Shareholder Derivative Action: A General Overview

This research paper is a detailedanalysis of meaning and implication of the shareholder derivative action as provided under the Companies Act, 2013. This paper also discusses the judicial interpretation on the same with decided landmark case laws.
Estimated Reading Time: 7 minutes

Introduction

Section 2(84) of the Companies Act, 2013 defines a “share” as a share in the share capital of a company and includes stock. Every person, including a corporation, who legally owns such a share in a company, is called its shareholder and is consequently, a member of the said company. When these shareholders bring an action regarding the rights of the corporation or on behalf of the corporation, it is referred to as a Shareholder Derivative Action.

Causes

It has two causes of action: firstly, to compel the corporation to sue and secondly, to redress harm to the corporation.[1] The source of the power to bring such an action comes from the membership of the company itself. The Plaintiff is seeking to enforce, not his own right of action, but a right of action vested in or derived from company and hence, in modern discussions, the action is referred to as a derivative action.[2]

Rationale behind shareholders derivative action

The rationale behind the significance of derivative action is well-explained in the judgment of Starlite Real Estate (ASCOT) Mauritius Ltd. & Ors. v. Jagrati Trade Services Pvt. Ltd.[3]Hon`bleCalcutta High Court stated that:

“In a derivative action, the company would be the only party entitled to sue for redressal of any wrong done to it. However, since a company is an artificial person, it must act through its directors. Where the wrong is being done to the company by the directors in control, the company obviously cannot take action on its own behalf. It is in these circumstances that the derivative action by some shareholders (even if they are in a minority) becomes necessary to protect the interest of the company. The minority shareholders sue on behalf of themselves and all other shareholders except those who are defendants and may join the company as a defendant.”

Shareholder Derivative Action: An Exception

There is a general rule that the Company has the power to sue and be sued. Consequently, when a wrong is done, a company can sue on its own behalf. However, a derivative action is an exception to this general rule.[4] It has also been described as, “the suit for derivative action is an exception to the general principle of locus.”[5]

Such an exception comes into use for the shareholder when the corporation has a valid cause of action and yet, it has refused to use it. The Bombay High Court[6] has also upheld the rule that a company is entitled to maintain an action for the wrongs done against it and a shareholder has no locus standi to maintain such a suit. However, it also affirmed an exception to this rule that a shareholder can maintain an action when he or she is able to show that the wrongdoers are in control of the company’s interests and hence, the company cannot maintain the action. Therefore, a derivative action is an exception and must be used like an exception.

“Bona Fide” Interest

A company may have a large number of shareholders and it will be extremely inconvenient if every shareholder brings a claim on behalf of the company.  A test had to be developed. Two crucial aspects of this general test are firstly, the claim must be “on behalf of the company” and secondly, it must be filed with a “bona fide” interest.

Landmark case laws

A derivative action derives its power from membership and therefore, only a member or a shareholder can bring such an action, that too to only protect the interest of the company. Personal interests must not be secured through these actions. In the case of Nurcombe v. Nurcombe (1985)[7], the Court of Appeal cautioned that the derivative action should not be permitted to be misused for individual purposes.[8]

There have been instances in Indian Jurisprudence when cases have been brought on behalf of the corporation through a derivative suit. For example, a case was filed to recover the damages to the corporation resulting from the alleged backdating of stock options by several former executives.[9] Also, the Delhi High Court in Rajeev Saumitra vs Neetu Singh[10], while dealing with a derivative action, has held that a director was liable to pay to the company any undue gains realised from breach of duties prescribed by Section 166 of the Companies Act, 2013.

Regarding the bona fide interest, it must be noted that the inter se relationship between the plaintiffs and the beneficial owner, which the Plaintiff seeks to represent, may involve a case of deceit, fraud, inability, or incapacity.[11]

The Court of Chancery in the matter of Forrest vs. The Manchester, Sheffield, and Lincolnshire Railways Company[12] has held as under:

It has been a very wholesome doctrine of this Court that one shareholder having in view the legitimate purposes of the Company may be permitted in this Court to maintain a suit on behalf of himself and the other shareholders of the company, but the principle upon which that constructive representation of the shareholders is permitted indisputably requires that the suit shall be a bona fide one, faithfully, truthfully, sincerely directed to the benefit and the interests of those shareholders whom the Plaintiff claims a right to represent.

The matter may involve ulterior motive when the action is prompted by family hostilities.[13] Such motives in bad faith often results in dismissal of the application. The Clean Hands Doctrine is significant to establish a successful claim under a derivative action, since the remedy under such a suit places its reliance on equity. 

