Corporate governance and compliance - Minority shareholder protection

Learning Outcomes

This article outlines the main legal protections available to minority shareholders in UK companies. It covers the principles established by the rule in Foss v Harbottle and the statutory exceptions under the Companies Act 2006, specifically the derivative claim and the unfair prejudice petition. Additionally, it touches upon the remedy of winding up on just and equitable grounds under the Insolvency Act 1986. Your understanding of these mechanisms will enable you to identify and apply the relevant legal rules and principles to SQE1-style single best answer MCQs.

SQE1 Syllabus

For SQE1, you are required to understand the mechanisms protecting minority shareholders from a practical standpoint. It is likely that you will need to identify the appropriate remedy in given circumstances and understand the procedural requirements and potential outcomes of these actions.

An appreciation of minority shareholder rights and remedies is essential for advising on corporate governance and potential disputes within a company.

As you work through this article, remember to pay particular attention in your revision to:

  • the rule in Foss v Harbottle and its implications for shareholder litigation
  • the statutory derivative claim under Part 11 of the Companies Act 2006, including the grounds and permission process
  • the unfair prejudice petition under s 994 of the Companies Act 2006, including the meaning of ‘unfairly prejudicial’ and available remedies
  • the petition to wind up a company on just and equitable grounds under s 122(1)(g) of the Insolvency Act 1986
  • the distinction between personal actions and actions brought on behalf of the company (including the no reflective loss principle).

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

  1. What is the general rule established in Foss v Harbottle regarding who can sue for a wrong done to the company?
    1. Any shareholder
    2. Only a majority shareholder
    3. The company itself
    4. Any director
  2. Under which section of the Companies Act 2006 can a shareholder bring an unfair prejudice petition?
    1. s 172
    2. s 260
    3. s 994
    4. s 122
  3. Which of the following is NOT a ground for bringing a statutory derivative claim under Part 11 of the Companies Act 2006?
    1. Negligence by a director
    2. Breach of duty by a director
    3. A breach of contract by a third party with the company
    4. Breach of trust by a director

Introduction

In company law, the principle of majority rule generally dictates that the wishes of the shareholders holding the majority of voting rights prevail. While this facilitates efficient decision-making, it can potentially leave minority shareholders vulnerable to oppressive or unfair actions by the majority or by the directors they control. UK law provides several mechanisms to protect the interests of these minority shareholders, ensuring a degree of fairness and accountability within the corporate structure. These remedies primarily stem from the Companies Act 2006 and the Insolvency Act 1986, offering avenues for redress when the company's affairs are conducted improperly or when the company itself fails to act against wrongdoing directors.

The Rule in Foss v Harbottle

The starting point for understanding shareholder remedies is the common law principle established in Foss v Harbottle (1843) 2 Hare 461. This case established two key rules:

  1. The Proper Claimant Rule: If a wrong is done to the company, the company itself is the proper claimant to bring legal action, not individual shareholders. This reflects the company's separate legal personality.
  2. The Internal Management Rule: Courts are generally reluctant to interfere in the internal management of a company where the company is acting within its powers. If an irregularity occurs that the majority of shareholders can ratify or approve, an individual shareholder cannot sue in respect of it.

These rules mean that, generally, a shareholder cannot sue for a loss suffered by the company (e.g., loss caused by a director's negligence) because the company is the proper entity to seek redress. Similarly, a shareholder cannot typically sue if the majority has approved, or could approve, the action complained of.

Key Term: Proper Claimant Rule
The principle derived from Foss v Harbottle stating that where a wrong is done to a company, the company itself is the correct entity to initiate legal proceedings.

Key Term: Internal Management Rule
The principle that courts will generally not intervene in the internal affairs of a company if the company is acting within its legal powers and the matter could be ratified by a simple majority of shareholders.

While the rule in Foss v Harbottle protects against a flood of litigation by individual shareholders over internal management issues, it created difficulties where the wrongdoers were the very people in control of the company (e.g., the directors or majority shareholders), as they would be unlikely to authorise the company to sue themselves. To address this, common law developed exceptions, which have now been largely replaced and codified by statute.

The Statutory Derivative Claim

Part 11 of the Companies Act 2006 (CA 2006) (ss 260-269) provides a statutory procedure for a member of a company to bring a claim on behalf of the company. This is known as a derivative claim because the member's right to sue is derived from the company's right.

Key Term: Derivative Claim
A legal action brought by a member of a company on behalf of the company in respect of a cause of action vested in the company, typically arising from a director's wrongdoing.

