A derivative action is one of the ways a minority shareholder, or another suitable stakeholder, can employ to effect good corporate governance in the company he invests in and to redress the wrongs committed against the company when those in control of the company refuse to do so. It also acts as a deterrent for directors not to abuse the proper functioning of the company by making decisions that adversely affect the company.
This article focuses on derivative actions as one of the methods a minority shareholder can employ to protect the legal interests of the company and, in so doing, protect his own rights. Firstly, I will briefly discuss the common law principles relating to the separate legal personality of the company, the impact thereof on actions to be taken by the company, and when this may possibly be circumvented, ie through a derivative action. I will then briefly discuss derivative actions in the new dispensation.
The common law derivative action
To understand the South African derivative action in section 165 of the Companies Act, it is best to briefly explore how common law functioned.
First, we must examine the rule laid down in the English case of Foss v Harbottle. The rule is that the company, as a separate legal entity that bears its own rights and obligations, must choose to litigate or take action against an alleged wrong, and it is the directors who make this choice on behalf of the company.
The rule in Foss v Harbottle entails and exists alongside the principle of majority rule. This principle entails that the decisions of the majority shareholders are binding on the minority shareholders. Courts will not intervene in the internal affairs of the company when the majority acts lawfully.
In Sammel v President Brand Gold Mining Co Ltd 1969 (3) SA 629 (A) at 678, the following was stated: “[B]y becoming a shareholder in a company a person undertakes… to be bound by the decisions of the prescribed majority of the shareholders if those decisions on the affairs of the company are arrived at in accordance with the law, even where they adversely affect his own rights as a shareholder.” If a shareholder’s personal rights are affected then he should seek redress using the personal actions available to him.
Simply put, the rule of Foss v Harbottle is that the company is the proper plaintiff to institute legal action in its own name, and the decisions of the majority shareholders, when lawful, are enforceable on the minority shareholders.
This is where it gets tricky. The directors are the driving force of the company and they have to make the decision on behalf of the company to institute legal proceedings to redress the wrong that was committed against the company. What if the directors committed the wrong, eg misappropriating company assets, and they have to make the decision to take legal action to redress that wrong? More specifically: why would directors choose to take legal action against themselves? In all probability, they won’t. This is why the derivative action doctrine exists, ie to protect the company from directors who act mala fide.
The derivative action is an exception to the rule in Foss v Harbottle. A minority shareholder may bring an action on behalf of and in the name of the company to protect the company’s legal interests. In terms of common law, certain criteria had to be met before such an application to court could be brought. This is not relevant to the current discussion. Also, section 266 of the Companies Act of 1973 partially codified common law, which was repealed by the new Companies Act.
The derivative action in section 165 of the Companies Act
Section 165 of the Companies Act has abolished the common law doctrine pertaining to derivative actions. It is now purely statutory and new jurisprudence needs to be developed for the proper functioning of the doctrine. A few cases have already been reported in the new section. It is clear from the reading of those cases that case law on the old section 266 and common law will continue to influence the new statutory derivative action and will aid in its interpretation.
Section 165 has various subsections that deal with the derivative action. Section 165 starts off by abolishing common law and thereafter deals with the procedure and other substantive matters. I will focus on subsections 3 through 5. This is the heart of the new derivative action. The rest of section 165 deals with other procedural matters that are not relevant to the present discussion.
The demand – section 165(2)
To commence with a derivative action a minority shareholder/s or other stakeholder/s needs to serve a demand on a company to protect the legal interests of the company or to continue legal proceedings. The person who may serve the demand and thereby commence derivative action proceedings is a shareholder, or a person entitled to be a shareholder of the company or related company; a director or prescribed officer of the company or related company; a registered trade union that represents the employees of the company or another representative of employees of the company; and a person who has been granted leave from the court to serve a demand on the company.
Thus, it extends further than just minority shareholders as provided for in common law. Secondly, a derivative action may be brought in respect of any wrong that is committed against the company and not only in relation to those committed by the directors or controllers of the company. Thus, it may be brought when outsiders and other internal persons committed the wrong and the directors choose not to protect the company’s legal interests.
The serving of the demand informs the board of directors of a certain wrong that was committed and gives the directors a chance to act on it. The person who wants to protect the company should not be allowed to institute action directly without the prior knowledge of the directors. The demand thus serves as a safeguard against a floodgate of litigation.
Section 165(2) does not make provision for a process of how the demand must be served, only that it must be served on the company. In Mouritzen v Greystone Enterprises (Pty) Ltd and Another, the court had to determine what constitutes “proper service”. Ndlovu J said that it is an essential prerequisite that a demand be served on a company before a person can proceed in terms of section 165(5) of the Act. It is thus a peremptory provision.
Furthermore, because the act does not provide for a specific process of how service must be effected, Ndlovu J held that “any legally recognizable manner of service of any court process or document initiating proceedings shall be adequate, provided that the court considering the matter, in the exercise of its discretion, is satisfied that the demand was duly served on the company for which it was intended”.
Frivolous, vexatious, and demands without merit – section 165(3)
Subsection 3 provides that when a demand is served on the company, the company has 15 business days to apply to the court to have the demand set aside on the basis that the demand is frivolous, vexatious, or without merit.
The High Court in Amdocs SA Joint Enterprise (Pty) Ltd v Kwezi Technologies (Pty) Ltd held that the phrase “frivolous, vexatious, or without merit” should be interpreted in its ordinary meaning. More particularly, “without merit” means that the demand is so bad in law or so at odds with the facts that it could not succeed. A shareholder should not initiate derivate action to protect some personal right, or where he has some other motive other than protecting the legal interests of the company.
