued banks would face difficulties if a prima facie case of wrongdoer control was essential. Many of the banks’ directors departed following the Government bailouts, and so are not now in control. If wrongdoer control is not a requirement there may be more scope for derivative actions in relation to failures within the banks.

Prospective indemnification

In considering the prospective order for expenses against the company, the court looked closely at the English authorities and at the analogous situations of agency and trusts, and found that as the shareholder is acting for the company he should be indemnified by the company for the expenses of raising the action. The order should, however, be limited as recognition has to be given to the possibility of a material change of circumstances. The indemnification in this case will apply up to the procedural hearing in the commercial action, at which stage the shareholder can seek an extension of the order. In the meantime the company can apply for a variation of the order if there is a material change of circumstances.

In certain circumstances a shareholder may raise an action against a director/directors for breach of their fiduciary duties or for negligence, with the protection that the company must fund the litigation, including covering any orders for expenses against the shareholder. Historically derivative actions have been very rare in Scotland. It is possible that in light of this decision we may see an increase in the volume of this type of action.