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The concern that part 11 will increase potential liabilities for directors and the chance of tactical and vexatious litigation by activist shareholders has been raised by many others. The City law firm, Lovells, says:
“The Explanatory Notes to the Bill explain that ‘the’”
“‘clauses do not formulate a substantive rule to replace the rule in Foss v Harbottle, but rather a new procedure for bringing such an action which set down criteria for the Court distilled from the Foss v Harbottle jurisprudence’. It is hard to see how this can be correct. As the Explanatory Notes themselves make clear, the rule in Foss v Harbottle is that is for the company to bring proceedings where a ‘wrong has been done to the company’, and that an exception can be made where there is conduct amounting to a fraud on the minority. The case of Estmanco (Kilner House) Ltd v Greater London Council made clear that ‘fraud’ in this context extends beyond fraud at common law to include ‘the equitable concept of fraud on a power’, including an abuse or misuse of power. It is generally considered that fraud, in this sense, does not include negligence. Other grounds include where the director’s act is illegal, ultra vires and not ratifiable, or where the shareholder has acquired a personal right against a relevant director.
Whilst the Explanatory Notes say that Part 11 does not seek to overturn these previous ‘well established principles’, it is hard to see how this can be. If Part 11 comes into law, individual shareholders will be able to bring proceedings against directors, including in respect of negligence, which cannot be summarily struck out for want of locus standii, but only under a brand new test, which is unconnected to these common law factors. As a result, there is a clear risk that multiple stakeholders might make good use of Part 11 to further their own various platforms, at the expense of companies’ time and money, and their directors time and money, personal stress, and claims upon their D&O insurance. It may even be possible for such a shareholder to use the provisions of this Part to apply for an order that the company pay his costs of bringing the proceedings, along the lines of the application upheld in Wallersteiner...If so, this could produce the very odd result that a number of activists could each buy a single share in the company, and each bring separate proceedings against directors, in respect of conduct predating their shareholding, at the company’s expense. Such claims may well, however, be struck out by the Court under the first stage of section 242 referred to above.”
We hope that that would be the case, but clearly the risks are there.
Let me turn to our amendments, which seek to rectify the problems that I have highlighted. Clause 260(3) states:
“A derivative claim...may be brought only in respect of a cause of action arising from an actual or proposed act or omission involving negligence, default, breach of duty or breach of trust by a director of the company.”
That wording is not sufficiently precise and is too wide. In particular, the use of the words, “or proposed”, go too far. A member should not have the statutory right to make a derivative claim to restrain some proposed act or omission. The intention should be to provide a remedy for a member where there has been an actual act or omission. To include the words, “or proposed”, may be a charter for members at any time to take action to restrain what they thought was a potential future breach of the relevant duties. We therefore propose to amend the wording of the clause as set out in amendment No. 412. In Committee, the Solicitor-General said that this approach is too restrictive, but we are yet to be convinced by his arguments.
Amendments Nos. 413 and 414 were brought to us by the Institute of Chartered Accountants, which sets out its position in its brief of 10 October:
“We are concerned that the draft clauses do not reflect the Government’s intention, as stated in its explanatory material and agreed to in the House of Lords Committee stage debate, of codifying existing common law principles on derivative actions. These clauses create new rights for members to bring a derivative action against persons other than directors. An actual or alleged breach of duty by a director”—
The Solicitor-General: I am interested that the briefing from the outside body suggests that we are codifying. The aim is to deal with some of the exceptions in part 11, not to replace the whole rule in Foss v. Harbottle. The case remains as part of common law.
Mr. Djanogly: Yes, but as I explained to the Solicitor-General, although the Government are maintaining that the case remains, the clause as drafted will significantly alter the application of the case.
Action against a director for breach of duty could, therefore, be effectively used as a springboard for a member to bring a derivative action against others. The Institute of Chartered Accountants believes that it will encourage nuisance claims against directors. We therefore tabled amendment No. 413. In Committee, the Solicitor-General stated that clause 260 was drafted on Law Society recommendations. He gave examples of third parties who hold money, transferred in breach of trust from the company, and who should be permitted to be pursued by a member of the company. Although that may be true in limited circumstances, we remain concerned about the growing scope of the clause and support the position of the Institute of Chartered Accountants.
8.45 pm
The City law firm Allen and Overy brought the substance of amendment No. 415 to us. It aims to ensure that the company retains an opportunity to exercise its primary right to sue the directors. Although it is easy to get carried away with arguments for and against members being able to seek relief on the company’s behalf, we should not forget that the primary right is for the company to initiate the action. The amendment would embed that right in primary legislation.
Amendment No. 416 is aimed at resolving some of the problems that I have highlighted. The Law Society has been a great help in drafting the amendment, which was first tabled by Lord Hodgson in the other place. It would insert in clause 263 three new provisions, which oblige the court to refuse permission to continue a claim.
