Confused Jurisprudence on Derivative Actions in India

[By Harsh Tomar]

The author is a student at the National Law School of India University (NLSIU), Bengaluru.

In this piece, through the analysis of the case of ICP Investments (Mauritius) Ltd v Uppal Housing Pvt Ltd. (hereinafter “ICP Investments”), the author will highlight the common misconceptions around the jurisprudence on ‘derivative action’ in India. It will be argued that the reasoning in ICP Investments is one such manifestation of the lack of clarity. The author will point out the flaws in the reasoning adopted by the Court. Further, it will be argued that derivative action is not subsumed under any other remedy in the Companies Act. Therefore, the author will further argue for a clear and separate statutorily-recognized remedy of derivative action to be adopted under the Companies Act,2013.

The Court in ICP Investments was of the opinion that after the enactment of the Companies Act, 2013 (“Act”) the derivative action as a separate remedy is no longer envisaged in India. This was mainly due to two grounds- 1) Derivative action as a separate form of remedy was not codified in the Act and 2) Such remedy is subsumed under the remedy provided under Sec. 241 of the Act.

Section 241 and Derivative action

Section 241(1) provides for remedy in cases of oppression, mismanagement, and prejudice. The Court in ICP Investments was quite confident in stating that derivative action in India is implicitly recognized under Section 241 of the Act. It is respectfully submitted that this case is a classic example of the failure of courts to understand the distinction between corporate wrongs and personal wrongs. Personal wrongs are wrongs suffered by individual shareholders and this can be remedied through oppression, mismanagement, and prejudiced actions. However, corporate wrongs are wrongs suffered by the company and it is the company only that can seek a remedy. Such wrongs can be remedied through derivative actions.

Under the Companies Act, 1956 oppression and mismanagement were two separate remedies available. Oppression could be invoked when the affairs of the company were conducted in a manner that they were oppressive to any shareholder or caused prejudice to the public interest. Clearly, this was a remedy to address a personal wrong. While the mismanagement remedy could be invoked when due to a change in the company’s management, it was believed that the affairs of the company would be conducted in a manner that would be prejudicial either to the public interest or to the interests of the company. Despite the fact that this remedy can also be applied when the company suffered prejudice, there is no jurisprudence that suggests that this was used as a derivative action.

The Companies Act, 2013 brought certain changes to this. It consolidated the oppression and mismanagement remedies and at the same time introduced an additional remedy called prejudice within a single provision i.e., Section 241. It is important to note that prejudice can be invoked when prejudice is caused not only to shareholders but also to the company. Hence, this may tempt one to jump to the conclusion that this is in fact statutory recognition of derivative action. This was the exact situation in the ICP Investments case.  At present, there doesn’t seem to have any clear court pronouncement on this, however, it is submitted that the provision should only be invoked when the prejudice caused to the company is coupled with evidence of personal wrongs. Otherwise in all corporate wrongs Section, 241 of the Companies Act 2013 can be invoked which is clearly not what the legislature would have intended. Such interpretation is also supported by some judgments from Singapore where a distinction between a purely private wrong and a private wrong which also comprises some corporate wrong was made.[i] Additionally, just because there is a possibility to grant a remedy to a company in a direct action under Section 241,[ii] it will not change the character of action from a direct to a derivative action.

It is important to not conflate direct and corporate claims, which is what the court in fact did. This is because firstly, in a direct claim there are no substantive filters required.[iii] However, under the common law derivative claim, which is recognized in India, there are many criteria that the court may consider before admitting such a claim. First, the plaintiff has to establish that there is fraud on minority. Second, the shareholder must come with clean hands and hence is required to take leave of the court before proceeding with the derivative action. And third, since the action is on behalf of the company, the court will also consider whether proceeding with the action is in fact in the interest of the company. There are no such criteria provided under Sections 241-244 of the Act which further substantiates the argument that derivative action is not subsumed in them. Secondly, the remedy sought and the benefit of the action under both the claims is drastically different. The two remedies are different in nature and serve completely different needs.

Section 245 and Derivative action

Although the Delhi HC in the ICP Investments case for some unstated reasons did not allude to Section 245, people still tend to confuse it with derivative actions. This is mainly due to certain similarities between the two remedies.[iv] However, it is submitted that class action suits recognized under Section 245 are different from the idea of shareholder derivative action. Section 245 is an enabling provision that allows a few shareholders to seek remedy on behalf of all the other shareholders whose right has been infringed i.e., they form a ‘class’ among themselves. It is also quite relevant to note that under Section 245, the shareholder(s) can seek remedy against the company. This is very different from the conceptual understanding of derivative actions where the remedy is sought on behalf of the company. Also, in a derivative claim, a single shareholder can bring a claim to court. He is not mandated by law to collate his claim with similarly suited individuals in order to bring it before the court, which is the case with a class action suit under Section 245 where at least 100 members are required.

