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RIGHT OF SHAREHOLDERS: DERIVATIVE ACTION

INTRODUCTION

In this complex environment of corporate governance, derivative action also called the shareholders derivative suit, acts as a safeguard and protects the shareholders from unlawful practices and mismanagement by the officers of the company. Shareholders are the ultimate owners of the corporation and hold certain rights that can make the officers accountable for their actions and protect the company’s interest. The company operates under the Directors, its employees, and its shareholders, each possessing certain rights and responsibilities that are often breached in the name of managing the company.

Derivative actions provide shareholders with a weapon against the wrongs committed towards the company when the management fails to do so. This remedy is significant, particularly for minority shareholders who lack influence within the company. The suit is usually initiated when the shareholders believe that the board of directors have not taken appropriate steps to address or resolve the misconduct within the corporation. The main aim is the protection of the corporation which indirectly safeguards the interest of the shareholder’s as well.

The case of Starlite Real Estate (ASCOT) Mauritius Ltd. & Ors. v. Jagrati Trade Services Pvt. Ltd highlights the significance of derivative action. In this case, “the high court emphasized that only the company has the right to initiate legal proceedings against any harm done to it.”[1] However, as a legal entity, the company acts through its directors, and it cannot bring legal action against its directors if they are responsible for the wrongdoing. In such circumstances, minority shareholders can step in and take legal action on behalf of the company to safeguard its interests.

IS DERIVATIVE ACTION NO LONGER MAINTAINABLE?

During the process of reviewing the Companies Bill of 2011, a standing committee acknowledged that class action suits cannot fully replace derivative actions and recommended that specific provisions for derivative actions be codified. However, the committee ultimately decided against it, arguing that such concepts should be allowed to evolve over time instead of being rushed into legislation.  However, the committee overlooked the fact that derivative actions and exceptions to the rule in Foss v. Harbottle have been recognized in India for a long time.[2]

Even though some aspects of derivative actions may be covered by Section 241[3] of the Companies Act, this does not mean that common law derivative actions will no longer be valid in India. Derivative actions have been codified in the UK, there have been instances where the court has acknowledged the existence of common law derivates which are not directly mentioned in the statute. Similarly, in India, the statute may not address derivative actions, it does not mean that common law derivative actions are no longer valid.

This raises the question of whether a separate statutory remedy for derivative actions is necessary in India. Derivative actions offer certain advantages over other remedies. In class action suits under Section 245 of the Company Act, 2013[4], minority shareholders must gather and organize similarly situated individuals to meet the requirements of the section. It is difficult for a group of unknown individuals to come together unless the company is closely held by a known group of shareholders. Even if the minority shareholder(s) can organize themselves, there are still obstacles to overcome. The Tribunal will have to decide whether the petition is made in good faith or not and whether the cause of action is one that the member could have pursued on their own rather than through the class action suit.

Derivative actions offer more significant financial advantages than direct actions since in a derivative action, both shareholders and non-shareholders benefit from the solution, while in a direct action, only the offended shareholder benefits, and the company does not receive any benefit.[5]  Overall, while class action suits and other remedies exist, derivative actions remain a valuable tool for shareholders to hold corporations accountable for wrongdoings that the company itself has failed to address.

JUDICIAL PRONOUNCEMENTS

Only a shareholder or a member can bring a derivative action to preserve the company’s interest. However, it is important that the shareholder must not look out for their own interest. In the case of Nurcombe v. Nurcombe the judges pronounced that the “shareholders should not misuse the power of derivative action for their selfish purposes.”[6]

In India, derivative action has been utilized in various lawsuits that were filed on behalf of companies. The Delhi High Court has declared in “Rajeev Saumitra v. Neetu Singh[7] that if a director breaches their responsibilities and gains unjustified profits, they are obligated to give back those benefits to the company according to Section 166 of the Companies Act, 2013.[8]” The court also explained that in a derivative lawsuit, the person bringing the claim must have a genuine interest, and the connection between the plaintiff and the beneficial owner may involve matters such as deception, fraud, disability, or incapacity. In the Forrest v. The Manchester, Sheffield and Lincolnshire Railways Company case, the Court of Chancery “upheld the principle of derivative action and stated that it is a constructive doctrine that permits a shareholder to bring a lawsuit in court on behalf of themselves and other shareholders of the company.”[9] However, the plaintiff is only permitted to represent shareholders if the lawsuit is genuine and aimed at protecting the interests of the shareholders they claim to represent. This principle demands that the plaintiff acts with honesty and sincerity in pursuing the lawsuit.