Grounds for a Derivative Claim

A derivative claim may be brought only in respect of a cause of action arising from an actual or proposed act or omission involving negligence, default, breach of duty, or breach of trust by a director of the company (s 260(3) CA 2006). This includes breaches of the general duties owed by directors under ss 171-177 CA 2006 (see separate article on Directors' Duties). The claim can be brought against the director or another person (or both).

The Permission Requirement

A member wishing to bring a derivative claim must apply to the court for permission to continue the claim (s 261 CA 2006). This involves a two-stage process:

  1. Prima Facie Case: The applicant must first show the court that they have a prima facie case (i.e., a case that appears valid on first impression) for being given permission. If they cannot, the application is dismissed (s 261(2)).
  2. Full Permission Hearing: If a prima facie case is established, the court proceeds to a full hearing. The court must refuse permission if it is satisfied that:
    • A person acting in accordance with the s 172 duty (to further the success of the company) would not seek to continue the claim (s 263(2)(a)); or
    • The relevant act or omission has been authorised by the company before it occurred or ratified since it occurred (s 263(2)(b)&(c)). Ratification requires an ordinary resolution passed without the votes of the director concerned or connected persons (s 239).

If permission is not refused on these mandatory grounds, the court then exercises its discretion, considering factors listed in s 263(3), including:

  • Whether the member is acting in good faith.
  • The importance a director acting under s 172 would attach to continuing the claim.
  • The likelihood of authorisation or ratification.
  • Whether the company has decided not to pursue the claim.
  • Whether the member could pursue the action in their own right (e.g., an unfair prejudice claim).

The court also has particular regard to the views of members who have no personal interest in the matter (s 263(4)).

Worked Example 1.1

Anya is a minority shareholder (10%) in TechStart Ltd. She discovers that Ben, the managing director and majority shareholder (60%), has diverted a lucrative contract opportunity intended for TechStart Ltd to another company wholly owned by Ben. TechStart Ltd's board (controlled by Ben) refuses to take action against him. Can Anya bring a derivative claim?

Answer: Yes, Anya may be able to bring a derivative claim on behalf of TechStart Ltd under Part 11 CA 2006. Ben's actions likely constitute a breach of his director's duties (e.g., s 175 - duty to avoid conflicts of interest). Anya would need to apply to the court for permission to continue the claim. She would need to establish a prima facie case. The court would then consider the factors in s 263. Given Ben's control, it's unlikely the company would ratify the breach, and a director acting under s 172 would likely pursue the claim to recover the lost opportunity for the company. Permission might therefore be granted.

Revision Tip

Remember that a derivative claim is brought on behalf of the company. Any remedy awarded (e.g., damages) goes to the company, not the shareholder bringing the claim. This differs from personal actions like the unfair prejudice petition.

Unfair Prejudice Petition

Section 994 CA 2006 provides a significant remedy for members (including minority shareholders) who feel the company's affairs are being conducted in a manner that is unfairly prejudicial to their interests as members, or to the interests of some part of the members.

Key Term: Unfair Prejudice
Conduct relating to a company's affairs that is both unfair and prejudicial (harmful) to the interests of a member or a group of members in their capacity as members.

Scope of "Unfairly Prejudicial" Conduct

The term "unfairly prejudicial" is interpreted broadly by the courts. It requires more than just disagreement with management decisions; the conduct must be genuinely unfair as well as causing prejudice (harm). Examples include:

  • Exclusion from management in quasi-partnerships where there was a legitimate expectation of participation (Ebrahimi v Westbourne Galleries Ltd [1973] AC 360).
  • Diversion of business opportunities or assets by directors/majority shareholders.
  • Non-payment or inadequate payment of dividends, especially where directors award themselves excessive remuneration.
  • Serious mismanagement or breaches of directors' duties.
  • Breaches of the company's articles or shareholders' agreements that affect members' interests.

The test is objective: would a reasonable bystander consider the conduct unfair? (Re Tobian Properties Ltd [2012] EWCA Civ 998). Conduct permitted by the articles can still be deemed unfair if it breaches equitable considerations or understandings between the parties, particularly in smaller, "quasi-partnership" companies (O'Neill v Phillips [1999] UKHL 24).

Key Term: Quasi-Partnership
A small, private company where the relationship between the members is based on mutual trust and confidence, similar to a partnership, often with an understanding that all members will participate in management.

Worked Example 1.2

Chen holds 20% of the shares in FamilyDine Ltd, a small restaurant business run by the majority shareholders, David (40%) and Eva (40%), who are siblings. Chen invested on the understanding he would be involved in key financial decisions. David and Eva consistently exclude Chen from board meetings where financial strategy is discussed and have started paying themselves significantly increased salaries while refusing to declare dividends, despite healthy profits. Does Chen have grounds for an unfair prejudice petition?