Company’s obligations in terms of section 165(4)
The company has certain statutory obligations it needs to fulfill when it does not challenge the demand or when the court does not set aside the demand.
The company has to appoint an independent and impartial person or committee to investigate the demand. The impartial person or committee must investigate the facts and circumstances surrounding the complaint in the demand, the probable costs, and the best interests of the company.
The company must within 60 days of being served with the demand initiate or continue legal proceedings or take steps to protect the legal interests of the company, as contemplated in the demand or serve a notice on the person who made the demand, refusing to comply with it.
Leave by the court to institute or continue legal proceedings in the name and on behalf of the company – section 165(5)
The court exercises its discretion to grant the person who served the demand to institute or continue legal proceedings in an attempt to curb vexatious or frivolous actions. This is the “screening” provision. If the person acts mala fide, or cannot show that the question is of a material consequence to the company, or it is not in the best interest of the company to institute legal proceedings, a court will not grant leave. These three principles will be dealt with below. All three of these requirements must be present before leave will be granted.
Furthermore, leave to institute or continue legal proceedings in the name and on behalf of the company by the person who served the demand will only be granted if the company itself has failed to carry out certain obligations in terms of section 165(5)(a).
The court will not grant leave if the company has complied with the demand. It will be illogical to allow the applicant to be granted leave to proceed with legal action on behalf of the company where the company itself can do so. This is in line with the rule in Foss v Harbottle. There is scope for abuse in this scenario and courts may be asked to intervene by the person who initially served the demand, thus a person may “continue” legal proceedings. In this regard, the directors may institute legal action for the wrong that was committed against the company without any intention to seriously pursue it. The applicant may bring an application to the court to intervene in such proceedings and the applicant may be granted leave to continue with the legal proceedings.
The good faith principle – section 165(5)(b)(i)
In the Mouritzen-case the court had to determine whether to grant leave to institute legal proceedings in terms of section 165(5). Before the court could grant leave the applicant had to prove that he was acting in good faith. The court held that the good faith requirement meant that the applicant has a good conscience for instituting derivative action and has a sincere belief in the existence of reasonable prospects of success in the proposed litigation. The person should thus not have an ulterior motive or collateral purpose, eg as a result of a pre-existing personal animosity towards the co-director. It must be established that the animosity is not the cause for bringing the application to the court. In the Mouritzen-case, there was animosity between the two directors and this was proof of bad faith.
The court relied on the Australian case of Swansson v Pratt in which that court laid down two interrelated factors for the determination of bad faith. Firstly, does the applicant honestly believe that a good cause of action exists and has a reasonable prospect of success? In this regard, the test may be whether a reasonable person would hold such a belief. Secondly, is the applicant bringing the application with such a collateral purpose as would amount to an abuse of the process?
Establishing good faith as an applicant is very important in the bringing of the application. A person is instituting derivative action to protect the legal interests of the company and not his own. The person should not have anything to gain from the action except that his rights as a minority shareholder are protected. The focus must be to protect the company’s legal interests.
However, one will still be able to show good faith in bringing a genuine cause of action even if there is some collateral purpose or ulterior motive on the part of the shareholder. This is presumed from the Mouritzen-case in which the court held that personal animosity per se is not conclusive proof of lack of good faith towards a respondent in section 165(5) application. It must be considered whether any other collateral purpose will result in a lack of good faith.
Trial of a serious question of material consequence to the company – section 165(5)(b)(ii)
No case law exists yet in this section and thus its interpretation will be left to the courts. We may delve into cases that have dealt with this principle, albeit not on derivative actions. It suffices to say that the claim must have merits and that it is an actual or genuine claim not brought before a court vexatiously, frivolously, or without merit. The traditional approach is that the applicant must show a prima facie right.
Best interests of the company – section 165(5)(b)(iii)
This requirement will overlap with the principle of good faith. If the shareholder is not bringing the application in good faith then it cannot be in the best interests of the company that the matter proceeds.
The court in Mouritzen referred to a quote in the Swansson-case that equally applies to section 165(5)(b)(iii): “At the outset, it is important to note that s 237(2)(c) requires the court to be satisfied, not that the proposed derivative action may be, appears to be, or is likely to be, in the best interests of the company but, that it is in the best interests.”
When a shareholder brings an application, not in good faith, eg personal animosity as was the case in the Mouritzen-case, then it will generally not be in the best interests of the company.
Derivative action is brought by a person listed in section 165(2) who serves a demand on the company. When the company serves a notice that it will not comply with the demand, refuses to comply with the demand, or where a company has not carried out certain obligations in terms of sections 165(4) and (5)(a), then the person so listed in subsection (2) may apply to the court for leave to initiate legal proceedings on behalf of the company.
A court will have to be convinced that the requirements in section 165(5) have been met before it will grant leave.
There are thus five requirements to be met before a court will grant leave:
- The service of the demand.
- Service of a notice refusing to comply with the demand by the company, or failure to comply properly or at all.
- Good faith.
- Establishment of a serious question of material consequence to the company.
- The best interests of the company.
Note that the last three requirements are listed in section 165(5)(b). This is indicative of the important role the court is entrusted with by serving as gatekeeper to frivolous and vexatious litigation. Furthermore, this reiterates the key concept in the new dispensation of derivative actions that minority shareholders or other stakeholders must at all times demonstrate that their claims have merits.
The text published here is a summary of the law of derivative actions and should by no means be construed as a comprehensive discussion of the issues raised herein and should also not be regarded as legal advice on the subject.