Critically discuss whether, in the context of the remedies available to minority shareholders, the right balance has been struck between non-interference with the internal management of companies and the need to redress a wrong done to the company or to a shareholder.

Introduction

The relevance of minority shareholders’ remedies cannot be overemphasized. This is essential for corporate governance and creates a positive investment environment, because the remedies for protection of shareholders are in place, and this leads to shareholder confidence.

Two organs of the company exercise the powers of the company. These organs are: general meetings of shareholders and the board of directors. In effect, the decisions of the company are made by the majority vote in these organs. This is the established principle of majoritarian rule that is the norm in company law. Shareholders being the investors in the company, essentially have decision making powers in the company, but these powers are exercised by the majority, putting the minority, if there is one, at a variance. When the powers of the majority are exercised in an inappropriate manner, or in a manner that is oppressive to the minority, the law gives certain remedies to the minority shareholders. The Companies Act 2006 (CA 2006) provides for rights and remedies of shareholders. Remedies include derivative claims, personal claims, unfair prejudice petitions and petition for winding up of the company. However, the principle Foss v Harbottle (Foss Rule) does not allow interference into the affairs of the company, as per which the company alone is the proper plaintiff in an action relating to a wrong against itself. However, as this essay will discuss, there are now certain exceptions to this rule, ensuring derivative actions by minority shareholders for wrongs done against the company. These exceptions work towards balancing shareholder protection with the principle of internal management of the company.

This essay explores and critically analyses the balancing of the rights of the minority shareholders with the need to respect the principle of Foss Rule by the courts in the UK.

The essay will first discuss the rule in Foss v Harbottle, which is the basis for the courts’ restrictive stand in cases such as Burland v Earle. Then, in order to understand how the courts have attempted to balance the rights of minority shareholders with the rule, the essay discusses the exceptions developed by the courts to mitigate the effect of the Foss Rule on the minority shareholders. The essay argues that essentially, these exceptions are in the nature of balancing exercise by the courts.

Minority shareholders: Does the law strike the right balance between the remedies and the principle of internal management?

The rule in Foss v Harbottle

In the case of Burland v Earle, Lord Davey observed:

“It is an elementary principle of the law relating to joint stock companies that the Court will not interfere with the internal management of companies acting within their powers, and in fact has no jurisdiction to do so. Again, it is clear law that in order to redress a wrong done to the company or to recover moneys or damages alleged to be due to the company, the action should prima facie be brought by the company itself. These cardinal principles are laid down in the well-known cases of Foss v. Harbottle and Mozley v. Alston, and in numerous later cases.”

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Foss v. Harbottle, 3 mentioned above is based on one of the fundamental features of company law, that is, the principle of internal management. These principles are based on the principles that emerged from judgements in partnership cases and cases relating to unincorporated companies in the nineteenth century. Lorraine Talbot, is critical of the restrictive approach of the courts in such cases, and particularly of tilting the balance in favour of the majority who at times are the wrongdoers. 4 However, as the ruling in Foss case and later cases do demonstrate, some restriction was necessary in order to allow companies to conduct their business without being brought to court by each and every minority shareholder, who felt that his rights had been impeded on by the majority. This was the essential application of the majoritarian rule, which is a based on the application of democratic principles within the company.

The Foss Rule is rooted in two important concepts in company law, which are explained here 5 . The first relates to the distinct legal personality of the company. As one of the foundational features of corporate personality, this principle would require that the company be the proper plaintiff in suits related to wrongs done to it. The restrictive stance on the minority shareholders’ actions is rooted in this principle. The second principle that became the basis for the court’s ruling was that for the company to function effectively, the constitutional arrangements within the company must be respected, for which the majoritarian principle was to be essentially followed

Basically, as case laws show, minority shareholders have been restricted in their pursuit of derivative actions. 7 Thus, the Foss Rule came to be the major impediment in protection of minority shareholders when there was some act of the majority that was wrongful to the company, but as it was ratified by the majority, the courts generally refused to intervene. Over a period of time, this was found to be too rigidly applied, so that in order to balance the considerations of rule of internal management with the need to protect minority shareholders, certain exceptions were evolved by the courts. In these exceptions, as the next part shows, the minority shareholders got some respite.

