Corporate governance and compliance - Unfair prejudice claim...

Learning Outcomes

This article outlines minority shareholder protections under the Companies Act 2006 through unfair prejudice claims (s. 994) and derivative actions (ss. 260–264), including:

• Purpose and operation of unfair prejudice claims and derivative actions under the Companies Act 2006
• Distinction between personal and corporate remedies for shareholder grievances
• Procedural requirements and limitations for each remedy
• Relevant legal principles and case law for SQE1-style problem questions involving minority shareholder protection
• Alternative remedies and strategic suitability (e.g. unfair prejudice petitions versus derivative claims) and the impact of ratification and good faith on permission
• Typical orders (including share purchase orders) and court approaches to valuation, minority discounts, and the appropriate valuation date

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, with a focus on the following syllabus points:

• 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
• Ratification of directors’ breaches (CA 2006, s. 239) and its effect on derivative claims
• The continued relevance of Foss v Harbottle and the surviving common law context for multiple derivative actions

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.

Both remedies sit against the backdrop of the rule in Foss v Harbottle: where a wrong is done to the company, the proper claimant is the company, not individual shareholders. Unfair prejudice petitions carve out a personal remedy for conduct that is unfairly prejudicial to members’ interests, whereas derivative claims permit a shareholder to litigate on the company’s behalf in respect of wrongs to the company, typically by directors. Understanding when each remedy is appropriate—and how the procedural filters, ratification, and reflective loss constrain private actions—is central to tackling problem questions.

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.

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. The court may also consider whether an actual or proposed act or omission of the company is or would be unfairly prejudicial.

Unfair prejudice is an adaptable remedy. It addresses harms to members that arise from how the company is managed and controlled, especially where the majority abuses powers or breaches equitable understandings among members. This is a personal remedy—the benefit of any order is directed to the member(s), not the company.

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). While prejudice often manifests financially (e.g. reduced value of shares), it can also be procedural or participatory (e.g. exclusion from management in a company run as a quasi-partnership).

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.

In O’Neill v Phillips [1999] 1 WLR 1092, the House of Lords emphasised that unfairness is assessed by reference to legal rights and any equitable considerations arising from the parties’ relationship or understandings. Legitimate expectations can be relevant where, for example, members joined on the understanding that they would have management participation and share in profits. However, mere aspirations without basis in the company’s constitution or clear understandings will not suffice.

The unfairness test is objective—the court asks whether a reasonable bystander would consider the conduct unfair. Conduct can be unfair even without a technical breach of the articles, especially in quasi‑partnerships where equity supplements strict legal rights (Re London School of Electronics [1986] Ch 211). Other illustrations include selling company assets at an undervalue to an entity controlled by the majority, self‑dealing, and sustained management failings.

Procedure and Standing

Any member (including those to whom shares have been transferred or transmitted by operation of law) may bring a claim. There is no requirement to prove insolvency or to demonstrate “clean hands,” although the court can consider the petitioner’s conduct when fashioning relief.

Key procedural points include:

• The petition is made under s. 994 and is personal to the member(s).
• The petitioner must identify the conduct of the company’s affairs (which can include decisions of directors, majority shareholders acting through governance structures, and acts of subsidiaries where relevant to the holding company’s affairs).
• “Interests of members” is interpreted broadly and is not limited to strict property rights in shares; it can include expectations about participation in management in quasi‑partnership companies.
• The court has case‑management powers to limit issues, require disclosure, and determine preliminary points (including whether a reasonable purchase offer has made the petition unnecessary).

A realistic and reasonable offer to buy the petitioner’s shares can be decisive. If the majority (or the company) offers to purchase the petitioner’s shares at a fair value determined by an independent expert on usual terms (including proper treatment of any minority discount and allocation of costs), the court may dismiss or stay the petition. This reflects that the most common remedy is a buy‑out, and a reasonable offer may render litigation disproportionate.

