7 December 2010

Derivative action in South Africa

Section 165 of The Companies Act, 71 Of 2008 Revokes The Common Law Derivative Action

The derivative action relates to wrongs done to the Company, typically by its directors or shareholders. If the Company cannot or will not act against those who wronged it, a derivative action on behalf of the Company may be instituted in certain circumstances. Such an action will have to be instituted against the wrongdoers by somebody acting on behalf of himself and all the shareholders, other than the wrongdoers. The Company, being unable to act as Plaintiff, must be joined as nominal defendant so that it is a party to the proceedings and any order of the Court can be made applicable to it.

It is generally accepted that the derivative action may be instituted if an unratifiable wrong has been done to the Company and the Company cannot or will not institute the action because the wrongdoers control the Company.

Unratifiable wrongs may be classified as acts in breach of the rights of the Company and unlawful conduct and conduct in breach of the common law of the type which is not rectifiable by ordinary resolution and amounts to a wrong to the Company. For example, conduct in contravention of Section 38 of the Companies Act, 61 of 1973 (the old Act) or theft of company funds. Fraud on the minority also constitutes an unratifiable wrong. Examples of "fraud on the minority" are where the majority manipulates matters in such a way that corporate assets end up in their hands or the hands of a company in which they have an interest.

The problem, however, is hard to determine which of these types of wrongs are unratifiable. It has been suggested that the wrong is unratifiable if the wrongdoer in his capacity as director acted mala fide towards his company or if the resolution to ratify results in the wrongdoer receiving a benefit at the expense of the Company, in the sense that the Company is prejudiced so as to place assets in the hands of the wrongdoer.

In the common law, protection was seldom available to the protection of minority rights. This was underscored by decisions of the Court, which held that an incorporated company must be treated like any other independent person. In Foss v Harbottle 67 ER 189 203-4, the Court held that the majority of the members in a Company have the power to bind the minority and that the Courts refused to interfere in the running of the Company while the majority is acting lawfully.

The second principle based on the rules mentioned in Foss v Harbottle is the 'proper Plaintiff rule', which provides that the Company is the proper Plaintiff that has to institute legal action where a wrong has been committed against the Company. As a general rule the members cannot institute proceedings to recover damages on behalf of a Company of which they are members.

The problem arises where the directors and the general meeting of members, who are in control of the Company, have been approached to institute action and have turned down the request.

In other words, where the wrongdoers are the persons in control of the Company, it is unlikely that they will approve a decision to institute legal action against themselves to recover the damages that the Company has suffered if they are party to an unratifiable wrong.

To overcome the common law difficulties presented by the rules in Foss v Harbottle Section 266 of the old Act was enacted to provide for a statutory derivatative action. Section 165 of the Companies Act 71 of 2008 (the new Act) also provides for a statutory derivative action.

It is important to bear in mind that the distinction between the derivative action and a personal action is that any damages awarded in a successful personal action will accrue to the shareholder personally while any damages awarded in the derivative action will accrue to the Company.

In terms of Section 266 a member of a Company may institute an action on behalf of a Company where the Company has suffered damages as a result of any wrong, breach of trust or breach of faith committed by any director. The remedy provided for in Section 266 only relates to wrongs as a result of which the Company has suffered damages and wrongs to members or minority shareholders are not included in this section. In terms of Section 266 a derivative action is only available if the damages or wrong suffered by the Company had been caused by a director or officer of that Company while such a person was a director or officer of that particular company and the Company had failed to institute an action to recover such damage. Section 266 differed from the common law action in that the latter was not limited to incidences of wrongful conduct, breaches of trust and faith. Unlike the common law the statutory action can also be instituted where the Company ratified or condoned the wrong or breach of faith or trust.

Section 165 of the new Act revokes the common law derivative action of a person other than the Company to bring legal proceedings on behalf of the Company and replaces the common law with the statutory provisions contained in Section 165.

Section 165 provides that the action may be used to protect the legal interests of the Company. The section does not specify the causes of action for which the derivative action can be used, but provides a wide description that allows use of the action to protect a wide range of legal interests. Section 266 was limited to instances of delict, breach of trust or breach of faith by a director or officer of the Company, whilst the provisions of Section 165 does not specify the causes of action and therefore Section 165 is considered to be much wider.

Section 165 extends the [right to sue] to a shareholder or person entitled to be registered as a shareholder of a company, a director or prescribed officer, a representative trade union of the employees of the Company or any other representative of employees of the Company and a person who has been granted leave by a Court to initiate proceedings.

Notwithstanding that Section 165 abolishes any common law right of a person other than a Company to bring or prosecute any legal proceedings on behalf of that Company, Section 165 does not specify the causes of action for which the derivative action can be used to protect legal interests of the company and, instead, provides a wide description that allows use of the derivative action to protect legal interests of the company.

While Section 266 of the Companies Act did not revoke the common law and both the common law and statutory derivative actions were available to aggrieved shareholders, the statutory derivative action provided for by Section 165 of the new Act extends the right of a derivative action to a broader category of persons.

It will be interesting to see if the extension of the rights to sue will be used by those categories of persons to whom the rights have been extended, for example, a representative trade union of the employees of the company and how the Courts will balance the interests of the shareholders against the interests of the company.

Tim Mills, Director, Employment

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