The Foss Rule came to become the basis for the restrictive stance of the courts and did impact minority shareholders’ actions. 8 In fact, over a period of time, the Foss Rule became the principal bar on actions by minority shareholders. 9 The effect of the rule was that company was considered to be the only ‘proper plaintiff’ in actions related to the company, including where some wrong was committed against the company. In Johnson v Gorewood & Co, 10 the derivate action related to directors’ breach of duty as not allowed. Here, the principle becomes too restrictive and goes against the interest of the company itself.

In Gray v Lewis, 11 James LJ observed:

“where there is a body corporate capable of filing a bill for itself to recover property either from its directors or officers, or from any other person, that corporate body is the proper plaintiff and the only proper plaintiff.”

In Prudential Assurance Company Ltd v Newman, 13 the same restrictive approach marred the chances of allowing derivative action for the benefit of the company.

Exceptions to the rule

The obvious objective for the courts to evolve exceptions to the Foss Rule, was to reduce the ill effects that the rigid application of the Foss Rule, imposed on the minority shareholders.

Edwards v Halliwell, 14 is an important case in this respect and demonstrates the balancing exercise done by the court. In this case, the court laid down certain exceptions to the Foss Rule. There is a clear and evident balancing exercise that is done by the court in the Edwards case. As Jenkins LJ himself observed in this case: ‘the rule [in Foss v Harbottle] is not an inflexible rule and it will be relaxed where necessary in the interests of justice’.

The exceptions laid down in Edwards involved: ultra vires acts of the majority; violation articles of association by not taking a by special majority, when required; violation of personal rights of members that they were entitled to as members of the company; acts that constituted a ‘fraud on minority’ being committed by the majority. 16 The last exception is important here because, this action constituted a derivative action by the shareholder, meaning an action allowed by the courts in the name of the company, although the action did not initiate from the company and was in fact a minority shareholder action. This was a major deviation from the Foss Rule, which held that only the company would be the ‘proper plaintiff’ in a case involving a wrong committed against a company. The rationale for this deviation could be that it was becoming increasingly evident that majority by its decision could subvert any such action by the company and could even convert a wrong against the company into a valid action by ratifying the wrongful action. Therefore, the wrongdoers could be in control of the company (‘wrongdoer control’ principle), or they could ratify a wrong done against a company. In either case, a strict or rigid application of the Foss Rule would have just meant the continuation of the wrong without a redressal given to the company or the minority shareholders.

In Daniels v Daniels, 17 it was held that the directors of the company would be committing a fraud on the company, if in order to benefit themselves at the expense of the company, they used their powers whether unintentionally or negligently, in a fraudulent manner. It is interesting that the court decided the case in this manner because common law as such, does not include unintentional or negligent acts in the definition of fraud. 18 The courts however responded to the issue of minority shareholders’ protection with flexibility. The 2006 company law reforms, incorporated the principle in Daniels case under Part 11 of the Companies Act 2006. It is important to note that the statutory changes mentioned above do not do away with the proper plaintiff rule laid down in Foss v Harbottle.

Bibliography

    1. Aliza S, and Ghadas ZAA, ‘Inequality of Bargaining Power and the Doctrine of Unconscionability: Towards Substantive Fairness in Commercial Contracts’, Australian Journal of Basic and Applied Sciences (2012) 6(11), 331-341.
    2. Barnhizer DD, ‘Power, Inequality and the Bargain: The Role of Bargaining Power in the Law of Contract - Symposium Introduction’, Mich. St. L. Rev. (2006 ) 841.
    3. Lawson R, Exclusion Clause and Unfair Contract Terms, (Sweet & Maxwell 2011) Furmston M P, Cheshire GS, Fifoot CS, Cheshire, Fifoot and Furmston's Law of Contract (Oxford University Press 2012).
    4. Slayton P, ‘The Unequal Bargain Doctrine: Lord Denning in Lloyds Bank v. Bundy’, Mc Gill Law Journal (1976) Vol 22, 94-109.
    5. Stone R, Devenney J, The Modern Law of Contract (Routledge 2015).
    6. Wertheimer A, Exploitation (Princeton University Press 1999).

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