Derivative Action Suits in Corporate Litigation in India

Derivative Action Suits in Corporate Litigation in India.

[Virali Nagda]

The author is a fourth-year student of NALSAR University of Law.

A derivative action, also called the shareholder derivative suit, comes from two causes of action, actually: it is an action to compel the corporation to sue and it is also an action brought forth by the shareholder on behalf of the corporation for redressal against harm to the corporation.[1] Such an action allows the shareholders monitoring and redressal of any harm caused to the corporation by the management within, in a case where it is unlikely that the management itself would take measures to redress the harm caused. Thus, the action is ‘derivative’ in nature when it is brought by a shareholder on behalf of the corporation for harm suffered by all the shareholders in common. This happens when the defendant is someone close to the management, like a director or corporate officer or the controller. If the suit is successful, the proceeds are forwarded not to the shareholder who brought the suit but to the corporation on behalf of which the cause of action was established.

If the American literature on this subject is to be believed, then the historical foundations of the derivative suit lay in the corporate purpose. This debate over the purpose raged in the first half of the 20th century with the proliferation of major conglomerates as public corporation where investors could buy stock in the corporation on the public stock exchange but had close to no control or active role in the management of the corporation.[2] Even before the early 20th century when most corporations were privately owned by the small groups of shareholders who managed the corporations,[3] there was a judicial struggle to understand the corporate purpose when shareholders sought to challenge the directors running the management of the corporations. This American literature roots different from the Indian base of derivative action, which comes not from a principled provision of the company law rules and legislation in the country but simply from the willingness of the courts here to rely on principles from the English common law. The provision that the law has provided with is redressal against oppression and mismanagement of the company where the Companies Act, 2013, has allowed for a provision of class action suits[4] to be filed by shareholders against directors or other officers of the company in cases of mismanagement. In the event of this section being now notified, this paper is an attempt to look at literature around derivative suits in India and the supplement of class action suits to understand where the interpretation and applicability of derivative suits in India stands at, presently.

Historical and Normative Foundation of Derivative Suits

Commentators have often claimed that the United States had imported the principle of shareholder derivative action from England.[5] The representative litigation in early cases of the English Court of Chancery showed semblance to the class action suits of today.[6] This was developed gradually from the communal harms within the thriving feudal societies of the 12th-15th century England. The American Revolution gave way from the precedent method of England for matters of corporate litigation to permitted exception to the necessary parties’ rule, a form of representative party law suits quite different from the contours of the actions in England.[7] The classification began when for the first fifty years post-independence the United States permitted shareholders to bring suits on behalf of themselves and all other shareholders,[8] but then near the later part of 1940, courts began to often describe such lawsuits as those being brought on behalf of the corporation itself.

The seminal case on shareholder derivative action is the English case of Foss v. Harbottle,[9] where the court had to consider the question of whether it was acceptable to depart from the rule of corporation suing in its own name and character as against that in the name of someone whom law appointed as its representative. Relying on the words of its predecessor Wallworth v. Holt[10] which allowed the consensus of all shareholders of a joint stock company to be represented by its shareholder in a suit against mismanagement, the court in Foss recognized the involvement of a true corporation and consequently recognized the right of its shareholders to bring a lawsuit to court on behalf of all the shareholders in some situations. The US courts in bringing this interpretation, understood homogeneity of interests of persons involved in a corporation or an organisation as with the interest of the corporation or organisation itself and thus allowed the shareholder’s cause of action to be derivative to the corporation’s interest in the cause of action.[11] Clear recognition to the shareholders’ derivative suits came when American courts restricted shareholders to filing suits only in circumstances where corporation was incapable of seeking redressal.[12] Percy v. Millaudon[13] was the first case decided in the Louisiana Supreme Court which appears to have accepted derivative action suit. The English cases that percolated in the following of the class action of the Chancery court slowly allowed the exception rule to allow corporation representation for the interest of the shareholders.

Derivative Suit as an Exception to the Principle of Corporate Law 

The voting rules in company law ensure that the shareholders who won the largest stake in the corporation are allowed the greatest impact on the venture policy, simply because these shareholders will gain most from the good performance and lost most from the bad performance of the venture giving them the largest incentive to maximize welfare interests of the corporation.[14] The minority share-holders then have no power to act on behalf of the venture or limit the will of the majority. This relative lack of power for the latter does not otherwise disadvantage them since the benefit of this decision-making mechanism is accrued to the minority as well. In this fundamental principle of corporate law, the derivative suit is a striking exception as shareholders with the tiniest of investment in the corporation can also bring the derivative suit on behalf of the corporation.[15] The litigation costs of such suit are then accrued by the corporation itself. This then encounters the problem of perverse incentive where the shareholder with the minor share does not understand the effect of the litigation on the maximisation of shareholder wealth and such lawsuit can cause more damage than harm to the value and liquidity of the corporation.