A quick glance over the remedies granted under Section 245(1) and Section 242 would indicate that almost all of them are directed at the company rather than for the benefit of the company which is the purpose of a derivative action. Hence, through the entire scheme of remedies under these sections, it is clear that they are consistent with direct actions and it would be wrong to consider that derivative action is subsumed under these sections.

Common Law Derivative action-no longer maintainable?

The court then relied on the assumption that globally, it has been a trend to codify derivative actions, and India has also passed a law recently owing to the recognition of the global trend and since it has not decided to make a separate provision for the same, they must have thought that the remedy has already been covered under Section 241. Hence, the court jumped to the conclusion that common law derivative action should no longer be held maintainable in India. However, it is submitted that the assumption made by the court was wrong due to the following reasons.

Firstly, the drafting history of the Companies Act 2013 does not suggest so. During the course when a standing committee was tasked to scrutinize the Companies Bill of 2011, it was brought to the notice of the committee that class action is not a correct substitute for derivative action and specific provisions for derivative action should be codified. However, the committee rejected this on the ground that concepts like derivative action “should evolve over time and should not be included hurriedly”. The Committee, however, completely missed that derivative actions and the exceptions to the rule in Foss v. Harbottle[v] were recognized in India a long time back.

Secondly, even if we assume that Section 241 covers some aspects of a derivative action, that doesn’t imply that common law derivative action will now not be maintained in India. This view is supported by the position in the UK where despite derivative actions being codified, the courts have held that the codification is not comprehensive and have recognized the existence of common law derivative actions in situations that are not covered by the statute since the statute has not expressly abolished them.[vi] In India where the statute doesn’t even expressly deal with derivative action, unlike in the UK, it will be wrong to assume that common law derivative actions are no longer maintainable.

This brings us to the most important question – Is there a need for a separate statutorily-recognized remedy of derivative action in India?

Need for Derivative action as a separate remedy?

It is important to realize that the direct-action remedies and the remedy of derivative action are not two alternate remedies. It is in fact possible that the same facts can attract both prejudice and derivative proceedings.[vii] The attempt to merge derivative action and other available statutory remedies as one will result in the reduction of the number of remedies available to the shareholders to redress the injuries caused by the directors.

Derivative action also offers certain benefits over other remedies. In class action suits under Section 245, a minority shareholder is required to collect and collate similarly placed persons to comply with the concerned section. It is a herculean task for a group of unknown persons to form a cohesive group unless a company is held by a closely held group of known shareholders. Even if the minority shareholder(s) are able to organize themselves, the provision poses other obstacles. The Tribunal will subjectively decide whether the petition is made in good faith and whether the cause of action is one that the member could have pursued in his own right rather than through the class action suit.

The derivative actions also provide greater economic benefits than direct actions. In a successful derivative action, all the shareholders and non-shareholders receive the benefits while in direct action, it is only the aggrieved shareholder that is enriched from the remedy the company enjoys no benefit.

Conclusion

At present, one of the major hurdles to the success of derivative actions in India is the lack of clarity. The decision in ICP Investments, as has been argued through this paper, is one such example of this. Statutory recognition of derivative suits in India would remove the ambiguity that currently surrounds the jurisprudence on derivative actions. It is important to effectively define the cause of actions that can give rise to a derivative action and differentiate them from those of other private remedies rather than merging the two remedies. The drafters should also take lessons from the experience with the common law derivative action and address the major problems like the costs of litigation. This will ensure a more viable, comprehensible, and efficient protection regime as it will result in added protection to the interest of a company and the minority shareholders. However, if the findings in the ICP Investments case stand, it would not only add further confusion to the jurisprudence of derivative actions in India, but will also diminish the power of shareholders to seek remedies for the wrongs caused to companies, and further diminish the strength of corporate governance in those companies.

 

[i] Ng Kek Wee v Sim City Technology Ltd (2014) 4 SLR 723 [63] and Ho Yew Kong v Sakae Holdings Ltd (2018) 2 SLR 333.

[ii] This will also apply to Section 245. For more details SeeKumagai Gumi Co Ltd v Zenecon Pte Ltd [1995] 2 SLR(R) 304 (Singapore Court of Appeal) where it was held that it is not uncommon to provide relief to the company in a direct action.

[iii] Under Section 244(1) the only filter applicable for direct action i.e., the oppression, prejudice, and mismanagement action is the requirement that it must be supported by a certain minimum number of shareholders.

[iv] Under Section 245 (5) (d) it is the company that is required to pay for the cost of litigation and under Section 245 (1) the shareholders or depositors are allowed to sue for the company’s interest also.

[v] (1843) 2 Hare 461.

[vi] Homes for England v Nick Sellman (Holdings) Ltd (2020) EWHC 936 (Ch), Boston Trust Company Ltd v Szerelmey Ltd (2020) EWHC 1352 (Ch).

[vii] Ehsman v Nutectime International Ptv Ltd (2006) 58 ACSR 7051.

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