Most company directors act in the best interests of the business and its shareholders. However, disputes can arise where shareholders believe a director has acted improperly, made decisions that have harmed the company, and/or breached their duties.
One of the challenges in these situations is that the company itself is usually the party entitled to bring a claim. This can create difficulties where the individuals responsible for making decisions about legal action are the very directors whose conduct is being questioned.
In circumstances like these, the law allows shareholders to step in and bring a claim on the company’s behalf. This is known as a derivative action.
In this article, we explain what a derivative action is, when it may be available, and how the process works.
What is a derivative action?
A derivative action is a claim brought by a shareholder on behalf of a company against one or more of its directors. Ordinarily, where a company suffers loss because of the actions of a director/s or a third party, the company itself is the proper claimant. In most cases, decisions about whether to pursue legal action are usually made by the directors.
Courts are also generally reluctant to interfere in the internal management of companies where decisions have been made within the company’s powers. Like we’ve highlighted above, it’s unrealistic to expect directors to authorise proceedings if they themselves are accused of misconduct.
A derivative action provides a mechanism for shareholders to seek redress on behalf of the company where certain types of wrongdoing are alleged.
When can a derivative action be brought?
Derivative actions are governed by the Companies Act 2006. A shareholder may seek permission to bring a derivative claim where the company has suffered loss as a result of a director’s:
- Negligence
- Default
- Breach of duty
- Breach of trust
Common examples might include directors placing their own interests ahead of the company’s interests, failing to manage conflicts appropriately, misusing company assets, or making decisions that fall below the standards expected of company directors.
Importantly, the claim belongs to the company rather than the shareholder bringing it. This means that if the claim succeeds, any damages awarded are paid to the company, not directly to the shareholder.
Why are derivative actions different from other shareholder disputes?
Many shareholder disputes involve disagreements between shareholders and directors about how a company is run. A derivative action is different because the focus is on the harm suffered by the company itself.
The shareholder is effectively stepping into the company’s shoes and asking the court for permission to pursue a claim that the company would otherwise be entitled to bring. As a result, the court will carefully examine whether the proposed claim is genuinely in the company’s interests rather than being driven by a personal dispute between individuals.
How does the process work?
Derivative actions are subject to a structured court approval process designed to prevent unmeritorious claims from progressing.
Step One: Applying for permission
The shareholder must issue a claim and provide evidence explaining:
- The alleged wrongdoing;
- The loss suffered by the company;
- Why the claim is in the company’s best interests; and
- Why court intervention is necessary
Step Two: The court’s initial review
The court will carry out a preliminary assessment of the evidence. At this stage, claims that do not meet the statutory requirements may be dismissed without progressing further.
Step Three: A full permission hearing
If the claim survives the initial review, the parties will have an opportunity to make submissions to the court. The court will then consider whether allowing the claim to proceed would genuinely promote the interests of the company.
The Companies Act 2006 requires the court to refuse permission in certain circumstances, including where:
- A director acting in accordance with their duty to promote the success of the company would not pursue the claim; or
- The conduct complained of has already been authorised or ratified by the company.
Step Four: The substantive claim
If permission is granted, the claim proceeds in much the same way as any other court action. Although the shareholder is bringing the proceedings, the claim is treated as one brought by the company.
What should shareholders do if they have concerns?
Allegations that directors have breached their duties can be complex and highly fact specific. Not every disagreement about company management will justify a derivative action, and shareholders should seek advice before taking formal steps.
Early legal advice can help establish whether a derivative claim may be available, what evidence will be required, and whether there may be alternative remedies that are more appropriate in the circumstances.
How Gorvins can help
Disputes involving directors and shareholders can have significant implications for both the business and the individuals involved. This is why obtaining advice as early as possible is important to clarify your options and avoid unnecessary costs.
If you’re concerned about the actions of a director, considering whether a derivative action may be appropriate, involved in a shareholder dispute, or you are the company (or director/s) involved in a dispute with your shareholders, our Litigation Team can help.
To speak to a member of the team, call us on 0161 930 5151, email us at enquiries@gorvins.com or complete our online enquiry form.