Answer: Yes, Chen likely has grounds. The exclusion from management relating to financial decisions, contrary to the initial understanding, could constitute unfair prejudice, especially if FamilyDine Ltd resembles a quasi-partnership. The payment of excessive salaries to David and Eva while withholding dividends, despite profits, could also be seen as unfairly prejudicial to Chen's interests as a member entitled to a return on his investment.

Remedies for Unfair Prejudice

If the court finds that the conduct is unfairly prejudicial, it has broad discretion under s 996 CA 2006 to "make such order as it thinks fit". The most common order is a share purchase order, requiring the majority shareholders (or sometimes the company itself) to buy the petitioner's shares at a fair value, often determined by the court without a minority discount. Other possible remedies include:

  • Regulating the future conduct of the company's affairs.
  • Requiring the company to do or refrain from doing a specific act.
  • Authorising civil proceedings to be brought in the name of the company (effectively initiating a derivative claim).
  • Providing that the company shall not make alterations to its articles without leave of the court.

Winding Up on Just and Equitable Grounds

A member can petition the court to wind up the company under s 122(1)(g) of the Insolvency Act 1986 (IA 1986) if it is "just and equitable" to do so. This is a drastic remedy of last resort, as it leads to the dissolution ("death") of the company.

Grounds where winding up might be considered just and equitable include:

  • Complete deadlock in management.
  • Loss of the company's "substratum" (its main original purpose).
  • Exclusion from management in a quasi-partnership (Ebrahimi v Westbourne Galleries Ltd).
  • Justifiable lack of confidence in the management, perhaps due to lack of probity or serious misconduct.

The court will not usually make a winding-up order if another remedy (like an unfair prejudice petition leading to a buy-out) is available and the petitioner is acting unreasonably in seeking winding up instead (s 125(2) IA 1986).

The No Reflective Loss Principle

Shareholders generally cannot sue for a loss that merely reflects the loss suffered by the company itself, for which the company has its own cause of action against the wrongdoer (Prudential Assurance Co Ltd v Newman Industries Ltd (No 2) [1982] Ch 204). For example, a shareholder cannot sue a director whose negligence caused the company loss, resulting in a fall in the company's share value or reduced dividends. The fall in share value or dividends simply reflects the company's loss. The company is the proper claimant. The Supreme Court in Sevilleja Garcia v Marex Financial Ltd [2020] UKSC 31 confirmed this rule applies specifically to shareholders claiming for diminution in share value or distributions resulting from actionable loss suffered by the company.

Exam Warning

Be careful to distinguish between personal claims (like unfair prejudice under s 994) where the shareholder sues for harm to their own interests, and derivative claims (under Part 11 CA 2006) where the shareholder sues on behalf of the company for a wrong done to the company. The no reflective loss principle primarily bars personal claims that duplicate the company's claim.

Contractual Protections

Minority shareholders can also seek protection through contractual means, primarily via:

  • Shareholders' Agreements: Private contracts between some or all shareholders setting out agreements on management, voting, share transfers, etc. These can provide rights beyond the articles but only bind the signatories.
  • Articles of Association: Specific provisions can be included in the articles to protect minorities, such as weighted voting rights on certain resolutions (Bushell v Faith [1970] AC 1099), rights of pre-emption on share transfers, or requiring higher quorum/majority levels for certain decisions.

Key Point Checklist

This article has covered the following key knowledge points:

  • The rule in Foss v Harbottle generally prevents shareholders suing for wrongs done to the company; the company is the proper claimant.
  • The statutory derivative claim (Part 11 CA 2006) allows members to sue on behalf of the company for director wrongdoing (negligence, default, breach of duty/trust), subject to obtaining court permission.
  • The unfair prejudice petition (s 994 CA 2006) allows members to seek remedies if the company's affairs are conducted in a manner unfairly prejudicial to their interests. The most common remedy is a share purchase order.
  • Winding up on just and equitable grounds (s 122(1)(g) IA 1986) is a drastic remedy available in situations like deadlock or exclusion from management in quasi-partnerships.
  • The no reflective loss principle prevents shareholders bringing personal claims for losses that merely reflect the company's loss.
  • Contractual protections (shareholders' agreements, specific article provisions) can provide additional safeguards for minority shareholders.

Key Terms and Concepts

  • Proper Claimant Rule
  • Internal Management Rule
  • Derivative Claim
  • Unfair Prejudice
  • Quasi-Partnership
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