Balancing Minority Shareholders' Remedies and the Principle of Internal Management in Uk Company Law

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.

For the significance of minority shareholders’ protection from investor confidence perspective, see Caspar Rose, ‘The Challenges of Quantifying Investor Protection in a Comparative Context’, (2007) European Business Organization Law Review 8.

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.”

Foss v. Harbottle, 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. 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. 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

• [1902] AC 83, [93].
• [1843] 67 ER 189.
• Lorraine Talbot, Critical Company Law (2nd edn, Routledge 2015).
• Alan J. Dignam, Andrew Hicks, Hicks & Goo's Cases and Materials on Company Law (Oxford University Press 2011) 425.

The Foss Rule is rooted in two important concepts in company law, which are explained here. 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. 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. In fact, over a period of time, the Foss Rule became the principal bar on actions by minority shareholders. 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, 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, 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, the same restrictive approach

• Ibid.
• David Kershaw, ‘The Rule in Foss v Harbottle is Dead; Long Live the Rule in Foss v Harbottle’ (Law Society Economy Working Papers, May 2013) < https://www.lse.ac.uk/collections/law/wps/WPS2013-05_Kershaw.pdf > accessed 18 July 2016.
• Ibid.
• Ibid.
• AJ Boyle, Minority Shareholders’ Remedies (Cambridge University Press 2002).
• [2001] 2 WLR 72.
• [1873] 8 Ch App 1035.
• Ibid.
• [1982] 1 All ER 354; Also see, Kathy Idensohn, ‘The fate of Foss under the Companies Act 71 of 2008 : Analyses’, (2012) SA Mercantile Law Journal 24 (3), 355.

In Prudential Assurance Company Ltd v Newman, 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, 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. 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.

• Edwards v Halliwell [1950] 2 All ER 1064.
• Edwards v Halliwell.
• Len Sealy and Sarah Worthington, Sealy and Worthington’s Cases and Materials in Company Law (10th edn, Oxford University Press 2013) 640.

In Daniels v Daniels, 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. 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.

Shareholder remedies

Shareholders’ remedies include: derivative claims, personal claims, unfair prejudice petitions and petition for winding up of the company. Unfair prejudice petition is an important shareholder action, termed by AJ Boyle “as one of the most significant forms of minority shareholders’ remedies”. Where the actions of the majority are ultra vires the memorandum of association, or infringe personal rights of the shareholders, or are contrary to the articles of association, common law allows actions by shareholders. Traditionally common law did not allow actions on behalf of the company by the shareholders, as these would be contrary to the proper plaintiff rule which was based on the independent identity of the company. Over time, as seen in the previous section, derivative actions were allowed where a fraud was being committed on the company. The Company Act 2006, s.261, allows the remedy of statutory derivative action to the minority shareholders and it can be said that the statutory provision is influenced by the evolving norms developed by the courts.

Balancing exercise

The concept of minority shareholder protection in the UK relates to varied aspects of the company law. One example of this is in the cases involving alteration of articles of association. The courts have held time and again that discriminatory alteration of articles, where the impact is on individual members, the alteration is contrary to the best interest of the company. The courts have evolved exceptions to the Foss Rule,

• [1978] Ch 406 [414]
• Stuart Sime (ed), Company Law in Practice (9th ed, Oxford University Press 2012) 161.
• See Cinematic Finance v Ryder [2010] EWHC 3387.
• AJ Boyle, Minority Shareholders’ Remedies (Cambridge University Press 2002) 132.
• For instance, Brown v British Abrasive Wheel Co. [1919] 1 Ch 290.

with the obvious objective of ameliorating the position of the minority shareholders affected by the wrongs committed against the company. Shareholders have been indemnified by the company for litigation costs of derivative actions, that are successful. For applicability of the derivative action claim, the best interests test is applied by courts.

According to Lele and Simms, minority shareholders are protected vis a vis majority shareholders, through exit provisions. Therefore, shareholders’ remedies are also as well entrenched in the English law, as the ‘proper plaintiff principle’ is.

The courts have managed to evolve principles that reflect just and equitable remedial provisions for minority shareholders when there is a fraud on the minority due to the actions of the majority shareholders. However, there is still a need for further reforms because the minority shareholders at times may be subject to the oppression of the majority shareholders. The majority may ratify wrongful acts and the minority may not be able to take any action against them, as the action itself may be barred by the majority through voting against it, or ratifying the wrongful act.

Conclusion

The hesitation of courts to interfere in the internal management of the company is rooted in well-established principles of law. The proper plaintiff in actions by the company, is the company itself, however, there are now established areas where derivative actions are allowed by the courts. These exceptional areas are evident of a balancing exercise carried out by the courts in order to ensure that minority shareholders’ rights are protected and not unfairly or unreasonably impacted by a rigid understanding and application of the proper plaintiff rule. At the same time, principles of internal management and proper plaintiff are well entrenched in the English company law. These are essential to the proper management of the company as well as to safeguard the most fundamental aspect of corporate personality, that is, the separate legal entity of the company. Company is a legal person separate from the identity of its members and as such, it is the proper plaintiff in actions related to itself.

• Wallersteiner v Moir (No.2) [1975] QB 373.
• Franbar Holdings v Patel [2008] EWHC 1534 (Ch).
• Priya Lele and Mathias Siems, ‘Diversity In Shareholder Protection In Common Law Countries’, (2007) Journal for Institutional Comparisons, 5 (1), pp. 3-9.
• For minority shareholders remedies without recourse to exit strategy, L Hirsh, J Fulton, ‘A Pound of Cure: Remedies for Minority Shareholders Without an Exit Strategy’, (2010) Business Torts Journal 11 (4).
• Sandra K. Miller, ‘How Could U.K and U.S Minority Shareholder Remedies for Unfairly Prejudicial or Oppressive Conduct be Reformed?’, (1999)American Business Law Journal 36.

The approach of the courts, which is now, incorporated in statutory law as well, with Company Act 2006, allowing derivative action, is to balance these concepts in order to provide a just and equitable remedial provision to the minority shareholders.

Bibliography

• Boyle AJ, Minority Shareholders’ Remedies (Cambridge University Press 2002)
• Dignam AJ, Hicks A, Hicks & Goo's Cases and Materials on Company Law (Oxford University Press 2011)
• Hirsh L and Fulton J, ‘A Pound of Cure: Remedies for Minority Shareholders Without an Exit Strategy’, (2010) Business Torts Journal 11 (4
• Idensohn K, ‘The fate of Foss under the Companies Act 71 of 2008 : Analyses’, (2012) SA Mercantile Law Journal 24 (3), 355.
• Lele P and Siems M, ‘Diversity In Shareholder Protection In Common Law Countries’, (2007) Journal for Institutional Comparisons, 5 (1), pp. 3-9.
• Miller SK, ‘How Could U.K and U.S Minority Shareholder Remedies for Unfairly Prejudicial or Oppressive Conduct be Reformed?’, (1999)American Business Law Journal 36.
• Rose C, ‘The Challenges of Quantifying Investor Protection in a Comparative Context’, (2007) European Business Organization Law Review 8.
• Sealy L, Worthington S, Sealy and Worthington’s Cases and Materials in Company Law (10th edn, Oxford University Press 2013)
• Sime S (ed), Company Law in Practice (9th ed, Oxford University Press 2012)
• Talbot L, Critical Company Law (2nd edn, Routledge 2015)

Take a deeper dive into Balancing Justice and Informant Protection with our additional resources.