Elements of a derivative action

Following the initial panic redemptions, insolvencies and restructuring, investment funds which have survived the ravages of the 2008 financial crisis have entered a new and distinctive phase.  

Regulators and investors now have a better understanding of the complex investment strategies pursued by some of the fund managers and are seeking to hold accountable those who have caused the pain visited upon investors.  

One strategy being adopted by investors, especially in the United States, is to file derivative shareholder actions against the funds’ directors and service providers. 

Where the fund is registered in the Cayman Islands, usually as an exempted limited liability company, the U.S. courts will, in those cases, apply Cayman law.  

It behoves Cayman hedge fund directors and service providers to have some understanding of the key Cayman law principles applicable to a derivative action, whether pursued in Cayman or in the U.S. 

 

Definition of a derivative action 

A derivative action is an action filed on behalf of a company by one or more shareholders seeking relief against the directors and others, for damage caused to the company.  

It is to be distinguished from a personal action in which the shareholder seeks relief for the infringement of some personal right such as, for example, a breach of their subscription agreement, or of their redemption rights under the articles.  

 

The rule in Foss v Harbottle  

Under Cayman law the general rule, known as the rule in Foss v Harbottle, is that the proper plaintiff in an action to recover loss suffered by a company is the company itself.  

It is an extension of the principle that the company has a separate personality from its shareholders.  

By that principle the property of the company, including its right to sue, belongs to the company, and not to any individual shareholder. 

The proper organ of a company for instituting legal action on behalf of a company is usually the board of directors.  

Where the directors fail to act, it is open to the company in general meeting to decide whether or not to sue.  

A simple majority may, with some exceptions, ratify the wrongful acts of the company’s directors. In such a case the courts will usually not allow the minority shareholders to use a derivative action to override the will of the majority.  

 

Exceptions to the rule  

The Foss v Harbottle rule admits of a few, limited exceptions. 

Ultra Vires – At common law the majority shareholders of a company have no capacity to ratify acts which are beyond the capacity of (or ultra vires) the company.  

Further, by section 28 of the Companies Law, an individual shareholder may bring an action to prohibit the company from disposing of property where the company is acting ultra vires and the company, or its liquidator, may sue the directors for losses caused to the company by their ultra vires acts.  

Very few actions are likely to fall within this exception. By section 7(4) of the Companies Law, and its memorandum of association, a modern Cayman company is likely to have the same capacity as a natural person.  

The only likely ultra vires acts are those which are illegal under Cayman Islands law. 

 

Special majority required – A derivative action may be allowed if the wrongful act may only be ratified by a special majority of the company.  

The usual rule which prevents the court from intervening in the company’s internal management has no application in such circumstances unless the company has convened a meeting and obtained the required special majority.  

 

Fraud on the minority – The most commonly invoked exception is that there has been a “fraud on the minority” and the wrongdoers are in control of the company. This exception has two elements: fraud and wrongdoer control. 

 

Fraud 

“Fraud” in this sense does not require evidence of dishonesty. The wrongful act may be wilful, or even negligent.  

It may constitute a breach of fiduciary duty or merely a breach of the duty to exercise proper care and diligence.  

There must however be some element of self-dealing, or evidence that the directors, or controlling shareholders, derive some profit, benefit or advantage at the expense of the company.  

 

Wrongdoer control 

The wrongdoers must be shown to control the majority of the voting rights and, if a meeting were convened, will likely use their control for their own personal advantage, rather than in the interest of the company.  

There is no requirement that the investor request the directors to convene a meeting.  

Evidence of voting control by the alleged wrongdoers may be sufficient, although the directors may be able to demonstrate independent decision making by having the decision whether the company should sue decided by a body independent of the alleged wrongdoers.  

 

Plaintiff must apply for permission to pursue action 

Order 15 rule 12A of the Grand Court Rules mandates that in every derivative action, the plaintiff must, after the defendants have served notice of intention to defend, apply for permission to continue the action.  

The plaintiff is required to file affidavit evidence which establishes that the case falls within one of the exceptions to the rule in Foss v Harbottle.  

If the plaintiff fails on this application to establish a prima facie case the action will be struck out. 

 

What losses can a shareholder recover in a derivative action? 

A shareholder cannot recover “reflective” loss.  

In other words, where the company suffers a loss by virtue of a breach of duty owed to it and the company has a cause of action, only the company may sue and no claim will lie by a shareholder to make good the loss suffered by him as a result of a reduction in value of his shareholding.  

This rule against the recovery of reflective loss operates in circumstances when the shareholders’ claims substantially overlap with matters of which the company could also complain.  

When it is engaged, the rule prohibits the shareholder from having any claim. 

Where the company suffers a loss but has no right of action to recover that loss, however, the shareholder may sue if he has a cause of action to do so.  

Further, where a company suffers a loss caused by a breach of duty owed to it but the shareholder suffers a loss, which is separate and distinct from that of the company (i.e. not a reduction in value of his shares or in any other benefit from the company), then the shareholder may be able to recover his separate loss: but neither the company nor the shareholder can recover the loss incurred by the other. 

 

Multiple derivative actions 

A multiple derivative claim is usually an action by a shareholder in a parent company in respect of a breach of duty owed to its subsidiary.  

The key point is that the shareholder wishing to bring the derivative claim is not a shareholder in the company in which the cause of action is apparently vested but only in a company further up the corporate chain.  

Such actions are permitted under Cayman Islands law.  

A beneficial holder of shares, however, would not have standing to bring a derivative action before the Cayman Courts. 

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