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 in future
• Requiring the company to refrain from or to undertake specified acts
• Setting aside, amending, or restraining alterations to the articles
• Appointing directors or convening meetings
• Authorising proceedings in the company’s name (derivative relief by order)

Where a buy‑out is ordered, courts pay close attention to valuation:

• Valuation date: often the date of the order or the petition, depending on fairness; if the prejudice depressed value, an earlier date may be used.
• Minority discount: typically no discount in quasi‑partnership contexts given the mutual expectations of participation; outside quasi‑partnerships, a discount may be applied to reflect a minority position where appropriate.
• Adjustments: the court may adjust for misconduct (e.g. stripping out ill‑gotten gains) and for control premiums.

Key Case Law

• O'Neill v Phillips [1999] 1 WLR 1092: Unfairness is assessed by reference to legal rights and equitable considerations from the relationship.
• Re London School of Electronics [1986] Ch 211: Unfairness can exist without a technical breach of the articles; diversion of business is plainly prejudicial.
• Re Little Olympian Each‑Way Ltd (No 3): Sale at undervalue to an entity controlled by directors can support unfair prejudice.
• Re Macro (Ipswich) Ltd: Persistent management failings may constitute unfair prejudice.
• Grace v Biagioli; Re Bird Precision Bellows: Guidance on valuation and approach to minority discount in buy‑out orders.

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.

Worked Example 1.2

Scenario:
After a petition is issued, the majority offers to buy the petitioner’s shares at “market value” set by the company’s accountant, subject to a 35% minority discount and with each side bearing its own costs. The petitioner refuses.

Answer:
The court will scrutinise whether the offer is a reasonable one. A buy‑out on fair terms typically requires an independent expert valuation on clear instructions, appropriate treatment of minority discount (often no discount in quasi‑partnership cases), and fair allocation of costs. A unilateral discount and use of the company’s accountant are likely to render the offer unreasonable, so the petition may proceed.

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. The claim is in the company’s name and, if successful, the remedy (e.g. damages, restitution) is for the company.

Derivative claims are designed to address the problem that wrongdoers who control the company may block the company from suing. The permission filter ensures only meritorious and company‑focused claims proceed.

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 available where the company has a cause of action, but those in control prevent action. The claim must arise from an actual or proposed act or omission involving negligence, default, breach of duty, or breach of trust by a director. It may be brought against a director and/or another person (e.g. a recipient of misapplied assets), provided a director’s wrongdoing is involved.

Scope points:

• Negligence without personal benefit can found a derivative claim (contrary to the old common law position).
• Breaches of the general duties (e.g. s. 171–177 CA 2006) are typical grounds.
• The claim is corporate. Relief (damages, account of profits, rescission) accrues to the company.

Procedure

There is a two-stage permission process:

1. Prima Facie Case (paper filter): The court considers the claimant’s evidence and will dismiss the application if there is no prima facie case.
2. Substantive Hearing: If the claim passes stage one, the court holds a permission hearing and considers both mandatory and discretionary factors. Central questions include whether a person acting in accordance with s. 172 (duty to advance the success of the company) would continue the claim, whether the act has been or could be authorised or ratified, and whether the claimant is acting in good faith.

Mandatory refusal (s. 263(2)) applies if:

• A person acting under s. 172 would not continue the claim; or
• The act/omission was or would be authorised or ratified by the company.

Discretionary factors (s. 263(3)) include:

• Good faith of the claimant
• Importance a s. 172‑compliant director would attach to litigation
• Potential for ratification/authorisation
• Whether the company has decided not to pursue the claim
• Availability of an alternative personal remedy (e.g. an unfair prejudice petition)

Ratification must be genuine and independent; interested members’ votes are excluded under s. 239. If independent shareholders ratify the conduct, permission will ordinarily be refused.

Costs and funding: if permission is granted, the company typically bears the costs of the action (and adverse costs risk), reflecting that the claim is brought for the company’s benefit. Courts can order indemnities and give case management directions.

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, weighing likely benefits against costs and disruption.
• The claimant must act in good faith; collateral purposes may be fatal.
• Where an alternative remedy (especially s. 994) is more apt, permission may be refused.

The courts are cautious where the pleaded wrong is better addressed by a buy‑out under s. 994, or where litigation would harm the company more than it helps. A hypothetical independent director’s view is determinative (Iesini v Westrip Holdings Ltd [2009] EWHC 2526 (Ch)).