There has been a massive debate whether or not a shareholder who is a minority can or cannot bring a derivative class of action has been argued from different angles. In the case of Prudential Assurance Co. Ltd. v. Newman Industries Ltd.[10] when a derivative suit was brought in by a minority shareholder then it was pertinent to answer the wrongdoing before answering about the ability to maintain the derivative suit. So, what was said here is that the act of wrongdoing must be reported first irrespective of whether or not the correct person reported the wrongdoing even though it may lead to procedural problems.

This can be proved by the instance if the derivative action is successful then the money received goes to the company and not to the shareholder that filed a suit. It is difficult to circumvent the transparency and accountability measures outlined in the Companies Act to gain profits through a derivative action. Therefore, it is crucial to treat derivative actions as an exception where the plaintiff has a genuine interest.

CONCLUSION

Derivative actions are a crucial legal mechanism for shareholders to safeguard their rights and promote corporate governance. However, the Indian company law currently lacks clarity and statutory recognition for derivative actions. Though the Companies Act, 2013 recognizes several common law principles, the codification of derivative actions still lags. Recognition of the same will help reduce fraud, and mismanagement within the company on the same hand will reduce the domination of the majority shareholders as well. 

The recognition of derivative actions was called for in 2005 by the J.J Irani committee, but even today there is no statutory recognition of derivative actions though the judiciary has recognized the same.

Although there have been instances where derivative actions shift their primary role of protecting the corporation, the tribunal has examined certain claims made by the shareholders that shift the focus away from the company itself. Moreover, various obstacles prevent shareholders from initiating legal proceedings against the company’s mismanagement, it becomes essential for the codification of derivative actions to ensure that the rights of not only the majority but the minority shareholders are also protected.

Providing statutory recognition for derivative actions would bring greater clarity and transparency to the legal framework, and encourage greater shareholder participation in the governance of companies. It would also help to build trust between shareholders and companies, and promote a culture of accountability and transparency.

However, after the 2009 Satyam scam, we have come a long way through the inclusion of derivative action which helped reveal the inadequacies in the law. Many flaws persist in the current law like the burden of justifying the claim and gathering an adequate number of shareholders to file the suit in the court of law. This goes against the very grain of the concept and ruins the entire purpose of having derivative action.

Author(s) Name: Khushi Khanna (SVKMs Kirit P. Mehta School of Law (NMIMS), Mumbai)

Reference(s):

[1] Starlight Real Estate (Ascot) … v. Agrati Trade Services Private Ltd [2015] AIR 173. accessed on 17th January 2024.

[2] Karthik Seshadri, ‘Class Action – An Obstacle Race for the Minority’ (SCC Online, 4 August 2021) < https://www.scconline.com/blog/post/2021/08/04/class-action/> accessed on 17th January 2024.

[3] Companies Act, 2013, s241

[4] Companies Act, 2013, s245

[5] Harsh Tomar, ‘Confused Jurisprudence of Derivative Actions in India’ (Centre for Business and Commercial Law NLIU)< https://cbcl.nliu.ac.in/company-law/confused-jurisprudence-on-derivative-actions-in-india/#_edn5 > accessed on 23rd January 2024.

[6] Nurcombe v. Nurcombe [1984] EWCA Civ J0724-3

[7] Rajeev Saumitra Vs Neetu Singh & Ors [2016]

[8] Companies Act, 2013, s166

[9] Forrest V Manchester, Sheffield and Lincolnshire Railways Company [1861] 45 E.R. 1131

[10] Prudential assurance Co. Ltd. v. Newman Industries Ltd [1982] 1 ALL ER 354.