Two interesting questions have emerged as relevant since the institution of part 11, chapter 1, sections 260-264 of the Companies Act 2006 (the 2006 act). They concern: (i) whether derivative claims will now have a better prospect of obtaining permission to continue; and (ii) how the courts will approach the ‘hypothetical’ or ‘objective’ director test established under those provisions.

As to the first question of whether such claims will have a greater prospect of successfully proceeding to a hearing on the substantive merits of the claim, it is too early to tell. To observe otherwise would be frivolous. During the 18-month period since the provisions came into force, there have been only two reported decisions in which permission to continue a derivative claim under the 2006 act has been sought and determined: Mission Capital Plc v Sinclair and another [2008] BCC 866 and Franbar Holdings Ltd v Patel and others [2008] BCC 885. The second question, however, has been the subject of judicial consideration on both those occasions.

IntroductionThe introduction of a new statutory procedure for bringing a derivative claim under the 2006 act immediately generated substantial speculation. Permitting a derivative claim to proceed was no longer to be confined to the application of the rule in Foss v Harbottle [1843] 2 Hare 461 and its exceptions. Both academic and professional commentators were quick to point to the wider ambit of the derivative claim and consequently to speculate that the new legislation would facilitate a rise in the number of such actions, or at least an enhanced prospect of launching a derivative claim. An assortment of other reasons were also put forward; hasty conclusions drawn. For example, certain analyses pointed to the twin effect of a new statutory statement of directors’ duties instituted by part 10 of the 2006 act and the new procedure contained in part 11. In so doing, they echoed concerns expressed during the bill’s passage through the House of Lords that this combination would lead to ‘a double whammy’ for litigants (679 HL Official Report (5th Series) col GC2 (27 February 2006)).

Such prophecies have not (or not yet) been borne out by events. Certainly the statutory procedure will alert interested parties to the existence of the provision. The ambit of the derivative claim is also now wider than at common law; it covers any cause of action falling within the four categories of ‘wrongs’ listed in section 260(3) of the 2006 act. And the limiting requirements of fraud on the minority and control by alleged wrongdoers no longer operate (cf Prudential Assurance Co Ltd v Newman Industries Ltd (No 2) [1982] Ch 204). However, part 11 came into effect on 1 October 2007. The past 18 months have seen only two reported decisions in which permission to continue a derivative claim under the new regime has been the subject of determination; in neither case has the court acceded to the application. In a third case, Fanmailuk.com Ltd v Cooper and others [2008] BCC 877, an application for permission to continue a derivative claim was adjourned for consideration, if necessary, after the trial of a preliminary issue.

There is thus not yet reason to suggest that the position under the previous regime – whereby derivative claims were seldom brought and those which were brought were seldom successful – will be modified. Certainly both Mission Capital Plc and Franbar Holdings Ltd were concerned with an analysis of the facts at issue. The very nature of the substantive criteria according to which the court will now determine whether a derivative claim may proceed, as prescribed by section 263 of the 2006 act, means that each case will, on analysis, invariably concern questions of fact individual to that case. That notwithstanding, these two recent cases call for comment as they provide an (and the first) insight for putative litigant shareholders of a company as to how the courts will approach the new legislation. In particular, the cases are instructive in indicating the courts’ application thus far of the ‘hypothetical’ director test.

The case lawThe first of the two cases in which permission to continue was refused was Mission Capital Plc, decided on 17 March 2008. Mission Capital’s former directors (the applicants) constituted a minority on its board. The board purported to terminate their employment and required them to resign from the board. Mission Capital obtained an interim injunction against the applicants, who: (i) counterclaimed for injunctive relief equating to specific performance of service contracts and reinstatement to the board; and (ii) brought a derivative claim against the remaining directors (a) contending that Mission Capital would suffer damage from their wrongful dismissal and the replacement director would act improperly and (b) claiming the same heads of relief as in the counterclaim.