The first provision would apply when the directors had decided not to pursue the claim. The second would apply when the shareholders had decided not to pursue the claim. The third would apply when the court concluded that pursuing a claim was not in the company’s best interests.
The first provision would apply when a company’s directors had decided not to pursue the claim, unless the court considered them to be in breach of their duties in making the decision. The purpose is to ensure that the court does not second-guess the directors’
commercial judgment unless it considers that, by deciding not to proceed, they are in breach of their duties. In Committee, the Solicitor-General maintained that that should be a relevant factor for the court in reaching its decision but not a bar. He said that the amendment would prevent meritorious claims from being granted permission for leave. However, we urge the Government to trust directors and accept the amendment.
The second provision, for when shareholders had decided not to proceed, would apply when the court believed that the majority of shareholders, excluding those with a personal interest in the decision, did not wish to proceed with a claim.
I hope that the third provision is self-explanatory and constitutes common sense.
Although the Government gave explanations about the amendment in Committee, we do not believe that they have merit. The amendment would improve the drafting considerably. We emphasise that its purpose is to introduce a threshold test that does not involve expense.
The Government have added new reasons for the court to reject a derivative claim. Are the tests strong enough? We contend that they will not be in practice. There is a concern that it will be possible for firm advice to be given on the court’s approach to the exercise of its unfettered discretion only after years of jurisprudence. Uncertainties will be damaging to business.
Amendment No. 417 would reintroduce the fraud on the minority and wrongdoer control tests that existing common law contains. I have already spoken about the way in which the radical departure from common law has worried several stakeholders to whom we have spoken. From the way that the hon. Member for Cambridge (David Howarth) is shifting in his seat, I have a feeling that he, too, will cover the matter.
I thank the Solicitor-General for his letter of 25 July on derivative claims, which set out the legal position about fraud on the minority following implementation. Although we acknowledge that the Government are attempting to clarify a difficult matter, we believe that the common law position should prevail and have tabled amendment No. 417 on that basis.
The issue is important to us. We have been lobbied significantly by companies, accountants, solicitors, the CBI and many interest groups, including many City solicitors. The Government need to reconsider the matter, because if we get it wrong, we open up the possibility of a culture of litigation, which exists in the United States, but that we do not want to experience in this country.
David Howarth:
I am surprised that so many Members are present now that we have got on to Foss v. Harbottle, the heart of lawyer’s company law. To re-emphasise the point made by the hon. Member for Huntingdon (Mr. Djanogly), the whole point of the rule in Foss v. Harbottle is to save time. It is to prevent shareholders—particularly minority shareholders—trying to sue in the company’s name to enforce the company’s rights against somebody else in circumstances where the company could easily get rid
of the wrong itself, does not want to sue or can validly prevent the action from going forward.
As I understand it, the Government have said that they are trying to clarify the law without codifying it. As the hon. Member for Huntingdon has said, the trouble with that is that it will tend to cause some confusion in areas where the statute does not mention the previous law. Would the courts reconstitute the previous law? It might be argued that it will be several years before we end up back where we started.
As the hon. Member for Huntingdon said, the law on this matter is not entirely clear. I have a problem with his amendment No. 417, simply on the ground that the concept of fraud on the minority is so difficult and so contested in the courts and academic journals that it is not really worth putting into a statute. Most academic writers think that it is too confusing to use, and many point out that what it really means is fraud against the company. Perhaps we should not put into statute a phrase of such contested meaning.
Other amendments that have been tabled have varied merit. The idea of amendment No. 412, which would leave out the word “proposed”, is, as the hon. Member for Huntingdon said, to prevent derivative actions in advance of the harm being done. That seems to me a useful aspect of the current draft, as it is frequently cheaper for all concerned to prevent harm from being done than to try to cure it later. Obviously, the word “proposed” does invite possible extra legal actions. The question, however, is whether the safeguards in the rest of the clauses with which we are dealing prevent abuse. To a large extent, I think that they do. I would not therefore support amendment No. 412.
Amendment No. 413 would take away the ability of a derivative action to cover rights that the company has against third parties. In the past, that has always been thought to be possible, and the amendment would impose a restriction on such action. This area of law is always about the company’s rights, not the personal rights of the individual shareholders or directors. The question is whether derivative action should be used to allow shareholders to enforce the company’s rights, and it seems to me perfectly sensible to propose that it should, given the other restrictions on the possible use of such action.
Amendment No. 415, however, seems to be a more sensible proposal. As has been said, the whole point of Foss v. Harbottle is to prevent shareholders in a minority action from wasting everyone’s time by bringing a derivative action that is unnecessary or has no chance of succeeding. The amendment allows the company—in particular, the board of directors, the organ of the company that normally has such a right—to decide first whether it wants to proceed with the action. It seems to me to be straightforwardly correct, and in the spirit of the existing law that goes back to the original 19th-century cases, to allow the company in the form of the board of directors to have a pre-emptive right of first refusal on whether an action should be brought.
