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204 Critical company law

20 per cent shareholding and Mr Nizar and his son together held 60 per cent. As majority shareholders they voted on an ordinary resolution to have Mr Ebrahimi removed from his directorship. And, as all the company’s profits were paid as directors’ remuneration rather than dividends Mr Ebrahimi was e ectively removed from both the management of the business and its profits. The court held that the company should be dissolved on ‘just and equitable’ grounds because the character of the company was one that was based on mutual trust and this had been lost, leaving Mr Ebrahimi with no right to the profits and no power to dispose of his shares. Lord Wilberforce stated that the ‘just and equitable’ provision enables ‘the court to subject the exercise of legal rights to equitable consideration; considerations, that is, of a personal character arising between one individual and another, which may make it unjust, or inequitable, to insist on legal rights, or to exercise them in a particular way’.43 And although the circumstances in which those considerations will apply are not clear cut, he stated, it would probably include more than one of the following elements. First, ‘an association formed on the basis of a personal relationship, involving mutual confidence’.44 Second, that all or some of the members will participate in the company’s management and third, where the member’s stake in the business is restricted, ‘so that if confidence is lost, or one member is removed from management, he cannot take out his stake and go elsewhere’.45

Section 459 Companies Act 1985

A member of a company may petition to the court under s 459 on the grounds that the company’s a airs are being conducted in a manner which is ‘unfairly prejudicial’ to some or all of the members. Under s 461 if the court was satisfied that a petition is well founded it has discretion to make ‘such order as it thinks fit’. This specifically included making an order to regulate the company’s future activities, making an order to stop doing the act complained of or to act if the complaint was a failure to act, making an order authorising civil action in the company’s name on its behalf and finally making an order requiring the company or any members of the company to purchase the petitioner’s shares. The value of shares could either be made pro rata, a percentage of the total value of the company, or discounted for being a minority holding. In Bird v Precision,46 the court held that in general, shares were to be valued on a pro rata basis, particularly if the shares were purchased at the time of incorporation. Shares that had been purchased later and

43Ibid, p 279.

44Ibid.

45Ibid.

46Re Bird Precision Bellows Ltd [1986] Ch 658.

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where the petitioner had either been excluded from management for bona fide reasons might be valued on a discounted basis.47

The precise terms of s 459 were introduced in 198048 following a recommendation from the Jenkins Committee in 1962, and it is by far the most popular and significant mechanism for minority shareholder redress, as the empirical work undertaken by the Law Commission and discussed later testifies.

As Lord Ho man stated in Re Saul D Harrison and Sons plc,49 (examined below), the term ‘unfairly prejudicial’ was selected by Parliament specifically because it was ‘deliberately imprecise’,50 thus allowing the courts wider powers of interpretation than that provided by the earlier s 210 of the 1948 Companies Act. Furthermore, he stated, s 210, which was intended to provide a similar remedy for minority shareholders, had been ‘too restrictively construed’. Having included the term ‘oppressive’ which the House of Lords had interpreted as ‘burdensome, harsh and wrongful’ it ‘gave rise to some uncertainly as to whether “wrongful” required actual illegality or invasion of legal rights’.51

In Re Saul the Court of Appeal held that a s 459 petition could only be brought if the petitioner had failed to have his ‘legitimate expectation met’. These expectations could be found in the company’s constitution, other external agreements and a shared understanding of a fundamental nature; a fundamental understanding between the shareholders which formed the basis of their association but was not in contractual form. In this case, there was no evidence that the latter two existed and thus only the articles of association expressed legitimate expectations. As the defendants had acted within their powers under the articles and had not breached their fiduciary duties, the petition was dismissed. Neill LJ set a number of guidelines to the ‘correct approach’ to the concept of ‘unfairly prejudicial’. First, Lord Wilberforce in Ebrahimi stressed that ‘unfairly prejudicial’ were general words which should be used flexibly but that this should be tempered with Lord Ho man’s appeal to control the scope of the definition.52 Second, the conduct should relate to the company of which the petitioner is a member and third, the conduct must be both unfair and prejudicial. Fourth, ‘unfairly’ covered legitimate expectations which encompassed legal rights held in the memorandum and articles and equitable considerations.

In O’Neill v Phillips,53 Lord Ho man radically reduced the scope of

47The empirical evidence gathered by the Law Commission (next section) suggests that the latter method of valuation is rarely ordered by the courts.

48Section 75. This became s 459 in the Companies Act 1985.

49[1995] 1 BCLC 14.

50Saul [1995] 1 BCLC 14, p 17.

51Ibid.

52In Re a Company (No 007623 of 1984) [1986] BCLC 362.

53O’Neill and another v Phillips and others, Re a company (No 00709 of 1992) [1992] 2 BCLC 1.

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unfairly prejudicial conduct. Indeed, he accepted culpability in its extension following his characterisation of unfairly prejudicial acts in Re Saul to be ones which o ended the petitioner’s ‘legitimate expectation’. His use of an essentially public law term allowed the concept to ‘lead a life of its own’, making it ‘capable of giving rise to equitable restraints in circumstances to which the traditional equitable principles have no application’.54 The purpose of his judgment in this case was to clarify the scope of equitable restraints.