On the application for permission to continue the derivative claim, Mr Justice Floyd first addressed his mind to section 263(2)(a) of the 2006 act and the question whether a notional director would not seek to continue the claim. (The grounds for permission at sections 263(2)(a) and 263(3)(b) both require the court to apply the standard of the objective, reasonable director under section 172 of the 2006 act: see the 2006 act for the precise terms of the provisions). The debate focused on whether the derivative action was purely duplicative of the counterclaim. ‘Nobody brings a claim just for the sake of it’ (at [41]). Hence his conclusion that he could not be satisfied, negatively, that such a person would not seek to continue the claim, was premised on the finding that the derivative action was not duplicative of the counterclaim. Specifically, that: (i) the derivative claim might succeed where the counterclaim failed; and (ii) Mission Capital would be able to claim damages against the directors for damage it had suffered as a result of the applicants’ wrongful dismissal, not available to the applicants’ as shareholders. As such, there was ‘real purpose’ (at [42]) in bringing the claim.

Floyd J went on to consider how to exercise his discretion under section 263(3) of the 2006 act. His refusal of permission was largely based on his judgment as to how important the hypothetical director would regard continuation of the claim within the meaning of section 263(3)(b). He held (at [43]) that, although he could not be satisfied that the notional section 172 director would not continue the claim, he did not believe that he would attach that much importance to it. His reasons were twofold: ‘Would a company which had wrongfully dismissed a director normally take action against those responsible for the damage that it has suffered? It would depend, but I suspect that the action it would take in preference would be to replace the directors. Moreover, on the evidence before me the damage… [Mission Capital] will suffer is somewhat speculative – another reason why the section 172 director would not attach great weight to it".

A second ground for Floyd J’s refusal seems to have been his brief consideration of section 263(3)(f), although not expressly cited (at [46]). He was not satisfied that there was anything sought by the applicants which they could not recover by means of an unfair prejudice petition under section 994 of the 2006 act.

Franbar Holdings Ltd was decided on 2 July 2008. The applicant company (Franbar) was a minority shareholder in Medicentres (UK) Ltd. Franbar sought permission to continue a derivative claim against the directors of Medicentres (the Respondents), on behalf of that company. Franbar claimed negligence, default and various breaches of duty of care owed by the respondents to Medicentres. The same substantive allegations founded a claim against the majority shareholder in Medicentres (Casualty Plus Ltd) for breach of a shareholders’ agreement it had entered into with Franbar and an unfair prejudice petition under section 994 against the respondents and Casualty Plus.

First applying the hypothetical director test in section 263(2)(a), William Trower QC, sitting as a deputy judge of the High Court, summarised the different stances which could be adopted by the hypothetical director (at [30]). The discussion then focused on whether there were circumstances which, if made out at trial, may give rise to a cause of action. The case was judged to be one where there was ‘sufficient material for the hypothetical director to conclude that the conduct of Medicentres’ business by those in control of it had given rise to actionable breaches of duty’, leading to the conclusion that ‘I cannot be satisfied that a hypothetical director acting in accordance with section 172 would conclude that the case advanced was insufficiently cogent to justify continuation of the claim’.

However, the balancing exercise carried out with regard to the factors at section 263(3) resulted in the refusal of permission. Applying the hypothetical director test in section 263(3)(b), Trower QC went on to set out certain of the considerations such a person would take into account (at [36]): ‘the prospects of success of the claim, the ability of the company to make a recovery on any award of damages, the disruption which would be caused to the development of the company’s business by having to concentrate on the proceedings, the costs of the proceedings and any damage to the company’s reputation and business if the proceedings were to fail. A director will often be in the position of having to make what is no more than a partially informed decision on continuation without any very clear idea of how the proceedings might turn out'.

It was held that the hypothetical director would not presently attach great importance to continuation of the claim, as there was work still to be done in formulating a clear claim for breaches of duty which had caused actionable loss to Medicentres. This did not preclude the hypothetical director from attaching importance to its continuation at some future stage (that is when the complaints were in a form tending to that conclusion). It was also considered that the hypothetical director would be more inclined to regard its pursuit as less important in light of the fact that several of the complaints were more naturally formulated as breaches of the shareholders’ agreement and acts of unfair prejudice.

In a similar vein, the availability (and use) of both the section 994 petition and shareholders’ action was attributed considerable weight, in a determination under section 263(3)(f). On an analysis of the facts, both the allegations of breach of duty to Medicentres and the losses it might have sustained were held likely to be relevant, respectively, to Franbar’s complaint of unfair prejudice as well as to the fair value of Franbar’s shares and attendant questions arising on the valuation.