Amendment No. 416 would reconstitute the details of the rule itself. Its ambition is admirable, and proposed subsections (d) and (e) are clearly linked to legal developments in the 19th century—the former to the Atwool case of 1867, and the latter to the Menier v. Hooper’s Telegraph case of 1874. The intention behind
the amendment is good, but it is difficult to encapsulate very complex cases in statute. In a way, the amendment is vulnerable to the objection expressed by the hon. Member for Huntingdon against the whole thrust of the Bill—that it tries to put into statutory form a very complex area of case law. One could argue that he has not got it quite right.
Mr. Djanogly: The hon. Gentleman is right that I do not want to create new case law, and that the amendment’s attempt to incorporate in the Bill the existing common-law position runs the risk of falling into that trap. However, he will appreciate that the amendment is an attempt to ensure that that the existing provisions should not be widened.
David Howarth: I appreciate the attempt, but the question is whether it is entirely successful.
Amendment No. 416 paragraph (f) is a new departure, in that it would insert in the Bill the sort of catch-all provision to which one would normally object on the grounds that it is vague and unclear. The amendment has its merits, therefore, but needs more work.
I have already dealt with amendment No. 417, which I said was not a good idea because it would bring back the notion of fraud on the minority.
Finally, the Bill is an important attempt at reform, as the hon. Member for Huntingdon has noted. He seems to think that that reform is not desirable, but many people would differ with him about that. The particular question that I am dealing with here is whether it is necessary to prove that the directors made a gain from their wrongdoing before a derivative suit can be brought. The present law states that such an action cannot be brought against directors who have committed negligence, except where that negligence has resulted in a gain for the wrongdoer.
It is not entirely clear why that rule is in place. I agree with the many people who think that it is simply an historical accident, the result of taking too seriously the notion of “fiduciary”—that a gain has to be identified before legal action can be taken. Another possibility is that the relevant case law was not consistent, so that judges went one way, regretted it, and then decided to go the other way.
The underlying question is whether a derivative suit should be possible when directors have lost the company money through their negligence. That would give rise to a claim that belongs to the company, and the next question is whether the proposed reform in the Bill would give directors an incentive to do their job better. I think that it would and therefore am in favour of it.
I recognise that there could be a problem if people on the outside think that what is being done is a codification rather than a reform. That would not be correct: the Bill proposes not a codification but a reformed system that has some merits.
9 pm
The Solicitor-General:
I thank the hon. Members for Huntingdon (Mr. Djanogly) and for Cambridge (David Howarth) for their comments on this part of the Bill. I particularly thank the hon. Member for Cambridge,
whose erudite and helpful contribution has helped to clarify many of the issues. I should like to make a couple of points for the sake of clarification before I set out a brief outline of the Government’s position.
The hon. Member for Cambridge is quite right to say that our aim is not to codify the whole of Foss v. Harbottle. That case states that only a company can sue for a breach of duty, and the courts have allowed shareholders certain exceptions to sue by various derivative claims. We are replacing the exceptions—rather than codifying—by means of part 11 of the Bill. As I have said, Foss v. Harbottle will survive.
The hon. Member for Huntingdon is right to say that we need to ensure that we do not create a culture of litigation in this country. We believe that our provisions will strike a balance that will avoid the development of that kind of culture. Our aim is similar to his in that regard, but we disagree over the way in which the provisions will apply.
Both hon. Members made the point that, in order to develop this area of law further, there would need to be more case law. They are quite right, and the new statute will bring new case law with it. The common law has developed through case law in any event. Even if we did not introduce these reforms or bring into operation the clauses in part 11, there would still be some case law. There will therefore be a degree of further development of the law, and the statute will help that development. That is our intention.
I also agree with the hon. Member for Huntingdon that this is an important part of the Bill. Let me therefore outline the Government’s approach in this area. Our starting point has been the need to balance the ability of directors to manage the affairs of companies in good faith and the right of the members to bring an action on behalf of a company in circumstances in which a director has acted in breach of his duty to the company and in which an action would not otherwise be brought. I believe that part 11 achieves that balance very well.
A derivative claim is not a shareholder action in the sense of an American class action. It is an action brought by a shareholder on behalf of a company. It follows from this that any damages arising from a successful claim would be paid to the company, not to the shareholders who have brought the action. Since shareholders who bring an action may also face heavy costs, a derivative claim is very much an action of last resort. It is not something that any shareholder is likely to embark on lightly, as they could put themselves in a very difficult position if they did so.
Mr. Djanogly: Our fear in relation to this provision concerns costs. If an action group persuaded 300 of its members to buy one share each in a company, then funded the action of those shareholders, that could give rise to problems. People might bring court cases without caring about the costs, because they were being funded by a third party.
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