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. This principle, rooted in Prudential Assurance Co Ltd v Newman Industries Ltd (No 2) [1982] Ch 204 and refined by later cases, prevents personal actions for diminution in share value or lost dividends where those losses mirror company losses caused by the same wrongdoer.

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

The Supreme Court in Sevilleja v Marex Financial Ltd [2020] UKSC 31 clarified and narrowed the scope of reflective loss. The rule applies to claims by a shareholder in respect of loss suffered in that capacity (diminution in share value or distributions) that is the consequence of loss sustained by the company against the same wrongdoer. It does not bar claims by creditors who are not suing in their capacity as shareholders. Reflective loss does not bar statutory derivative claims (as proceeds benefit the company). The focus in problem questions should be: is the claimant suing qua shareholder for share value/dividend loss? If yes, reflective loss likely bites (absent a viable derivative route). If the claimant sues in another capacity (e.g. as a creditor with a direct duty owed), Marex indicates the bar does not apply.

Key Case Law for Derivative Actions

• Prudential Assurance Co Ltd v Newman Industries Ltd (No 2) [1982] Ch 204: Reflective loss principle.
• Sevilleja v Marex Financial Ltd [2020] UKSC 31: Reflective loss narrowed to shareholder‑capacity claims for share value/dividend loss; non‑shareholder claims not barred.
• Iesini v Westrip Holdings Ltd [2009] EWHC 2526 (Ch): Hypothetical director test under s. 172; permission where claim in company’s interests.
• Franbar Holdings Ltd v Patel [2008] EWHC 1534 (Ch): Permission may be refused where s. 994 offers a more appropriate personal remedy.
• Wallersteiner v Moir (No 2): Indemnity principles for derivative claim funding.

Common law context: Part 11 CA 2006 largely replaces the common law derivative action. However, multiple derivative claims (e.g. a member of a parent company suing on behalf of a subsidiary) remain within the common law’s residual scope and are treated cautiously.

Worked Example 1.3

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 (e.g. the independent majority would not ratify), permission may be granted. If an unfair prejudice petition seeking a buy‑out would more effectively resolve the dispute, the court may prefer that route and refuse permission.

Permission Filters in Practice

At stage two, courts interrogate:

• Merits: Is there a real prospect of success and a clear company loss?
• Company interest: Would an independent board litigate, considering costs, disruption, and prospects?
• Good faith: Is the claimant genuinely seeking redress for the company rather than pursuing a personal agenda?
• Ratification: Is independent ratification plausible? If so, permission will be refused.
• Alternative remedies: If s. 994 can practically resolve the dispute (e.g. exclusion from management in a quasi-partnership), permission may be declined.

Where facts are unclear, limited directions may be given (e.g. disclosure) to complete the permission record (Stainer v Lee).

Comparison: Unfair Prejudice Claims vs Derivative Actions

The comparison points to a strategic choice: use s. 994 when personal prejudice requires tailored relief (often a buy‑out). Use a derivative claim where the focus is restoring the company’s loss and private remedies are inadequate.

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).
• Unfairness is assessed objectively, taking account of legal rights and equitable understandings; quasi‑partnership factors are central where mutual trust and management participation were expected.
• A reasonable buy‑out offer (independent valuation; appropriate discount treatment; fair costs) can lead to dismissal or stay of a petition.
• The court has wide discretion in granting remedies for unfair prejudice, with share purchase orders being the most common; valuation date and minority discount depend on context.
• Derivative actions enable shareholders to bring claims on behalf of the company for wrongs committed against it (ss. 260–264 CA 2006).
• Permission filters require a prima facie case and, at a full hearing, satisfaction of s. 263 factors including s. 172 company interest, ratification, good faith, and the availability of alternative remedies.
• Ratification under s. 239 (excluding votes of interested members) is a key bar to permission if likely or effected.
• The reflective loss principle bars personal recovery by shareholders for losses mirroring company losses; the Supreme Court in Marex narrowed the rule to shareholder‑capacity claims for share value or dividends, leaving non‑shareholder claims unaffected.
• Unfair prejudice claims are personal remedies; derivative actions are corporate remedies. Courts may prefer s. 994 where a buy‑out resolves governance breakdown efficiently.

Key Terms and Concepts

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