Palmer’s Company Law, 24th edition 1987 at page 978 very rightly describes the Clean Hands Doctrine, in regard to a derivative suit:

The derivative action is subject, however, to the doctrine of clean hands. As an equitable invention, the derivative action cannot be used to do injustice. The principle has been applied in cases of acquiescence by the plaintiff shareholder in the wrongdoing of which he later complains and in cases where the plaintiff has been regarded as the puppet of outsiders whose interests are opposed to those of the company. The requirement of clean hands does not apply to personal action.

The debate regarding whether a minority shareholder can bring a derivative suit has also seen various angles with different evolutions as per the facts and circumstances. However, when such an action was brought by a minority shareholder the question whether in fact the company was controlled by the alleged wrongdoers should first be determined before the derivative action itself was allowed to proceed.[14] Therefore, determination of the wrongdoing is placed at a higher pedestal than maintainability. Procedural difficulty may arise. However, very rightly stated, if a wrongdoing prevails, it must be looked into and not be dismissed because the right person did not approach the Court.  There is another reason why the fraud and ulterior motive involved is overrated. Even if a derivative suit is successful, the proceeds of the suit go to the corporation and not to the shareholder who brought the suit. With the transparency and accountability measures present in the Companies Act, it is not easy to bypass these procedures and create an incentive of getting the profits through the suit.  

Treating the case of derivative action as an exception with a bona fide interest is important. If the action is brought for an ulterior purpose or if another adequate remedy is available, the court will not allow the derivative action to proceed and the shareholder will be allowed to sue on behalf of the Company if he is bringing the action bona fide for the benefit of the Company for wrongs to the Company for which no other remedy is available.[15]

Conclusion

For corporate governance to be effective, derivative suits are significant and an important measure for the shareholder to assure his or her rights. However, the company law in India still lacks clarity and is in dire need to give statutory recognition to these derivative actions. Section 245 of the Companies Act allows for the initiation of a class action suit by a member or a depositor only on behalf of the members or depositors of a company.[16] However, one has to differentiate between these class action suits, personal action suits, derivative action suits etc. The internet and procedure behind all these are different.

Several common law principles were recognised by Companies Act, 2013. However, codification for derivative actions still lags behind. If such recognition is provided, the chances of mismanagement, frauds and dominant control of majority shareholders is bound to decline. In 2005, more than a decade earlier, The J.J. The Irani Committee noted that although derivative actions have been allowed by courts, they are yet to be reflected by statute.[17] However, still today, in 2020, there is judicial recognition to derivative action brought in by shareholders but no statutory recognition.


[1]Seth Aronson, Sharon L. Tomkins, Ted Hassi, Andrew R. Escobar, Shareholder Derivative Actions: From Cradle to Grave, (June 2009), https://www.mondaq.com/pdf/clients/87654.pdf.

[2] Darius Rutton Kavasmaneck vs. Gharda Chemicals Limited, 2015 (2) BomCR 100 (India).

[3] Judgment dated 14 May 2015 (India).

[4] Supra note 3.

[5]Ahmed Abdulla Ahmed Al Ghurair and Ors. vs. Star Health and Allied Insurance Company Limited and Ors, (2019) 13 SCC 259 (India).

[6] B.B.N. (UK) Limited v. Janardan Mohandas Rajan Pillai,1993 (3) Bom. C.R. 228 (India).

[7]1 All ER 65; 1 WLR 370.

[8]M. Sreenivasulu Reddy and Ors. vs. Kishore R. Chhabria and Ors, [ 2001] 42 CLA 93 (Bom) (India).

[9]Mercury Interactive Corp. v. Klein: MC/07/00099.

[10][2016] 132 CLA 74 (Kar).

[11] Supra note 6.

[12]45 ER 1131.

[13] Barrett Vs Duckett, [1995] 1 BCLC 243.

[14] Prudential Assurance Co. Ltd. v. Newman Industries Ltd. (No. 2), [1982] 1 All ER 354.

[15] Supra note 14.

[16]Mithun Verghis, Ashish Kabra & Vyapak Desai, Derivative Action by a Shareholder: Director liable for the breaches of its fiduciary duties, Feb 26, 2016, http://www.nishithdesai.com/information/research-and-articles/nda-hotline/nda-hotline-single-view/article/derivative-action-by-a-shareholder-director-liable-for-the-breaches-of-its-fidiciury-duties.html.

[17]Irani, Jamshed J, Report on Company Law (31 May 2005),

http://www.primedirectors.com/pdf/JJ%20Irani%20Report-MCA.pdf, at para. 10.1.

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