Derivative Action as A Right of The Shareholder

Derivative actions allow minority shareholders to enforce a company's rights when the management, majority shareholders and/or directors, are in breach of their duties. In India, derivative actions are recognized as common law rights and there are no specific statutory provisions.

Derivative action can be used for initiating a civil case against a company and its management by a shareholder or even a Promoter/shareholder on behalf of a corporation to enforce or defend a legal right or claim, that the corporation has allegedly failed to address. Such actions are typically brought against ‘miscreants,’ including directors and management, alleging fraud, mismanagement, or dishonesty which may tarnish the reputation and adversely affect the interest of the company.

United Kingdom statutorily recognizes derivative actions under Part 11 of the Companies Act, 2006 against the director or another person (or both) in respect of a cause of action arising from actual or proposed acts or omissions involving any negligence, default, breach of duty or breach of trust by a current, former director of the company [Section 260(3) Companies Act, 2006 (UK)].

FOSS v/s HARBOTTLE is a leading English precedent in company law which laid down the principles of derivative action suits, which are relevant to date. The case highlighted that the company is a separate legal entity from its shareholders and can sue or be sued in its own right and recognised that, if any loss is suffered by the company by the negligent or fraudulent actions of its members or outsiders, then an action can be brought in respect of such losses, either by the company itself or by away of derivative action.

However, if strictly applied, the parameters laid down in the above case are challenging for the minority shareholders to take steps under derivatives action, especially in the event, a company suffers from managerial misconduct from those who may hold the majority of voting rights, and/or control the majority of shareholders. In order to address this eventuality, common law courts have allowed shareholders to pursue litigation on behalf of the company in limited circumstances, known as exceptions to the rule of FOSS v/s HARBOTTLE.

It has been observed that though the courts in India are hesitant to categorize cases as derivative actions due to lack of statutory provisions, they have time and again allowed derivative action suits. However, the Indian courts have been strict while applying the parameters laid down in Foss v Harbottle.

The Calcutta High Court emphasized the importance of derivative action when wrong doing is done by miscreant directors, making it necessary for minority shareholders to protect the company's interests, while the Bombay High Court relied on the exception to FOSS v/s HARBOTTLE rule, allowing shareholders to maintain action if wrongdoers control company's interests, and act against the company's interests. The benefit and remedy are intended for the company, not the individual shareholder initiating the action.

Contrarily, the Delhi High Court in one of the cases deviated from common law procedures by using key factors in the preliminary stage and applied the doctrine of good faith instead of clean hands, and selectively relied on evidence. The court also narrowed the grounds for derivative action claims by linking them to Section 241 of the Companies Act,2013, that is a shareholder-centric remedy.

Thus, lack of uniformity from the Indian Courts in derivative action claims, has made it a less exercised option.

It is time, India formulates statutory provisions for derivative actions as clear statutory basis for derivative action can avoid confusion caused by varying court interpretations.

Specific and unambiguous statutory provisions, increased awareness, and streamlined procedures are needed to encourage minority shareholders to utilize derivative actions as a tool and strengthen shareholder protection in the country's corporate statutory framework.

Mahua Roy Chowdhury is the Founder and Managing Partner of Royzz & Co. Advait Borade is an Associate at the Firm.

This article is intended as a general guide on the subject matter. It is advisable to seek professional guidance about specific instances.