Fraud on the Minority

Company is Proper Claimant I

It is a fundamental principle that a company is a legal person with its own corporate identity, separate and distinct from the directors or shareholders. It has its own property rights and interests to which it is entitled. If it is defrauded by a wrongdoer, the company itself is the only person entitled to sue for the damage. Individual shareholders, whose shareholding is reduced in value, cannot usually take legal action, for loss and damage suffered by the company.   This is the rule in Foss v Harbottle.

The rule is easy to apply when the company is defrauded by outsiders. The company itself has the sole right to take legal action. The courts will not interfere or second-guess the management of the company in the normal course. There should be no conflict of interest between the minority and the majority in this case.


Company is Proper Claimant II

If the company is defrauded by insiders who control its affairs, the majority/controllers/ directors are likely to decide in their personal interests (usually by inaction), not to take legal action against themselves or others connected to them, for the loss or damage to the company.  If a general meeting is called, the controllers can vote down any proposal that the company should sue the directors.

The majority/controllers have a conflict of interests when they enter a transaction in their own interests and in disregard of the company’s interests.Where they do so, the court may intervene, under an exception to the rule in Foss v Harbottle.


Exceptions to Rule

The common scenario set out in the last paragraph presents a risk of injustice. In Foss v Harbottle, the court provided a solution. The company is permitted to sue in the name of a person who is appointed to be its representative.

The so-called derivative action is available in cases where an exception to the rule in Foss v Harbottle applies. In the absence of permitting a derivative action, a wrong against the company might go un-remedied.  In a derivative action, any shareholder may act for himself and other shareholders.

The (minority) shareholder applies for leave to use the name of the company. If he can show reasonable grounds for charging the directors or other controllers with equitable fraud, the court may appoint him as representative of the company to bring proceedings in the name of the company against the directors/ controllers who have abused their powers.

The company itself is a party, so that an order may be made against it to compel it to take the requisite action, if the derivative action succeeds.  The action is taken for the benefit of the company.


Ratification

The derivative action is not permitted to proceed where it would be futile.  The effect is that the minority may not seek recourse and protection where the breaches of duty can be ratified by the majority/ controlling shareholder(s).

Some actions may not be ratified or waived without a special resolution.Others may not be waived other than unanimously. The minority is permitted to take action by way of the derivative action, only where the action cannot be ratified or approved by the majority in value of the shareholders. A bare majority of shareholders (50%+)  cannot ratify something that would breach the constitution.

In some cases, a  special resolution (75% majority) would rectify the matter, such as by a change in the constitution. Where the majority can regularise the matter by amending the constitution by a special resolution, the power to amend must be undertaken in good faith in the interests of the company as a whole.The minority may be in a position to show that the directors have exceeded their powers to the detriment of the company.


Fraud on the Minority

Action taken by the majority may appear to be lawful and within the powers of the company. However, if it is a fraudulent use of the powers to the detriment of the company, and in particular, the minority’s interest in it, it may be remedied and restrained as a so-called “fraud” on the minority.

The directors owe extensive duties of care and duties of good faith to the company. The duties owed by the shareholders is much less extensive. However, in exercising their respective powers, the shareholders must also act in good faith in the interests of the company as a whole. The duty is owed to the company.

In this context, “fraud” does not necessarily mean dishonest action. It is equivalent to “equitable” fraud, as recognised in other contexts by the Courts of Equity. Equitable fraud is inequitable or unconscionable conduct. It usually involves damage to another’s proprietary or quasi-proprietary interest.

“Fraud” on the minority typically involves the defendant obtaining a benefit wrongfully at the expense of the company. The majority has directly or indirectly appropriated to itself money, property, or advantages which properly belong to the company. Negligence on the part of a director without any corresponding benefit to himself is not actionable by means of a derivative claim under the ‘fraud on the minority’ principle.


Expropriation

Where the shareholders do not act in good faith in the interests of the company but instead act in their own interests, there may be fraud on the minority. The majority’s actions must be such that they come close to, or are in substance, an expropriation of the minority’s interest in the company or of part of it.