The subsequent question that arises is the limit and scope of allowing derivative actions by shareholders and this is where literature allows one to bring this conceptual question in consideration of the Indian context. India becomes an important case study for derivative action suits not simply because it is now the only country in Asia that has not encouraged this possibility considering the nature of the commercial market, but also because it is one of those countries who by their common law heritage have substantial limitations on their derivative action suits.

These actions are more valuable in certain ownership and institutional mechanism.[16] The scope comes in where the shareholders of the corporation are widely dispersed and raise collective action concerns due to weaker institutional structures; and the value of such suits rises as enforcement mechanisms.[17] Literature gives us a jurisdictional transition that the Indian commerce stands at- the wider and more dispersed shareholder with the absent role of management of minority shareholder in the corporation. And in spite of this, there is a strikingly high limitation placed on the use of derivative action in India, supplemented by the present legal, judicial and economic landscape.

Analysing the Advantageous Circumstance of Derivative Suits

There is a severalty in the modality of enforcement of laws. Public enforcement of laws results in penalties imposed through government initiated proceedings. Private enforcement allows for recovery of damages to the victim of the wrongdoing in the suit.[18] Derivative suits are a type of private enforcement which therefore allows a claim induced judgment for the subject corporation. Private enforcement means that victims have more access to information about the wrong which the enforcing agents in public enforcement would now be able to access.[19] Direct suits do not always allow the aggregate representation that derivative suits can afford, simply because of the nature of their suing.[20] The larger incentive is that rarely do plaintiff shareholders end up paying the costs of claims, because it becomes incumbent upon the corporation of incur these litigation costs. This stands in contrast with the nature of a direct suit where the shareholder plaintiff must pay his own costs.

Derivative Suit in India

Derivative action thus has more than the limited value ascribed to it in India. But combined with the Indian provision on contingency fees, as well as the liquidity guarantees for the shareholders in the stock market, derivative suit holds a strong case of its own.

The only way of invoking the provisions of derivative suit in India is by reference to the UK case law, the header of which is the Foss case discussed above. Extending the ratio which disallowed an individual shareholder to bring suit unless there was direct harm,[21] the corporation which suffers harm can be held plaintiff by any of the shareholders of the subject corporation. There have been a very small number of cases that have been filed on derivative suit principle, and even fewer admitted. But this admittance means that the exclusion clauses still apply: meaning that the exceptions from Foss allow the shareholders in India to sue on behalf of the corporation in cases of a) ultra vires or illegal transactions b) matters requiring special resolution and c) fraud on the minority itself. The Indian courts have added their own qualifiers to these exceptional allowances, as in the case of Needle Industries (India) Ltd. v. Needle Industries Newey (India) Holding Ltd.[22] where the court ruled out the case if the benefit accrued to accused directors was incidental in nature.

Therefore other than the additional common law principles like clean hands doctrine, there are also certain procedural bars to such suits, one amongst which is the representative suits as defined in the Civil Procedure Code of India.[23] In both, the joinder was made to ensure that multiplicity of litigation was avoided. But the plaintiffs in both are different because representative suit includes company in the suit as a defendant while the other is law suit on behalf of the corporation where claim is derived from that of the plaintiff shareholder, that is, the company becomes the main plaintiff. This distinction was drawn by the court in Jaideep Halwasiya v. Rasoi Ltd.,[24] while also making the distinction that derivative suits had an additional qualification of being allowed when the obligations could otherwise not be enforced on the wrongdoer, suggesting a lack of sufficient litigation.

Class Action Suits as an Alternative Remedy

That is not to say that there is no other provision that allows the accountability check on the directors and board of the corporation. Company law provides for the Tribunal to hear cases where mismanagement occurs, phrased as when the ‘affairs of the company are being conducted in a manner prejudicial to public interest or in a manner prejudicial to the interests of the company’ or when a ‘material change in the management of the company occurs which is likely to affect the affairs of the company prejudicially…’

To the extent that both this and derivative suit recognize claims for direct losses they are similar but then the recent provision in the Companies Act of 2013 allowing class action suits makes them different insofar as remedy is provided through the NCLT and not regular civil courts. The NCLT which is a quasi-judicial body is not subject to the impediments of a regular court as was laid down by the Supreme Court recently.[25] Additionally, the J.J. Irani Committee which recently conducted a review of the company law noted the presence of these derivative action cases in courts[26] but the paralleled absence in statute.[27] Meaning, there is a calling need for the statute to register this concept as necessary to be codified, bringing a certain balance in the remedies provided and filling the void where precedence are not accepted as opportune enough to allow derivative representation to be made by shareholders in accessible regular civil courts.

