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Australian Statutory Derivative Action Needs Reforming

The Statutory Derivative Action in Australia allows current or former shareholders or officers of a corporation to bring action in the name of and on behalf of the corporation where management fails to institute proceedings for misdeeds against the company such as violation of company constitution or breach of directors’ duties.[1] It is outlined in Part 2F.1A (s 236-242) of the Corporations Act 2001 and it seeks to enlarge shareholder rights in line with other remedies available to shareholders such as the oppression remedy and the shareholder class action. It is derivative as a company is a separate legal entity with the right to sue in itself, and the shareholders derive this right from the company. While, normally, it is the management’s duty to safeguard the company’s interests, consideration is given to situations where the entire or part of the board is responsible for the ills committed against the company. In such cases, it becomes necessary to allow shareholders to assert the company’s rights. However, years after the statutory derivative action took effect, it remains unpopular among Australian citizens. Notably, most shareholders seeking litigation opt for other remedies such as the shareholder class action and oppression remedy which have recorded higher uptake and that do not require the leave of court to bring action. Duffy alludes this development to the shortcomings in the statutory derivative action specifically, concerning the criteria that a shareholder needs to meet to obtain leave of court to start a derivative action.[2] This article explores the defects of the statutory derivative action that include: lack of clarity in the interpretation of certain criteria set out in s 137 required to be met to be granted leave of court; uncertainty as to which party would ultimately bear the cost of litigation; restricted information rights to shareholders to gather evidence from the company to apply for leave of court; and uncertainty as to the scope to which the derivative action would apply in company liquidation. Due to the aforementioned defects, the statutory derivative action needs to be reformed.

Before the institution of the derivative action, cases of shareholders rights to assert the company rights were handled under the exemptions to the Foss v Harbottle[3] rule in which it was required that the shareholder meet conditions that were hard to establish. For instance, the applicants were required to prove fraud, prove control on the part of the wrongdoers, invasion of personal shareholder rights, and that the act complained of is beyond the company’s powers. It was difficult to establish such conditions and to add to that, the courts were unwilling to intervene in internal company affairs.[4] Thus, the statutory derivative action helped reduce uncertainties and lend clarity to the law. The entrenchment of the derivative action in law in March 2000 helped address the shortcomings of the English law that had been in force, particularly it increased certainty in law.

The first defect with the Australian derivative action is the lack of clarity in the interpretation of certain criteria set out in s 137 that a shareholder applicant needs to meet to obtain leave of court. The derivative action requires that a shareholder or officer of a company be granted leave by the court before pursuing a derivative action in the name of and on behalf of the company. Section 137 of the Act spells out conditions that need to be met but it is unclear whether attaining these criteria automatically qualifies one for the leave of court or they are only the necessary conditions. The criteria stipulates that it ought to be likely that the corporation will not bring forth proceedings; the action must be in good faith and in the best interests of the corporation; the question to be tested be solemn and the applicant to offer the corporation a notice in writing of intent to apply for leave of court. Of these criteria, there are defects in the criteria that the derivative action be in the “corporation’s best interests”[5] and be in “good faith”[6]. There are difficulties in assessing whether an action meets the criteria of “good faith” and “best interests of the company” as these terms have no practical definitions in the Australian law and are thus, subject to different judicial interpretations.[7] Judicial interpretations of the term good faith include the application of two tests: First test being if the shareholder sincerely believed the corporation had a proper cause of action and realistic probability of success; and second being whether the applicant had any collateral motive in instituting the action.[8] In a different case of Vinciguerra v MG Corrosion Consultants Pty Ltd [2010][9], the judge failed to apply these tests instead making a determination based on the assessment of both parties’ conduct and the nature of claims of breach in duties. This creates inconsistencies.

Similarly, there are ambiguities surrounding the term ‘best interests of the company’ Corporate governance is currently leaning towards corporate social responsibility thereby changing the modern definition of company to extend beyond ‘shareholders as a whole’ to include suppliers, employees and the community. Consequently, it has become unclear whether derivative actions one seeks to bring forth should uphold the best interests of the broader stakeholders that now constitute a company. Moreover, the criteria that an action be in the company’s best interests is often read with section 237 (3) of the Act that presumes that directors are always acting in the corporation’s best interests. Thus, in addition to proving that the litigation is in the corporation’s best interests, the applicants also have to demonstrate how the directors’ actions is doing the converse. This is a difficult task where the company is performing well financially.[10]

Secondly, there is uncertainty as to which party would ultimately bear the cost of litigation. The courts have discretion over the issuance of the costs order and there is no way of determining beforehand who will bear the costs. A decision initially made giving responsibility for the litigation costs to one party can be reversed if it is determined later that the claims by the other party lack merit. Therefore, there is the chance that the shareholder could ultimately bear the cost of litigation if they fail to prove their allegations on the company’s behalf. This is demonstrated in Woods v Link Golf Tasmania Pty Ltd [2010][11], in which the judge broke away from the common law practice and ordered the company to pay the preliminary costs of the derivative action but with the statement that the order could be reviewed if the claims were later established to lack merit. Also, unlike in shareholder class actions where costs are shared among a group of shareholders, a shareholder cannot compel other shareholders affected by the action to help foot the costs of litigation. In numerous cases, shareholders have been ordered to bear the costs which deters litigants from seeking this form of remedy.

Third defect in the derivative action provisions is the restricted information rights to shareholders to gather evidence from the company to apply for leave of court. Applicant shareholders in their quest to obtain incriminating evidence about the company before making leave applications are often confronted with hurdles due to their limited information rights. While the shareholders applying for leave have the right to apply to courts for examination of company books and documents, the Courts peg the granting of this information right to the attainment of a stringent criteria that is hard to meet. The courts are keen not to impinge on the privacy rights of companies who own the documents. Moreover, the courts have consistently regarded the provision for application for inspection to be for remedial and last resort purposes. As a result, applicant shareholders have difficulty obtaining evidence to successfully apply for the leave of court.[12]

Fourth defect is the uncertainty as to the scope to which the derivative action would apply in company liquidation. Company liquidation could present a situation where the liquidator’s mandate to meet the interests of suppliers and employees conflicts with an applicant’s move to defeat the liquidator’s actions and safeguard and assert the company’s rights. During liquidation, the liquidator comes in to realise the assets of the corporation and settle amounts owed to employees and creditors.  There is lack of consensus as to the applicability of the derivative action in such an event with some courts upholding its applicability while others are refuting this.[13] This fact has created a lack of judicial precedent and even with case laws that demonstrate the applicability of the action in company liquidation, the scope and extent of this applicability is unclear.

Conclusion

Clearly, the statutory derivative action is defective and this fact largely account for its low uptake among shareholder litigants. There are various uncertainties in the legislation provisions touching on the criteria to be met to warrant being granted the leave of court which is a requirement for one to institute the action. Particularly, the varied interpretations of the terms ‘good faith’ and ‘best interests of the company’ have been problematic. Similarly, uncertainties in relation to who bears the cost of litigation with more and more applicants being burdened with costs, the scope of to which the action applies during company liquidation and the shareholders’ restricted information rights that hamper the collection of evidence from the company to make leave applications, are major hindrances that need reforming if the legislation is to achieve its intended goal.

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