[Roopam Dadhich and Sankalp Jain are fourth year student at NALSAR University of Law, Hyderabad]
Derivative Injury Suits [Derivative Suits] can be said to be the corollaries to ‘penetration of the corporate veil’ by Courts. Derivative suits are filed by the shareholders on behalf of all shareholders in common in response to any injury suffered by the Company. In such cases, whatever remedy that the Court awards would be with respect to the Company, and the legal costs are also borne by it. With the codification of directors’ duties in the Companies Act, 2013, shareholders have clearer grounds to approach courts, however, the determination of whether the suit is a derivative suit still relies on Common Law principles. In direct suits shareholders have to bear the costs of litigation, though may be reimbursed later (according to the loser pays principle).
Even though Derivative Suits are very rare in India, the authors believe that it needs further analysis due to the social function that they can play. This post reviews the jurisprudence of Derivative suits and supplies further reasons to include statutory provisions for the same in the Indian law.
Analyzing Derivative Suits in India
Derivative suits in India are still couched in Common law principles, though many jurisdictions have codified the same in their Company regulation statutes. It is curious to note that despite many jurisdictions like the UK, Singapore and Hong Kong having amended their company law statutes to include derivative suits, in India, the deliberations done on the Companies Act, 2013 are silent on the issue. In Derivative Suits, the plaintiff is supposed to demonstrate a prima facie case showing that, firstly, the action is likely to succeed had the Company initiated the action, and secondly, the case falls within the exception to the case of Foss v. Harbottle. The researchers shall deal with the latter requirement first.
The Exception in Foss v. Harbottle
The case of Foss v. Harbottle is a decision by the Chancery Court in the UK, which had barred a suit by the minority shareholders of the company as it held that only a company could sue for harm done to it, however, there was an important exception carved out of this rule by later court decisions. Lord Wigram’s observations gave rise to the ‘majority rule’ and his observations can be summarized as, “since an incorporated company was the ‘proper plaintiff’ in any action concerning its rights or its constitution, it would only be very exceptionally in the case of grave abuse that a minority might be allowed to sue in their own name by joining the company as defendant.” Lord Wigram’s observations provide the crux of the matter and mark an important point in the jurisprudence on Derivative Suits. The exception was developed in the case of MacDougall v. Gardiner, where Lord Mellish held that if the acts constituting the alleged wrongs were ratified by the shareholders, then the minority did not have any grounds to sue. Lord Mellish further held that these rules have been developed to reduce unnecessary litigation.
This exception was finally transplanted in India which saw its application in S.K. Ghandy v. L.P.E. Pugh before the Calcutta High Court in 1923. The Court in the aforementioned case upheld the principle laid down by Foss v. Harbottle, however, it also observed that, “where the persons against whom the relief is sought themselves hold and control the majority of the shares in the company, and will not permit an action to be brought in the name of the company…the Courts allow the share-holders complaining to bring an action in their own names.” This observation, however, does not deal with Derivative Suits and hints towards direct suits (or representative suits).
In Rajahmundry Electric Supply Corp. Ltd. v. Nageshwara Rao, the Supreme Court was dealing with an appeal arising from a case of misappropriation of funds by the directors of the company. Here the Court reiterated that courts generally do not interfere with the functioning of the company unless the directors are not acting in accordance with the articles of association of the company. However, the Supreme Court, in later cases has admitted the possibility of adjudicating a Derivative Suit under three conditions, i.e.,
(1) where an ultra vires or illegal transaction takes place;
(2) in cases of matters which require a special resolution; and
(3) in cases of fraud committed on the minority itself.
Likelihood of Success had the Company Sued and Other Requirements
The burden of proving that the suit would succeed had the company taken action, lies on the shareholders pursuing the Derivative Suit. Proving ‘likelihood’ would necessarily depend upon satisfaction the abovementioned conditions laid down by the Court. Further, the shareholder must prove that they adequately represent the interests of other shareholders and the company as a whole. This issue of similar ‘interest’ was adjudicated in the case of 63 Moons Technologies v. Union of India before the Bombay High Court. The principle followed by Courts is that the injury to the company must be direct and not merely reflective. In the aforementioned case, a loss-making subsidiary company was amalgamated with its profit-making parent company by the State, exercising its powers under Article 31 of the Constitution of India. The shareholders of the parent company filed a suit against this measure taken by the State as the act had affected their interest in the parent company. To put it in simpler terms, the shareholders had suffered a reduction in the value of their shares due to the absorption of the liabilities of the subsidiary company by the parent company. The Court discussed the ‘sameness’ of interests between the Company and its shareholders but ultimately held that while shareholders have a legal interest in the company, they do not have an economic interest vested in them. Therefore, any injury sustained by the company would only constitute reflective losses and not actual injury to the shareholders. In essence, the court reiterated the principle that it is the company that holds the assets of the company and not the shareholders.
Derivative Suits in India
While the Companies Act, 2013 does provide, under Chapter XVI, sections for the prevention of Oppression and Mismanagement, it does not specifically provide for Derivative Suits. Rather, it provides for a remedy which closely resembles a direct suit. The cost element associated with Derivative Suits can play a public function among the diversity of shareholders in India. Aggregation and mobilizing shareholders constitute a time consuming and costly legal process, in such a case, laws providing for a statutory derivative action would bolster accountability of the managers towards the shareholders. An increase in managerial accountability would increase liquidity in the market due to better investor sentiment.
Indian conditions appear to be the ideal one for Derivative suits as there happens to be a transition to more dispersed shareholders with existing institutional structures already slow and inefficient. The base of retail investor has expanded due to a string of recent public offers of securities by companies in India and the requirement to have at least 25% public shareholding for a listed company, thus dispersing the shareholder base. Thus, the utility of Derivative suits cannot be dismissed. Yet, Indian laws give an implicit preference to other methods of corporate remedy mechanisms like direct suits and approaching other dispute resolution forums. These forums include the Company Law Board and the SEBI (for listed companies). The reform measures that SEBI has taken are only effective insofar as listed companies are involved.
Unlike India, Derivative suits have been incorporated in the Company law statutes in jurisdictions like Singapore, Hong Kong and the UK. Incorporating Derivative Suit provisions in India would also necessitate lowering the threshold for locus standi, as has been the case in Hong Kong’s statutory provision for Derivative Action – here, the test of establishing a prima facie case has been replaced with “that there is a serious question to be tried and the specified corporation has not itself brought the proceedings”.
Further, there needs to be procedural clarity on Derivative Suits, especially in the face of Order 1 Rule 8 of the CPC which, by its nature, talks about representative suit or a direct suit often mistaken as Derivative Suit. For instance, under a representative suit, the claimant is representing the rights of other similarly placed shareholders and the relief provided reaches directly to them, not the company, whereas, under a derivative suit, company is the only affected party and not a particular shareholder.
Derivative suits provide a unique corporate remedy which would be immensely useful, given the manner in which shareholders would be dispersed thus, increasing costs should they sue as a Direct action. After the codification of Director’s Duties through the Companies Act, 2013, several questions remain as to the omission of provisions for statutory derivative suits which appear in the Company Law statues in other Common law jurisdictions like the UK, Hong Kong and Singapore. Derivative suits would soon become a popular remedy and in such a case its statutory insertion would become necessary and though Common Law principles should also be affirmed while adding the aforementioned.