Derivative Actions and Breach of Director’s duty

Derivative Action: Definition

The Board of Directors have to duty to make management decisions in the best interests of the company. Typically, such duties include decisions to commence legal action(s) to right a wrong suffered by the Company and recover losses resulting from such wrongdoing.

However, what happens when it is the directors themselves that are the ones responsible for the wrongdoing? In that scenario, there is a risk that the company will not receive vindication for the harm done to it because the very perpetrators of the wrongdoing, i.e., the directors, are unlikely to have the company taken action against themselves, which is to say they certainly would not vote in the boardroom to authorize the company to commence lawsuits against themselves.

Thus, a “derivative action” gives the company adequate recourse by allowing certain stakeholders to, on the company’s behalf, sue the offending director(s) or initiate arbitration proceedings against them.

Legal provisions:

It should be noted that pursuing derivative action(s) requires the permission of the court. Section 216A of the Companies Act of Singapore governs an application to commence a derivative action (also known as a ‘statutory derivative action’). Derivative action may also be available under common law (as opposed to statute), though the governing principles are slightly different. Regardless, permission from the Court is still required.

In what situations would it be appropriate to seek the Court’s permission to commence a derivative action?

The following is a non-exhaustive list of situations in which a derivative action may be the appropriate or even necessary course of action:

When a director(s) commits unauthorised acts that result in a loss for the company. For example, by engaging in a fraudulent contract with another company.
When a director(s) refuses to repay the money, it owes to the company, the company will sue it for debt repayment.
When a director(s) causes loss to the company by breaching their directors’ / fiduciary duties. For example:
- When directors violate their duty not to improperly use their position to gain a personal advantage, such as by using confidential information of certain company needs / financial status to undercut other vendors in an open tender through a personal bid or bid from an entity related to / controlled by the director.
- When directors fail to act honestly or with reasonable skill and diligence in carrying out their responsibilities.
- When directors force the company into less profitable or even unprofitable / loss-making transactions due to some personal benefit, (for e.g., taking bribes) and / or otherwise wrongfully using the company to obtain an unauthorised personal profit.
- When directors use information received through their position in the company to divert resources or contracts to themselves at the expense of the company, causing business and profits that would otherwise accrue to the company to accrue to themselves or to another company / entity that is related or controlled by them.

When is a statutory derivative action not applicable / applicable?

It is important to note that there is a distinction to be made between losses suffered by the company and losses suffered by individual shareholders. This is a common point of confusion due to the fact that this typically both occurs at the same time, or a combination of different losses are suffered by the company and individual shareholders arising from the same chain of events / wrongdoing.

The key distinction is where the loss in question affects individual shareholders rather than the company, then the statutory derivative action is not the appropriate remedy because such an action is to vindicate the rights of the company, not the individual shareholders.

To illustrate, take for an example a drop in share prices which could be considered a loss caused to shareholders personally. However, it is important to delve deeper to understand what has caused such a drop.

This drop in share prices could be because of a director’s wrongdoing in accepting bribes and entering into loss-making contracts – this would be wrong committed by the director on the company, where the company suffers the loss, but at the same time, the natural consequence is also that the share prices drop. In this scenario, this may be more of a corporate wrong / loss suffered by the company, where only the incidental / consequential loss is suffered by the shareholder (and not a personal wrong). This would mean that a statutory derivative action would be more appropriate.

Now take a different situation where the drop in share price is due to dilution of share pattern to minority shareholders, where more shares are issued by the majority at depressed prices but in such a design where the majority receives some of the issued shares such that their total value is not affected and only the minority shareholders’ true value is affected. This would now be more akin to a personal wrong rather than a corporate wrong, where a minority oppression action under section 216 of the Companies Act may be more appropriate.

We have discussed Minority Oppression separately in this other article.

One further important requirement to note is that a statutory derivative action must be initiated in respect of a company incorporated in Singapore; not outside Singapore.

Additionally, where a company is in liquidation, then a statutory derivative action cannot be brought on behalf of a company. This is because when a company goes into liquidation, the liquidator takes over and the board of directors is no long in control and has no ability to initiate or authorize any type of legal action, much less prevent the company’s rights from being vindicated which is now within the power of the liquidator.

Obtaining the Court’s permission to commence a Derivative Action – what requirements must be met?

Proper person
The applicant/ claimant must be:

a company employee; or
In the case of companies under investigation, the Minister of Finance (for reasons such as fraud).The requirements are not limited to the above and it is in the court’s discretion to permit (or not permit as the case may be) any appropriate person to initiate a claim.

Notice period:

If the directors of the company do not commence or continue the lawsuit or arbitration demanded, the applicant must give the directors 14 days’ notice of his intention to apply to court for permission to pursue the statutory derivative action.
At this point, the applicant must demonstrate that, despite being given 14 days’ notice, the directors are unlikely to bring or continue the action diligently. The key thing to note is that the Court will examine and must be satisfied that an action would be commenced and prosecuted diligently and this would be based on the totality of the circumstances. For example, a sole director who intends to avoid diligent prosecution of his / her wrongdoing may cause the company to sue himself / herself, but with no intention of actually diligently prosecuting the case – in that sense, the sole director would purposefully allow the action to fail, in an attempt to wrongfully use the Court machinery to relieve himself / herself of liability to the company. In such situations, the Court would come to the conclusion that while there may be an action, it is unlikely to also be pursued diligently, and therefore would grant permission for the commencement of a derivative action (despite the existence of an action against the errant director)
If the board of directors decides to sue the wrongdoing director after receiving the notice of intention to commence a derivative action, the application for statutory derivative action will be rendered obsolete.
If a court determines that strict adherence to the notice period is undesirable (for example, because the company or errant director can use the 14-day period to conceal evidence or assets), the court may issue any interim order pending the applicant’s provision of the required notice.

Good Faith
The applicant must demonstrate that he is acting in good faith and must demonstrate that the action is, on the surface, in the best interests of the company. This requires evidence to prove that action is both legally sound and practical and commercially viable for the company. Put another way, if the application is made in bad faith, then this would be in all likelihood be fatal to the application.It is not uncommon for there to be some form of animosity or even clear hostility between applicant and the potential defendant directors – this a natural consequence of an accusation of wrongdoing which is to be expected. Thus, the mere presence of animosity and hostility would not constitute bad faith.There must be something further for a finding of bad faith, such as where the court believes based on the evidence that the applicant was motivated by personal vendetta.
Furthermore, even if the applicant stands to benefit personally from a successful derivative action, this will not be considered bad faith if his personal interests are aligned with those of the company.

Other considerations
Shareholder approval is not required for derivative action. Even if shareholders vote in a general meeting to uphold and approve a wrongful act, this does not mean that the application for a statutory derivative action will fail.
After grant of permission for statutory derivate action by the Court:
After granting permission for the applicant to file the statutory derivative action, the court may make any order it deems fit, including:

An order authorizing the applicant or another authorized person to control the course of the lawsuit or arbitration on the company’s behalf.
An order requiring the company to pay reasonable legal fees and disbursements related to the lawsuit or arbitration.
Without the court’s permission, statutory derivative actions (or applications for such actions) cannot be stayed, discontinued, settled, or dismissed.

Conclusion

Ultimately, while there are clear routes to right the wrongs committed against the company, there are important considerations to take note of, particularly in identifying the proper route to remedies and obtaining the Court’s permission to do so.

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