BIG BUSINESS BEWARE – THE CLASS AND DERIVATIVE ACTIONS ARE COMING! BY CARL STEIN

Friday, April 17, 2009
  • SHARE THIS ARTICLE

The trend over the past decade in the USA, and more recently in the UK after the enactment of its new Companies Act in 2006, towards more aggressive shareholder activism seems likely to be followed in South Africa once our new Companies Act becomes operative.  This new Act is only awaiting the State President’s signature in order to become law, although it will only come into operation at least one year after the State President does so.
In recent years, South African institutions and quasi-governmental shareholders have curtailed some of the powers of boards of directors of public companies by, for example, voting against the annual shareholders’ resolution authorizing such boards to issue shares for cash at their discretion during the next year and by applying pressure to limit excessive remuneration packages.  These actions have, however, been little more than irritants to most boards of directors, who have had the luxury of being shielded by a Companies Act that is relatively toothless when it comes to the powers and remedies available to minority shareholders and other stakeholders, such as employees, against directors who they believe have excessive powers or who take decisions which they regard as being harmful to the companies in which they have invested or they serve.
All this is set to change dramatically.  In line with USA legislation, the pendulum will swing – some would argue to the other extreme.  Not only will the new Act significantly increase the exposure of directors and other officers to personal liability if they don’t do their jobs properly, it will also see the introduction of new legal weapons into the arsenal of stakeholders’ rights which are far more powerful than they ever had before, two of which are the class action and the derivative action.  The combination of the two may prove to be lethal in certain circumstances.
The class action is legislated for in S157 of the new Act, which simply and succinctly provides that, if any matter can be brought before a court in terms of this Act, the right to do so “may be exercised by a person acting as a member of, or in the interest of, a group or class of affected persons”.
The derivative action is more complex and thus requires a brief explanation.  The law regards a company as being a separate legal person.  But, of course, a company cannot think for itself; its mind is its board of directors.  So, where a company has suffered, or may suffer, loss or has been, or may be, harmed, it is the company’s board of directors, and its board alone, which has the power to take remedial action.  This often requires a board decision to institute legal or similar proceedings on the company’s behalf.  In very limited instances, however, a shareholder who believes that legal action should be taken on the company’s behalf in circumstances where its board of directors has failed or refused to do so, can apply to court for an order to effectively force the board to do so.  This is the derivative action.
The difficulties faced by shareholders under the present regime are twofold.  Firstly, our courts have been reluctant to interfere with the decisions of a company’s board of directors unless the directors themselves have acted illegally or unlawfully.  Secondly, although the present Companies Act does contain a form of the derivative action in S266, it has proved to be largely ineffectual because the costs of bringing such an action are prohibitive in most cases and because it is very restrictive in its scope for the following reasons 
– a shareholder, and no one else, may bring derivative proceedings;
– S266 may only be invoked if a company has sustained damages or loss, or been deprived of any benefit, as a result of "any wrong, breach of trust or breach of faith" committed by a director or officer, and no one else; and
– the complainant shareholder must apply to court for the appointment of a person called a curator ad litem to investigate the claim, who must then report back to the court with a recommendation as to whether or not the court should order the company to commence legal proceedings before a court may order a company to do so.
The new Companies Act will drastically change the law, the scope and the procedure in relation to derivative actions, all in favour of shareholders and other stakeholders.  Undoubtedly, the result will be that directors and officers of companies will be far more exposed to the threat of derivative actions.  Furthermore, they may well find themselves in precarious positions even if derivative claims against them do not progress beyond the first stage, or even if they ultimately succeed in quashing the derivative claim in subsequent court proceedings.
It will be entirely possible for a class action to be instituted by way of derivative proceedings.  In fact, the new Act envisages this very situation by effectively providing in S165, being the section which contains the new derivative action, that a person’s right to bring a derivative action may be exercised by another person on that person’s behalf in the manner permitted by S157.
The new derivative action will be extremely broad in a number of respects.  Firstly, the following persons may initiate derivative proceedings 
– a shareholder of the company or of a “related company”, which includes a holding company, a subsidiary and fellow subsidiaries; or
– a director or prescribed officer of the company or of a related company; or
– a registered trade union or another representative of the company’s employees; or
– a person who has been granted leave of the court to do so, which may be granted if it is necessary or expedient to do so to protect a legal right of that person.  This would include creditors, amongst others.
Secondly, S165 broadens the scope of the derivative action considerably by empowering any of the above persons to initiate derivative proceedings in order to “protect the interests of the company”.  These words send shivers down the spines of lawyers who advise big business because our courts have consistently given a very wide interpretation to the word “interests”.  There is a clear legal distinction between the words “rights” and “interests”.  The former means a legally recognised and enforceable claim.  The latter means a mere concern, involvement or investment, which could be of a financial, legal or even an environmental nature, to name but a few.
Thirdly, S165 provides that all a person has to do to commence derivative proceedings is simply serve a demand on the company to do so.  The company (ie, the board) may apply to court to set aside such a demand but only on the very narrow grounds that the demand is “frivolous, vexatious or wholly without merit”.  If it does not do so, the board is then obliged to appoint an independent and impartial person or committee to investigate the demand and then report to it on any facts or circumstances that may give rise to a legal claim, as well as the probable costs of the legal proceedings and whether it appears to be in the best interests of the company to pursue the legal action.
The board has three months after being served with the demand to either initiate the legal proceedings or to inform the person who made the demand that it refuses to do so.  If, after having considered the report, the board refuses to comply with the demand, the person who made the demand may still apply to court for leave to bring legal proceedings in the name and on behalf of the company.  A court may grant such leave only if it is satisfied that the person is acting in good faith, the proceedings “involve the trial of a serious question of material consequence to the company” and such grant is in the best interests of the company.  It is true that it may prove to be too costly for the complainant to apply to court.  Even if he does, he may have great difficulty in so satisfying the court.  But by then the damage may well have been done.  The board may have spent up to three months of valuable time and effort dealing with the demand and the report, the costs incurred in obtaining the report may be material, the negative publicity which the demand may trigger may be harmful to the board if the proposed legal proceedings are contraversial, and there may be significant disruptions to the company’s business if the demand is made by, for example, a trade union on behalf of the company’s employees.
To add fuel to the fire, S165 also provides that even if the company’s shareholders have approved any particular conduct of its board, such approval does not prevent a person from making a demand or otherwise invoking any provision of S165, but a court may take that approval into account in deciding whether or not to order legal proceedings to commence.
Carl Stein is a director in the Corporate Department at Bowman Gilfillan.