Added Protection
Date: 27 February 2009
Authors: Peter Hayden
Issue: Vol 159, Issue 7358
Categories: Features, Commercial, Banking, Company
The starting point when considering a derivative action is the first limb of the well cited rule in Foss v Harbottle (1843) 67 ER 189, namely that the proper plaintiff in an action in respect of a wrong alleged to be done to the company is prima facie the company itself. There are several exceptions to this rule which allow a shareholder to bring a derivative action on behalf of the company. However, it was originally envisaged that such a claim would be brought by a person holding shares in the company which had the cause of action.
The crucial question that arises is whether a person holding shares in a parent company, which has suffered an indirect loss as a result of the direct loss suffered by the subsidiary, can bring a derivative action on behalf of the subsidiary.
In the context of a hedge fund registered in the
Such a claim has been called a “double” or “multiple” derivative action (for convenience referred to in this article as multiple derivative actions), depending on how far the shareholder wishing to bring the action is removed from the company on whose behalf he wishes to bring it. The recent decision of the Court of Final Appeal of Hong Kong in Waddington Limited v Chan Chun Hoo Thomas FACV 15/2007 provides useful guidance on the common law position.
The derivative action
There are a number of exceptions to the rule in Foss v Harbottle, but the most significant is where what has been done amounts to fraud and the wrongdoers are in control of the company. In these circumstances, the rule is relaxed to allow the aggrieved minority to bring a derivative action because otherwise there would be no remedy, since the wrongdoers in control of the company would not allow it to sue. As Lord Denning MR stated in Wallersteiner v Moir (No. 2) [1975] 1QB 373 CA: “But suppose [the company] is defrauded by insiders who control its affairs—by directors who hold a majority of the shares—who can then sue for damages?... In one way or another some means must be found for the company to sue. Otherwise the law would fail in its purpose. Injustice would be done without redress.”
The constitutional documents of hedge funds often contain restrictions on the ability of shareholders to remove those in control of the fund, such as the directors and investment manager. Such restrictions may push investors in the direction of bringing their own claim rather than attempting to have the master fund bring a claim.
In Johnson v Gore Wood & Co [2002] 2 AC 1, [2000] All ER (D) 2293 the House of Lords considered the relationship between personal actions by shareholders and derivative actions brought by them on behalf of the company. It was held that, even if a shareholder has a personal cause of action against the company, he cannot recover loss which is merely reflective of loss suffered by the company. The only way to recover this loss is therefore through a direct action by the company or a derivative action by a shareholder on behalf of the company.
The multiple derivative action
Surprisingly, the issue of the multiple derivative action does not appear to have been specifically determined in a higher court in any common law jurisdiction outside the
Nevertheless, a number of the reported English decisions involve a multiple derivative claim. Wallersteiner was itself an example of such a case where a shareholder in the parent company sought to recover damages for a subsidiary company. Other English examples include
In Waddington, the Court of Final Appeal of Hong Kong considered the common law position and held that a multiple derivative action could be brought. In that case, the plaintiff Waddington was a minority shareholder in Playmates Holdings Limited. Playmates owned a company called Playmates International Limited, which in turn owned companies called Profit Point Limited and Autoestate Limited. Losses were alleged to have been incurred by Profit Point and Autoestate and the issue which arose was whether or not Waddington could bring derivative actions on behalf of those companies the subsidiaries) as well as on behalf of Playmates (the parent).
Common law position
In giving the leading judgment (with which all the other judges agreed), Lord Millett reviewed the common law position. His Lordship noted that the substantive law was sufficiently different in the
In considering these reasons, the court rejected the argument that a multiple derivative action contravened fundamental principles of company law such as separate corporate personality and that directors owe duties only to the company and not to its shareholders, let alone the shareholders of its parent company. It also rejected the argument that a multiple derivative action comprises two derivative actions (one by the shareholders on behalf of the parent company against the subsidiary for its failure to sue the wrongdoers and one by the parent company on behalf of the subsidiary against the wrongdoers), neither of which was maintainable (the first because the subsidiary owed the parent no duty to sue the wrongdoers and the second because the parent company was in control of the subsidiary). The fact that multiple derivative actions were permitted in a number of jurisdictions with similar company law was seen to weaken these arguments. The “two claims” analysis was said to be deceptive, because the action was only a single action on behalf of the company in which the claim was vested. The question of who could bring this action was found to be an issue of locus standi. The argument that it was well established that only a person holding shares in the company suffering loss could bring a derivative action on behalf of that company was also rejected. Upon reviewing the authorities, the court reached the view that most of the dicta to this effect were merely obiter. The only case where the issue had been decided was the Australian case of Ruralcorp Consulting Pty Ltd v Pynery Pty Ltd (1996) 21 ACSR 161, in which a senior master decided that a multiple derivative action could not be brought under the common law jurisdiction. The court was critical of the approach taken in Ruralcorp which was said to have consisted of mere assertion (that the plaintiff was not a shareholder of the subsidiary) and a failure to understand the distinction between a shareholder of record and someone simply claiming an equitable interest in the shares (the proper position being that only the latter could not bring a derivative claim because a company does not recognise equitable interests).
Locus standi
On the question of locus standi, Lord Millet said that the court had to ask itself whether the plaintiff had a legitimate interest in the relief claimed such as to justify him bringing proceedings to obtain it. The answer in relation to a person seeking to bring a multiple derivative action was said to be “plainly yes”. The depletion of a subsidiary’s assets caused indirect loss to its parent company and shareholders. The fact that according to Johnson v Gore Wood (a case in which Lord Millett had sat in the House of Lords) this loss was viewed as reflective loss simply mirroring that sustained by the subsidiary was a reason for not allowing a personal action by the shareholder to recover it. It was not, however, a reason for not allowing a multiple derivative action to be brought on behalf of the subsidiary by those who had indirectly suffered the loss. In Giles v Rhind [2003] Ch 618, the English Court of Appeal had held that there was an exception to the reflective loss rule set out in Johnson v Gore Wood in circumstances where a wrongdoer steals the whole of the company’s business with the intention that the company should be so denuded of funds that it cannot pursue a claim. Lord Millett indicated that he believed Giles v Rhind to be wrongly decided because it would result in the losses being recovered by a shareholder personally rather than by the company, to the prejudice of the company and its creditors. While some remedy was needed in those circumstances, the proper remedy was said to be a derivative action.
Although it was previously assumed that a multiple derivative action could be brought at common law, Waddington confirms this to be the position. While not binding on other common law courts, the clear explanation of the common law position provided by Lord Millett is likely to be followed. The clarification of the reflective loss rule is also welcome.
The decision of Waddington is a welcome one for investors in hedge funds registered in the
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