What is a Statutory Derivative Action?
A common issue faced by the shareholders of a company is the redress available to them if the directors or other parties with control over the management of the company cause harm to the company’s financial health and therefore devalue the company’s share capital.
In these instances, the aggrieved shareholder may face a barrier to seeking a remedy since the company, rather than the shareholder personally, suffered the harm and therefore the company will be the proper applicant to commence proceedings.
Where the harm caused is the result of a director’s wrongful actions, it is unlikely that those directors will commence proceedings in the name of the company to address the wrong.
In these circumstances, sections 236 – 242 of the Corporations Act (Cth) 2001 (Corporations Act) create a statutory regime through which shareholders or officers of a company can commence derivative proceedings on behalf of a company to pursue a wrong suffered by the company.
A crucial point to remember when considering whether to commence a statutory derivative action is that the proceedings will be commenced in the company’s name. Therefore, the remedies available if the derivative action is successful are for the benefit of the company, so that, for example, if an order for damages is made, monies recovered will not go to the applicants that commenced the derivative action on behalf of the company but instead will be paid to the company for the benefit of the company as a whole.
How to commence derivative proceedings
Before commencing a statutory derivative action, section 237 of the Corporations Act sets a number of hurdles that a potential applicant must meet before the Court allows it to bring the action.
The elements that must be met by a potential applicant to bring a derivative action are:
- it is probable that the company will not itself bring the proceedings, or properly take responsibility for them;
- in bringing the proceedings, the applicant is acting in good faith;
- it is in the best interests of the company that the applicant be granted leave;
- there is a serious question to be tried in the proceedings; and
- the applicant has given requisite notice to the company of its intention to apply for leave and the reasons for applying for leave to commence the derivative action.
In the matter of Winifred Avenue Pty Ltd [2023] NSWSC
A recent case which involved an application for derivative relief is In the matter of Winifred Avenue Pty Ltd [2023] NSWSC.
The facts
The applicant, Mr Karam, a director and shareholder of Winifred Avenue Pty Ltd was successful in meeting the above hurdles and therefore obtaining leave to commence a statutory derivative action, despite potentially being in breach of director’s duties himself.
In the Winifred Avenue matter, Mr Karam brought proceedings against the other company director and shareholder, Mr Fox, in circumstances where Mr Karam alleged that Mr Fox had improperly retained company monies. On behalf of the company, Mr Karam sought a declaration that Mr Fox was in breach of his fiduciary, equitable and statutory duties and sought judgment in the sum of $2,783,565 less any dividends Mr Fox was entitled to or orders by way of constructive trust, damages or equitable compensation.
In the course of the proceedings, it emerged that the defendant, Mr Fox, potentially also had a claim against Mr Karam for also improperly retaining monies that belonged to the company.
The decision
In his judgment, Black J made observations on the five elements that an applicant must prove to be granted leave to bring a statutory derivative action. His Honour’s comments on the requirements of good faith, whether there was a serious question to be tried and whether it was in the best interests of the company for Mr. Karam to be granted leave provide useful explanations of the matters the Court will consider when deciding whether to grant leave under section 237 of the Corporations Act.
The requirement of good faith
Black J cited and affirmed the decision of Palmer J in Swansson v RA Pratt Properties Pty Ltd [2002] NSWSC 583; 20 ACLC 1594, in relation to the factors that that the Court should consider when determining whether an applicant acted in good faith in applying for leave to bring derivative proceedings. These factors are whether the applicant believes that a good cause of action exists and has reasonable prospect of success and whether the applicant is seeking to bring the derivative claim for a collateral purpose that would amount to an abuse of process.
In the Winifred Avenue matter, the defendant argued that the claim was not brought in good faith as the applicant’s own conduct (being the withdrawal of company funds without apparent authority) meant that the applicant himself was in breach of his director’s and fiduciary duties and therefore did not bring the derivative claim in good faith.
Black J rejected this argument and noted that in circumstances where both directors may be in breach of their duties to Winifred Avenue Pty Ltd, it does not follow that the directors are deprived of good faith in pursing a claim in the company’s name and instead either director may potentially have an entitlement to be granted leave to pursue a statutory derivative claim.
In circumstances where Mr Karam had more than a token shareholding and it was plain that the recovery of the amount claimed against the defendant would significantly increase the Company’s assets, Black J held that Mr Karam was acting in good faith in bringing the derivative claim.
Whether there is a serious question to be tried
In his decision, Black J noted that the test of whether there was a serious question to be tried had a relatively low threshold, as would apply in the case of an interlocutory injunction. In granting leave, the Court is not required to resolve disputed questions of fact.
The best interests of the Company
In determining whether it was in the best interests of Winifred Avenue Pty Ltd for Mr Karam to bring proceedings on its behalf, Black J took into account the nature of the company’s operations so as to understand the effects of litigation, whether there was any other way to obtain the same redress via a different avenue and the defendant’s capacity to meet at least a substantial part of any judgment awarded in the company’s favour.
Black J, taking into account the amount of money involved and the risk to Winifred Avenue if those monies were not repaid (including that the return of those monies would assist the company in paying its creditors and increase the company’s share value), noted that it was plainly in the best interests of Winifred Avenue Pty Ltd for Mr Karam to bring the proceedings in its name.
Two other matters were noted by Black J in coming to this decision.
The first being that had either party sought orders for a receiver to be appointed, Black J would have been inclined to make those orders, noting that this would be a more efficient and cost-effective course of action.
The second was that the applicant, Mr Karam indemnified Winifred Avenue in respect of the costs to which the company would be exposed by the conduct of the proceedings. By agreeing to pay the company’s costs if a costs order was made against it, Mr Karam reduced the risk to the company if the proceedings were not resolved in the company’s favour.
Who pays for a statutory derivative action?
The question of who pays for a statutory derivative action is an important consideration that should be taken into account before commencement of such proceedings.
Section 242 of the Corporations Act gives the Court the power to make any orders it considers appropriate about the costs of the person who applied for or was granted leave, the company and any other party to the proceedings.
The Court therefore has the discretion to make an order that the costs of the aggrieved party who is bringing a derivative action on behalf of the company be indemnified from the company’s funds, however, it may also make orders that the aggrieved party indemnify the company for the costs the company may incur in the proceedings, including any adverse costs order made against the company.
In the Winifred Avenue matter, the fact that the plaintiff was willing to indemnify the company for its costs was a relevant consideration in Black J’s determination of whether the proceedings were in the best interests of the company.
Therefore, before commencing a derivative action it is important to consider whether the plaintiff has the capacity to indemnify the company if the derivative action is unsuccessful.