Consideration was also devoted to section 263(3)(d). In determining that certain of the conduct alleged may prove to be incapable of ratification, Trower QC construed section 239(7) of the 2006 act, which preserves any rule of law as to acts incapable of ratification, as including not only acts which are ultra vires the company in the strict sense, but also acts which, pursuant to any rule of law, are incapable of ratification for some other reason. He concluded that the proposition in North-West Transportation Company v Beatty [1887] 12 App Cas 589, 594 (that a company cannot ratify breaches of duty by its directors where it is oppressive towards those shareholders who oppose it) remained good law. Consequently, that where the question of ratification arises in the context of an application to continue a derivative claim, the court must still ask itself the question whether ratification has the effect that the claimant is being improperly prevented from bringing the claim (cf Smith v Croft (No. 2) [1988] Ch 144, 185B).

Future consequences Mission Capital and Franbar Holdings illustrate that certain of the criteria listed in section 263 will involve similar considerations to those given to derivative claims under the previous regime. As such, for those factors assistance may be derived from decided case law in anticipating how the tests will operate in practice. For example, in relation to the issue of whether there is a personal claim that could be pursued without involving the company arising under section 263(3)(f) (cf Konamaneni v Rolls-Royce [2002] 1 WLR 1269; Jafari-Fini v Skillglass [2005] BCC 842; Mumbray v Lapper [2005] BCC 990). Or indeed under section 263(3)(d), as illustrated by Franbar Holdings.

Anticipating judicial determination of the hypothetical director test will, it is suggested, present greater difficulty when advising a prospective litigant on risk. The usual uncertainties of litigation will inevitably bear on a court’s determination of what such a person would decide in known circumstances. The considerations attributed to the hypothetical directors discernable in the decisions above, despite reflecting the facts at issue, reveal a similarity of approach and constitute broader commercial considerations militating against continuation. To that extent the cases afford an insight as to how the test will operate in practice. The hypothetical director deciding whether to continue the claim would, in Mission Capital, consider whether it had a ‘real purpose’, and in Franbar Holdings, consider whether there was ‘sufficient material’ or a sufficiently cogent case to substantiate a cause of action. The hypothetical director deciding how much importance to attach to its continuation would, in Mission Capital, consider the availability of an alternative course of action which did not involve litigation as well as the extent to which it could be said that the company will suffer loss, and in Franbar Holdings, consider the facts that the complaints were not in a form supporting a clear claim for breaches of duty causing actionable loss and more naturally fell within other types of claims already being pursued.

Of contrast is the position under section 172 of the 2006 act. Section 172 grants a discretion to directors to act in the way they consider, in good faith, would be most likely to promote the success of the company. Although the factors listed in section 172 will be relevant to the balancing exercises conducted under both that section and on an analysis under subsections 263(2)(a) and (3)(b), at common law the duty now contained in section 172 was held to be a subjective one. The question was not what a court may consider was in the interests of the company (cf Re Smith and Fawcett Ltd [1942] Ch 304; Re Regentcrest plc v Cohen [2001] 2 BCLC 80). This contrast in approach may, it is suggested, be explained on two bases. First, an act or omission challenged on an allegation of breach of the duty now contained in section 172 is conduct capable of subjective assessment – a judgment on past conduct rather than on a hypothetical. Second, the hypothetical director test is central to a permission application as the effect of permission being granted is to override the rights of a company’s directors to determine whether litigation should be commenced to enforce the company’s rights. That determination being displaced, the court steps into the shoes of a director to substitute its – hypothetical – view.

Georgina Peters is a barrister at 3-4 South Square and has contributed to The EC Regulation on Insolvency Proceedings: A Commentary and Annotated Guide and Company Directors: Duties, Liabilities, and Remedies, both published by Oxford University Press and available via the Law Society Online Bookshop (http://www.lawsocietyshop.org.uk).

This article is abbreviated from an article which first appeared in the quarterly 3-4 South Square Digest. If you wish to be added to the circulation list please send an email to kirstendent@southsquare.com