Conclusion

The above literature survey has shown a stark desirability of the provisional need for derivative suits in Indian company law legislation.Additionally, procedural screens need clarity and this combined with the legislative allowance of the mechanism in the first place means that the plaintiff shall no longer need to restrict himself to the capacity of representative suit via CPC if need be to institute suits in mediums accessible to all- regular civil courts.

[1] Aronson v. Lewis, 473 A.2d 805, 811 (Del. 1984) (“The nature of the action is two-fold. First, it is the equivalent of a suit by the shareholders to compel the corporation to sue. Second, it is a suit by the corporation, asserted by the shareholders on its behalf, against those liable to it.”). Also seen in Brown v. Tenney, 532 N.E.2d 230, 232 (Ill. 1988).

[2] Charles R.T. O’Kelley, ‘The Evolution of the Modern Corporation: Corporate Governance Reform in Context,’ U. ILL. L. REV. (forthcoming 2013).

[3] Adolf A. Berle & Gardiner c. Means, The Modern Corporation and Private Property, xxx-xxxv (rev. Ed. 1967) (1932).

[4] Section 245, Chapter XVI under the Companies Act 2013.

[5] Nicholas Calcina Howson, ‘When “Good” Corporate Governance Makes “Bad” (Financial) Firms: The Global Crisis and the Limits of Private Law,’ 108 Mich. L. Rev. First Impressions 44, 47 (2009).

[6] Raymond B. Marcin, ‘Searching for the Origin of the Class Action,’ 23 CATH. U. L. REV. 515, 517–24 (1974).

[7] Graham C. Lilly, ‘Modeling Class Actions: The Representative Suits as an Analytic Tool,’ 81 NEB. L. REV. 1008, 1013-14 (2003).

[8] Chancey v. May, 57: When the English Chancery Court held that part of the proprietors of an enterprise may bring suit without making all the proprietors actual parties, if they sue on behalf of themselves and all the proprietors.

[9] Foss v. Harbottle, (1843) 67 Eng. Rep. 189 (Ch.); 2 Hare 461.

[10] Wallworth v. Holt, (1841) 41 Eng. Rep. 238 (Ch.) 244-46; 4 My. & Cr. 619, 634-40.

[11] Mason v. York & Cumberland R.R. Co., 52 Me. 82 (1861).

[12] David A. Skeel, Jr., ‘Shareholder Litigation: The Accidental Elegance of Aronson v. Lewis,’ in The Iconic Cases in Corporate Law 165, 167 n.4 (Jonathan R. Macey ed., 2008).

[13] 8 Mart. (n.s.) 68 (La. 1829).

[14] Daniel Fischel and Michael Bradley, ‘Role of Liability Rules and the Derivative Suit in Corporate Law: A Theoretical and Empirical Analysis,’ Cornell Law Review, Vol. 71, Issue 2 , pp. 261-298.

[15] Ibid.

[16] Vikramaditya Khanna and Umakanth Varottil, ‘The Rarity of Derivative Actions in India,’ Berkeley Business Law Journal, Vol. 9, Issue 1 (2012), pp. 1-28.

[17] Black, Bernard and Reinier Kraakman, ‘A Self-Enforcing Model of Corporate Law’(1996) 109 Harvard Law Review 1911.

[18] John C. Jr., ‘The Rise of Dispersed Ownership: The Roles of Law and the State in the Separation of Ownership and Control’ (2001) 111 Yale Law Journal.

[19] Landes, William and Richard A. Posner, ‘The Private Enforcement of Law’ (1975) 4 Journal of Legal Studies.

[20] Kraakman, Reinier R., et al., ‘The Anatomy of Corporate Law: A Comparative and Functional Approach,’ (Oxford: Oxford University Press, 2009).

[21] Nagappa Chettiar v. The Madras Race Club, (1949) 1 MLJ 662 (Mad).

[22] AIR 1981 SC 1298.

[23] Order I Rule 8, Civil Procedure Code, 1908.

[24] [2009] 150 Comp. Cas. 1 (Cal).

[25] Union of India v. R. Gandhi, Civil Appeal No.3067 of 2004 (judgment dated May 11, 2010).

[26] Onyx Musicabsolute.com Pvt. Ltd. v. Yash Raj Films Pvt. Ltd., MANU/MH/0583/2008.

[27]Irani Jamshed J, Report on Company Law (31 May 2005), at para. 10.1.

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