Corporate governance and compliance - Unfair prejudice claims and derivative actions

Learning Outcomes

After studying this article, you will be able to:

• Explain the purpose and operation of unfair prejudice claims and derivative actions under the Companies Act 2006.
• Distinguish between personal and corporate remedies for shareholder grievances.
• Identify the procedural requirements and limitations for each remedy.
• Apply relevant legal principles and case law to SQE1-style problem questions involving minority shareholder protection.

SQE1 Syllabus

For SQE1, you are required to understand the legal remedies available to shareholders where company affairs are conducted in a manner that is unfair or where directors commit wrongs against the company. Focus your revision on:

• The statutory basis and requirements for unfair prejudice claims (Companies Act 2006, s. 994)
• The statutory basis and requirements for derivative actions (Companies Act 2006, ss. 260–264)
• The distinction between personal and corporate remedies for shareholder grievances
• The procedural steps and limitations for bringing each type of claim
• The principle of reflective loss and its impact on shareholder claims
• The range of remedies available to the court under each procedure
• Key case law interpreting the statutory provisions

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 are the main differences between an unfair prejudice claim and a derivative action?
2. Under what circumstances can a shareholder bring a derivative claim on behalf of the company?
3. What is the principle of reflective loss, and how does it affect shareholder remedies?
4. What remedies can the court order if unfair prejudice is established?

Introduction

Shareholders who are dissatisfied with the way a company is run or who believe that directors have acted improperly may have legal remedies under the Companies Act 2006. Two key mechanisms are the unfair prejudice claim and the derivative action. These procedures are designed to protect minority shareholders and ensure proper corporate governance when internal company democracy fails or directors breach their duties.

Unfair Prejudice Claims

Statutory Basis and Purpose

Section 994 of the Companies Act 2006 allows a shareholder to petition the court if the company's affairs are being conducted in a manner that is unfairly prejudicial to the interests of members generally or some part of its members.

Key Term: unfair prejudice claim
A statutory remedy allowing a shareholder to seek relief from the court where company affairs are conducted in a way that is unfairly prejudicial to their interests.

What Constitutes Unfair Prejudice?

Unfair prejudice is interpreted broadly. Common examples include:

• Exclusion from management in a quasi-partnership company
• Diversion of company business or assets for personal benefit
• Withholding dividends without justification
• Excessive director remuneration
• Breaches of the articles or shareholders' agreements
• Persistent breaches of directors' duties

The conduct must be both prejudicial (causing harm) and unfair (contrary to equitable considerations or legitimate expectations).

Key Term: quasi-partnership
A company operated on the basis of personal relationships and mutual trust, where members expect to participate in management, similar to a partnership.

Procedure and Standing

Any member (including those to whom shares have been transferred by operation of law) may bring a claim. There is no requirement to show that the company is insolvent or that the petitioner has "clean hands." The claim is personal to the shareholder.

Court Powers and Remedies

If the court finds unfair prejudice, it has wide discretion to grant relief. The most common remedy is an order requiring the majority shareholders or the company to purchase the petitioner's shares at a fair value. Other possible orders include regulating the conduct of the company's affairs, requiring the company to refrain from certain acts, or altering the articles.

Key Case Law

• O'Neill v Phillips [1999] 1 WLR 1092: Unfairness is assessed by reference to the parties' legal rights and any equitable considerations arising from their relationship or understandings.
• Re London School of Electronics [1986] Ch 211: Conduct may be unfair even if it does not breach the articles, especially in quasi-partnership companies.

Worked Example 1.1

Scenario:
A minority shareholder in a small family company is excluded from management and denied dividends, while the majority shareholders pay themselves high salaries.

Answer:
The minority shareholder may bring an unfair prejudice claim under s. 994. The exclusion from management (in a quasi-partnership context) and the withholding of dividends may be both prejudicial and unfair, especially if contrary to prior understandings.

Derivative Actions

Statutory Basis and Purpose for Derivative Actions

Sections 260–264 of the Companies Act 2006 provide for derivative claims. These allow a shareholder to bring proceedings on behalf of the company against directors (or others) for wrongs done to the company, such as breach of duty, negligence, default, or breach of trust.

Key Term: derivative action
A statutory procedure enabling a shareholder to bring a claim on behalf of the company for wrongs committed against it, typically by directors.

When Is a Derivative Action Available?

A derivative claim is only available where the company itself has a cause of action, but the wrongdoers control the company and prevent it from suing. The claim must relate to an actual or proposed act or omission involving negligence, default, breach of duty, or breach of trust by a director.

Procedure

There is a two-stage permission process:

1. Prima Facie Case: The shareholder applies to the court, which will dismiss the claim if there is no prima facie case.
2. Substantive Hearing: If the claim proceeds, the court considers factors such as whether a person acting in accordance with s. 172 (the duty to advance the success of the company) would continue the claim, whether the act is capable of ratification, and whether the claimant is acting in good faith.

If the court grants permission, the claim proceeds as an action brought by the company.

Limitations

• The court will refuse permission if the alleged breach has been or could be ratified by an unconflicted majority.
• The claim must be in the interests of the company as a whole.
• The claimant must act in good faith.

The Reflective Loss Principle

Shareholders cannot recover for losses that merely reflect the company's losses. Only the company can recover such losses to avoid double recovery.

Key Term: reflective loss
The principle that a shareholder cannot recover for loss that simply mirrors the loss suffered by the company.

Key Case Law for Derivative Actions

• Prudential Assurance Co Ltd v Newman Industries Ltd (No 2) [1982] Ch 204: Established the reflective loss principle.
• Iesini v Westrip Holdings Ltd [2009] EWHC 2526 (Ch): Permission for a derivative claim will be refused if a hypothetical director acting in accordance with s. 172 would not pursue the claim.
• Franbar Holdings Ltd v Patel [2008] EWHC 1534 (Ch): The court may refuse permission if an alternative remedy, such as an unfair prejudice petition, is more appropriate.

Worked Example 1.2

Scenario:
A company's directors divert a lucrative contract to a separate business they own. The company suffers loss, but the directors control the board and refuse to take action.

Answer:
A shareholder may seek permission to bring a derivative action on behalf of the company for breach of duty. If the court is satisfied that the claim is in the company's interests and cannot be ratified, permission may be granted.

Comparison: Unfair Prejudice Claims vs Derivative Actions

Key Point Checklist

This article has covered the following key knowledge points:

• Unfair prejudice claims allow shareholders to seek relief for conduct that is unfairly prejudicial to their interests (s. 994 CA 2006).
• Derivative actions enable shareholders to bring claims on behalf of the company for wrongs committed against it (ss. 260–264 CA 2006).
• The reflective loss principle prevents shareholders from recovering losses that merely mirror company losses.
• Unfair prejudice claims are personal remedies; derivative actions are corporate remedies.
• Derivative actions require court permission and are subject to strict procedural and substantive limitations.
• The court has wide discretion in granting remedies for unfair prejudice, including share purchase orders.

Key Terms and Concepts

• unfair prejudice claim
• quasi-partnership
• derivative action
• reflective loss