Professor Bob Baxt examines a recent court case that demonstrates how the courts are becoming more comfortable with the idea of shareholders taking derivative action against a company and its directors.

    When the statutory business judgment rule (section 180(2)) of the Corporations Act 2001 was introduced into Australian law in 2002, there was a corresponding decision by the Federal Government to enhance the right of shareholders (Part 2F. 1A of the Act).

    It enabled shareholders to bring statutory derivative actions in the name of, and on behalf of, the company in which they held shares.

    These could be brought against the company’s directors for alleged breaches of the company’s constitution or breaches of duty.

    These could also be used to pursue rights against third parties, where the company would not do so because of perceived conflicts between the board of directors and the third parties (often the company was also a defendant).

    For centuries the English law (as adopted in Australia) required the company to be the plaintiff in such cases.

    This rule, which stems from Foss v Harbottle in 1843, has had a number of exceptions carved out of its operation, but these were difficult to establish.

    Because of this, the introduction of the statutory derivative action provisions were seen as a particularly important enlargement of shareholders’ rights.

    For some time after their introduction, these provisions were interpreted in a fairly conservative fashion by our courts.

    Now, in what may be regarded as an important decision, True Value Solar Holdings Pty Ltd and Anor v Fernandez (2013) VSCA 27, the Victorian Court of Appeal has given what appears to be a more generous interpretation of the steps shareholders have to establish when obtaining leave from the court to allow a statutory derivative action to be pursued as such.

    The most relevant sections of the Corporations Act provide that a court should allow a derivative action to be brought in the name of the company by shareholders if the court is satisfied by those shareholders that the relevant grounds needed to support an application have been established.

    Three of the more difficult grounds to be satisfied are that shareholders are acting in good faith (the least difficult of the three to establish), that it is in the best interests of the company that the matter proceed in the name of the shareholders and that it is "probable that the company will not bring the proceedings itself, or take proper responsibility for them, or for the steps in [the relevant proceedings]".

    This last ground was interpreted by the Court of Appeal as establishing that the directors would generally not be keen to pursue an action against their own numbers.

    Sometimes the actions are brought not only by shareholders in their capacity as shareholders alone, but shareholders who are also directors.

    So, how do the shareholders establish the company will not pursue action in its name against the directors or a third party that may have strong links with the majority of the directors?

    In the True Value decision, the relevant facts were these.

    Fernandez, a shareholder in True Value Solar Holdings, in his own right and in the name of a company he controlled, applied for leave pursuant to the Corporations Act to commence derivative proceedings in the name of the company against a director of the company (one Robert Gattereder) and a number of companies associated with the company and Gattereder (namely, M+W Solar GmbH, M+W Solar and M+W High Tech Projects Malaysia Sdn Bhd, which were subsidiaries in the M+W group of companies – referred to as M+W Solar).

    Fernandez, and the company he controlled, Fernandez Corporation, held only a small proportion of the shares in True Value Solar Holdings while M+W Solar owned 62 per cent of its issued capital.

    Fernandez argued that he and his colleagues would allege in the name of the company that it had suffered a loss and damage as a result of certain contracts engaged in by the company in procuring solar panels.

    They would further allege that these contracts had the effect of diverting business opportunities from the company, or at least imposing a prejudicial purchasing regime on it that would result in M+W Solar receiving benefits.

    They would also establish that Gattereder had breached several duties owed by him as a director of True Value Solar Holdings as well as common law duties.

    The company, in its name, would seek compensation from Gattereder and would allege that a constructive trust existed in favour of the company for profits gained by M+W Solar as a result of the unfair set of contracts that had been generated in this case.

    Fernandez was successful at first instance, but the M+W Solar companies and Gattereder appealed that decision, arguing the action was not in the best interests of the company.

    Another interesting question in relation to the appeal was whether the company would have pursued the action itself.

    The appellants argued that the trial judge had made a mistake in ruling it was not probable that the board of the company (because of the control exerted by M+W Solar) would properly have taken responsibility for any such actions.

    The appellants contended that the decision of the company’s board to conduct an investigation into the solar procurement proposal, by using the services of the accounting firm Deloitte Haskins, made it "probable" that the company would in fact "properly take responsibility" to investigate the allegations (see para [9]).

    On behalf of the Court of Appeal, Justice Osborne ruled that interpretation of section 237(2)(a) of the Corporations Act (requiring the company to take steps in relation to a proceeding) meant more than simply taking responsibility for investigating a matter internally.

    The Court of Appeal agreed with the trial judge’s assessment that the internal investigation was no more than a "crafted and rehearsed response" (at [24]) by the board of the company.

    In Justice Osborne’s view, the trial judge had been correct in ruling that at the relevant date it was probable that the company would not bring these proceedings (as opposed to conducting internal investigations) against the directors and the other companies in its own name.

    The appellants also argued it had not been established that it would be in the best interests of the company that leave be granted to the applicants. This was because Fernandez had also sought relief under the oppression section of the Corporations Act – namely section 232.

    It was suggested by the appellants that the two actions in effect "contradicted" each other in terms of the spirit behind the legislation.

    The trial judge had ruled that the existence of an oppression remedy would lead to different remedies, if successful, to any action based on statutory derivative action. An oppression remedy was brought in the name of the shareholder against another shareholder rather than against the company.

    An oppression remedy often leads to an order of the court for the ascertainment of the fair value of the shares to be purchased from the oppressed shareholder to resolve the particular claim.

    There are inherent limitations in the oppression remedy in pursuing the constructive trust argument and related claims pursued by Fernandez in the name of the company in this case – these were more appropriately pursued through a derivative action.

    It will be interesting to see if leave is sought to appeal this decision in the High Court of Australia. There has not been a significant recent High Court decision on this provision.

    In addition to the success of the applicant in this case, there have been similar successes in a number of other cases.

    But there have also been cases where applications have been unsuccessful because one of the tests set out in section 237(2) of the legislation has not been established.

    This means that each case will be determined on its own facts.

    What is encouraging for shareholders, and therefore of concern for company boards, is that courts are gradually becoming more comfortable with the idea that it is not inappropriate for remedies to be sought against directors of a company and the company itself, especially where third parties are involved.

    These can be properly brought by minority interests on behalf of the company and not necessarily by the company itself.

    This development is in line with others where there appears to be a greater willingness on the part of the courts to ensure that, where there has been what seems to be inappropriate and perhaps unlawful action taken in the administration of a company, appropriate relief should not necessarily depend purely on the intervention of the Australian Securities and Investments Commission or some other regulator, but can properly be vested in the hands of the shareholders in the company or those that represent them to pursue.

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