Typically, the majority/ controllers do not act in good faith. They act to benefit themselves at the expense of the company and the minority. The majority shareholders/ directors/ controllers divert benefits to themselves, which properly belong to the company as a whole. Their inequitable unconscionable action leads to a diminution of the minority’s proprietary interest in their shares.

In some cases, the company enters a transaction with the majority shareholders, which is clearly for their benefit and not in the company’s interests. The requisite element of inequitable conduct may be present where the controller/ majority benefit personally to the detriment of the company. It may be readily apparent that the transaction is not in the interests of the company, but is in the interests of the controllers.


Constitutional Issues

There is some support for the view that constitutional considerations may arise in cases involving fraud on the minority. It is argued that the majority should exercise its powers in accordance with natural/ constitutional justice. This is on the basis that companies are creatures of statute and are thereby subject to constitutional fair procedure obligations, where the proprietary interests of other are in jeopardy.

It is argued that the majority must listen to and hear the concerns of the minority, at least in some circumstances.  The minority’s rights in their shares are property rights.  If the minority is not given a fair hearing in relation to matters affecting and which may deprive or limit their rights in the sense of depriving them of the benefit of their property, it is argued that the courts should intervene.

The argument that constitutional considerations should apply in this context, is controversial. The courts are likely to consider both the procedural and substantive aspects together, in in any event, in judging whether the majority has acted in good faith.


Where Justice Permits

It has been argued that there is or should be a further exception to the rule in Foss v Harbottle where the justice of the case so requires. While the wide import of the term ‘fraud’ enables most deserving cases to avail of the exception, it has been said that there is probably no good reason why the courts should not carve out further exceptions, if justice so requires. The rule should not be applied in so rigorous a fashion so as to lead to injustice.

Against this, it is argued that the entitlement of a shareholder to pursue by way of derivative action a claim for and on behalf of a company is an exception to an “elementary principle”  of company law and that as such, it should not be broadly or liberally available.

A very strong case is required in all cases. Any extension would have to be consistent with the principles underlying the rule and the exceptions to it. This include the reluctance of the courts to interfere in the internal management of a company.


References and Sources

Primary References

 

Companies Act 2014 (Irish Statute Book)

Companies Act 2014: An Annotation (2015) Conroy

Law of Companies 4th Ed.  (2016)     Courtney

Keane on Company Law 5th Ed. (2016) Hutchinson

Other Irish Sources

Tables of Origins & Destinations Companies Act 2014 (2016) Bloomsbury

Introduction to Irish Company Law    4th Ed. (2015) Callanan

Bloomsbury’s Guide to the Companies Act 2015      Courtney & Ors

Company Law in Ireland 2nd Ed. (2015) Thuillier

Pre-2014 Legislation Editions

Modern Irish Company Law   2nd Ed. (2001) Ellis

Cases & Materials Company Law 2nd Ed. (1998) Forde

Company Law 4th Ed. (2008)  Forde & Kennedy

Corporations & Partnerships in Ireland (2010) Lynch-Fannon & Cuddihy

Companies Acts 1963-2012   (2012)  MacCann & Courtney

Constitutional Rights of Companies   (2007)  O’Neill

Court Applications Under the Companies Act (2013) Samad

Shorter Guides

Company Law – Nutshell 3rd Ed. (2013) McConville

Questions & Answers on Company Law (2008)        McGrath, N & Murphy

Make That Grade Irish Company Law 5th Ed. (2015) Murphy

Company Law BELR Series (2015)   O’Mahony

UK Sources

Companies Act 2006 (UK) (Legilsation.gov.uk)

Statute books Blackstone’s statutes on company law (OUP)

Gower Principles of Modern Company Law 10th Ed. (2016) P. and S. Worthington

Company Law in Context 2nd Ed. (2012) D Kershaw

Company Law (9th Ed.) OUP (2016) J Lowry and A Dignam

Cases and Materials in Company law 11th Ed (2016) Sealy and Worthington

 

UK Practitioners Services

Tolley’s Company Law Handbook

Palmer’s Company Law