Corporate Finance

Company has a separate legal entity from its members, can sue or be sued on its own behalf. As illustrated in Foss v Harbottle (1843), the proper plaintiff is the company itself. In other words, directors have the power to decide whether or not to sue in protection of the company. However, very often, the persons who commit misconduct are the major controller of the company and improbable to permit the company to sue. A common law right is therefore reserved for shareholders to sue the wrongdoers on behalf of the company by taking derivative action. This provides a valuable remedy for minority shareholders to protect the company. Minorities can take either Common Law Derivative Action (CLDA) or Statutory Derivative Action (SDA).
In this essay, the protection of company under fraud on minority will be firstly examined. Then, the comparison of Common Law and Statutory derivative action will be carried out followed by the discussion of the limitations of derivative action.
First and most importantly, derivative action can protect the company where the wrongdoers are the controller of the company and trigger fraud against the minority. As an exception to Foss v Harbottle rule, an individual member may bring a derivative action when abuse of power occurred by the majority. It is described as fraud on minority. The company will be joined as a defendant in this instance, with the intention that the court will grant the remedy sought to the company; it is the company which is harmed by the abuse of power (Stott, 2011). According to Alexander v Automatic Telephone Co (1900), directors who abuse their power to obtain benefits at the expense of company without informing other shareholders is regarded as fraud on minority. In Daniel v Daniel (1978), the court held that the minority shareholders can sue where there is fraud and the majority directors confer some benefits for themselves in the advantage of company. When fraud had been detected and harm caused to the organization, directors found guilty of a breach of fiduciary duty, shareholders can sue on behalf of the company under CLDA or SDA against the wrongdoers. The court can make reasonable sanction or judge on the fraudsters to protect the wealth of the company. This can support the fact that derivative actions can largely protect the company from harmed by abuse of power.
Added to the above, the establishment of SDA largely enhanced the protection and governance of company. Under CLDA regime, several problems have been pinpointed by the critics. Firstly, the wrongs which can be ratified are not actionable. As illustrated in Tan Eng Guan v Southland Co Ltd(1996), breach of fiduciary duty without causing any loss to company could be ratified are unable to be taken any derivative action since it is a prerequisite to prove the majority have abused their power. Secondly, an individual cannot sue on the ground that directors are negligent unless it is “fraud on minority”. Thirdly, in the case relating to directors outside Hong Kong, there may involve some conflicting law issues so non-Hong Kong organizations are excluded from the scope of CLDA. However, the introduction of SDA can supplement the drawbacks of CLDA. It is agreeable with Kwan (2006) that the scope of complaint upon which the action is found has been widened under SDA. It allows members to bring an action or intervene in any proceedings in the event of misfeasance which is defined as not only fraud but also including negligence, breach of duty and default in compliance with any enactment or rule of law under section 168BB(2). In addition, the scheme does not need any proof of fraud, whether common law or equitable, by those who are in control of the companies and who have abused of their powers. Also, the statutory right is equally applied to non-Hong Kong companies. It is inevitable that the coverage under SDA has been widened and some situations are more clearly defined so the protection and governance of the affected company has been improved.
Undeniably, derivative action can protect and govern the affected companies to a large extent. Still, both have some limitations which are incapable of protecting the companies.
In terms of CLDA, except the problems mentioned above, The Court of Appeal in Waddington Ltd v. Chan Chun Hoo (2006) held that the plaintiff must establish a prima facie case in the course of action in order to entitle to the relief claim. Hong Kong is actually following the rules in UK and Wales to require the establishment of a prima facie case. As a matter of fact, it is not a 100% effective to show a prima facie case as it is quite hard for plaintiff to gather sufficient evidence. Indeed, the absence of effective case management can increase the cost and time of litigation.
In terms of SDA, minority must get a leave from the court but the court must satisfy that the action is in the interest of the company, there is a serious issue to be tried or company not taken action to protect itself diligently and the member has served a written notice to the company in accordance with S 168 BD.(S.168BC(3)). In fact, it is difficult for the court to make these judgments without ample proof of evident. If the minority could not appear to be prima facie to support the application of leave, it may possible to discontinue the leave approval. It may, again, suffer cost and time loss. What’s more, the indoor management rule provided that minority cannot sue on behalf of the company where it is internal problem and can be solved through general meeting. As illustrated in MacDougall v Gardiner (1875), the court would not interfere in any matter that company can resolve it by calling a meeting. It is upon the company’s decision when they call the meeting. Thus, it is a limitation of derivative action in protection of affected company when dealing with internal matters as the court would not take any legal action on it.
To sum up, the derivative action can greatly protect and govern the company under common law and statutory based on the above analysis. However, there are still some drawbacks on common law and statutory derivative action when it comes to prima facie case and prerequisite of applying leave as well as the indoor management rule. Thus, the degree of protection and governance of affected company under derivative action is highly depends on different situation and the court judgment. There is no absolute certainty for the protection of firms. Generally, the derivative action can offer large degree of protection to the firm.