What is a Derivative Claim?

If you’re a shareholder in the UK and concerned that a company’s directors are misusing their power or neglecting their duties, you may be able to take legal action on behalf of the company. This process is known as a derivative claim. In essence, a derivative claim allows a shareholder to step in and act on behalf of the company when directors fail to do so. This unique claim provides minority shareholders—those who own smaller shares in a company—with a way to hold directors accountable when they engage in misconduct. Let’s take a closer look at how derivative claims work, why they exist, and the steps involved in making one.

Why Do Derivative Claims Exist?

In the UK, companies are treated as separate legal entities. This means that a private limited company, or “Ltd,” is legally distinct from the individuals who own and manage it. As a result, a company can enter into contracts, own assets, and even sue or be sued in its own name. Directors manage the day-to-day operations and make major decisions on behalf of the company, while shareholders are typically passive investors who receive dividends (a portion of profits).

But what happens when directors misuse their power or act against the best interests of the company? Normally, the company itself would be the one to bring a claim against them. However, in situations where the directors themselves are involved in the misconduct, it’s highly unlikely they’ll sue themselves! Majority shareholders—those with larger stakes in the company—also may not want to take action, particularly if they are complicit or close to the directors. This can leave minority shareholders without any direct way to protect their investment and the company’s interests.

The derivative claim steps in to bridge this gap, giving minority shareholders the opportunity to take action when directors or majority shareholders fail to do so. In short, it allows shareholders to pursue a claim on behalf of the company to hold directors accountable.

Key Grounds for Making a Derivative Claim

Under the Companies Act 2006, shareholders can bring a derivative claim against a director based on certain types of wrongdoing. These include:

Negligence 

This is when a director fails to meet the expected standard of care and attention in their role, causing harm to the company. For example, if a director makes careless financial decisions that result in significant losses, shareholders may be able to bring a claim based on negligence.

Breach of Duty  

Directors are required by law to act in the best interests of the company and its shareholders. A breach of duty could occur if a director makes decisions that benefit themselves personally rather than the company. For instance, if a director diverts a profitable contract from the company to a business they own, that would be a clear breach of duty.

Breach of Trust 

A breach of trust happens when a director abuses their position of trust within the company for personal gain. For example, using company funds for personal expenses without approval would be a breach of trust.

Default 

Default occurs when a director fails to perform their required duties under the Companies Act, such as providing financial transparency or ensuring the company complies with the law.

Derivative claims typically arise when there’s serious misconduct by directors, which has the potential to harm the company’s financial health or reputation.

Who Can Make a Derivative Claim?

Derivative claims are generally made by shareholders who feel that the directors are acting against the company’s best interests. However, shareholders are not the only ones eligible to bring a claim. In certain situations, individuals who have received shares through inheritance, bankruptcy, or other legal processes can also bring a derivative claim if their shareholding is not yet registered. In all cases, though, the claim is made in the name of the company, and any awarded damages are paid to the company rather than directly to the shareholders who brought the claim.

The Process for Making a Derivative Claim

Bringing a derivative claim is not a simple task and involves a two-stage court process. Here’s a basic overview:

First Stage: Permission from the Court

  • A shareholder must submit a claim form to the court, explaining the reasons for the derivative claim and why they believe it should proceed. The court will review the claim to determine if there’s a valid basis for it. This initial review is known as establishing a prima facie case.
  • A prima facie case essentially means that, at first glance, the claim appears strong enough to proceed. The court will examine if the evidence provided suggests there’s been wrongdoing and that the claim is being made in the company’s best interests.

Second Stage: A Court Hearing

  • If the court is satisfied with the prima facie case, it moves to a hearing where the judge reviews arguments from all involved parties, including shareholders and directors.
  • At this stage, the court assesses whether the claim meets the statutory criteria for a derivative claim. The court may also consider factors such as:
    • Whether the shareholder is acting in good faith.
    • Whether a reasonable director, acting to promote the success of the company, would pursue the claim.
    • Whether the act of misconduct could be ratified (approved) by a majority of shareholders, which would effectively eliminate the need for the claim.
  • If the court is satisfied, it will allow the derivative claim to proceed.

Potential Challenges in Bringing a Derivative Claim

Derivative claims are complex and can be difficult to prove. Because the shareholder bringing the claim must represent the company’s best interests, they must present evidence of wrongdoing, often without full access to the company’s records. Additionally, directors may attempt to block or contest the claim, arguing that it does not benefit the company. Courts also require that claims be made in good faith and not for personal gain or as a way to resolve unrelated shareholder disputes.

Possible Outcomes of a Derivative Claim

If a derivative claim is successful, the court has a range of options to address the misconduct. These remedies include:

  • Financial Damages: If directors are found liable, they may be ordered to pay damages to the company for the harm caused.
  • Director Removal: In cases of serious misconduct, the court may order the removal of the director from their position.
  • Cost Recovery: Sometimes, the company may cover the legal costs of the shareholder who brought the claim, especially if funds are recovered from the director.
  • Injunctions: Courts can issue orders (injunctions) to prevent a director from continuing harmful actions.
  • Reversing Transactions: If a director gained financially through a conflict of interest, the court may reverse these transactions to protect the company.

Final Thoughts

A derivative claim is a powerful tool for shareholders, especially minority shareholders, to protect the interests of a company when directors fail in their duties. However, bringing a derivative claim is complex and requires substantial evidence and commitment, so it’s wise to seek expert legal advice before moving forward. 

This claim is not about personal profit; rather, it’s about holding directors accountable for actions that threaten the company’s health and, ultimately, the shareholders’ investments. For UK shareholders, derivative claims provide a necessary safety net, empowering them to step in and protect the company they’ve invested in when directors fall short of their obligations.

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