In O’Neill, the petitioner had worked as an employee of Pectal Ltd and having impressed its majority shareholder (Mr Philips), had been given 25 per cent of the shares and promoted to a directorship. Mr Phillips gradually withdrew from the business, leaving O’Neill as de facto managing director and relinquishing two-thirds of his dividends in order that O’Neill would receive 50 per cent of the profits through dividends and wages. There had been some negotiations between the two shareholders in respect of Mr O’Neill obtaining a 50 per cent shareholding, but these were never concluded. After a period of time, the business began to fail and Mr Phillips regained management control, having reduced his opinion of Mr O’Neill’s abilities. He determined that Mr O’Neill would no longer be paid 50 per cent of the dividends and would instead receive dividends accruing to his 25 per cent shareholding plus a director’s salary. O’Neill issued a petition under s 459, which was dismissed at first instance because the judge found that Mr Phillips had not promised to give Mr O’Neill half of the profits or half of the shares. The Court of Appeal allowed Mr O’Neill’s appeal ordering Mr Philips to buy the petitioner’s shares: ‘O had a legitimate expectation that he would receive an equal share of the profits and additional shares and that P’s denial of those expectations was unfairly prejudicial to O’s interest as a member and had forced him out of the company.’55

The House of Lords upheld the respondent’s appeal on the basis that a s 459 petition could only be granted if the conduct complained of fell within the normal ambit of equitable consideration. Thus a promise to do something may not be enforceable in law but may be binding under equity. However, in this case the judge had found that no promise had been made and therefore ‘there was no basis, consistent with principles of equity, for a court to hold that P had behaved unfairly’.56 An expectation that something would happen, albeit reasonably, did not give rise to the operation of equity. Lord Ho man explained this in the context of the purpose and history of company law and of English law per se. A company was a commercial arrangement the terms of which were to be found for the most part in the

54Ibid, p 11.

55Ibid, p 1.

56Ibid, p 2.

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company constitution. All members both know and have agreed to these terms. However, company law’s ‘seamless[ly]’ emergence from partnership law meant that it carried much of the baggage of partnership’s good faith principles. Therefore, although in general the company and its members will be governed by the express terms of the constitution there will be some circumstances when ‘equitable considerations make it unfair for those conducting the a airs of the company to rely upon their strict legal powers. Thus unfairness may consist in a breach of the rules or in using the rules in a manner which equity would regard as contrary to good faith’.57 However, that which equity considers contrary to good faith is strictly limited to established equitable concerns. Indeed, stated Ho man, it is only a quirk of the English legal system that a dichotomy is drawn between the legal (that which is strictly by the letter) and the equitable (that which is justice-based). Courts of Law and Courts of Equity once amalgamated continued the practice of distinguishing the two approaches. Other legal systems approach issues without such distinction, the stick of the law followed by the salve of equity. Ho man notes that continental systems introduce a general requirement of good faith into contractual arrangements, which, Ho man implies,58 is the more sensible approach that achieves the desired outcome of s 459 with less complication. The question to ask in a s 459 situation is what is the plain meaning of the terms such as to give rise to honest expectation.

Furthermore, he stated that there needed to be inequitable behaviour for s 459 to apply. The notion that the breakdown in relations between, in this case, Mr Phillips and Mr O’Neill, would justify a petition was without authority. Drawing upon the reform process, Ho man argued that the Law Commission’s case for no fault exit at will rights for quasi-partnership type companies indicated that it clearly did not consider s 459 to already contain this remedy.59 This was a proposition to which he subscribed.

O’Neill was to have a profound impact on the reform process as its restrictive approach was said by the CLR to render obsolete a number of the Law Commission’s recommendations, discussed below. However, the strict application of equitable considerations required under O’Neill would probably not inhibit the continued application of many earlier cases to present cases if they involved equitable considerations.

A significant misuse of powers would continue to fall under the O’Neill restrictions. For example Scottish Co-operative Society Ltd v Meyer,60 whence

57Ibid, p 8.

58Although he says a new approach would cause uncertainty, he also states that ‘it (traditional English theory) is derived from arrangements for the administration of justice which were abandoned over a century ago.’ Ibid, p 8.

59This proposed that private companies adopt a clause in the articles which allowed shareholders to have their interest purchased on a no-fault basis.

60[1959] AC 342 (HL).

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the strict interpretation of the term ‘oppressive’ (noted by Lord Ho man in Re Saul ) originated, involved a misuse of powers by the majority shareholders in the company. The minority shareholders were two directors who were brought into the company for their expertise and ability to secure the licence to produce the product rayon, which the company required. The majority shareholders later caused the company to transfer its business to another subsidiary and cut o the company’s supply of raw materials. The company was left without business and without profits, to the great detriment of the minority shareholders who had no interest in the subsidiary company. The court held that the company’s a airs had been conducted in a way that was burdensome, harsh and wrongful and ordered the company to purchase the petitioners’ share at a fair value.

Exclusion of a member from the management of a quasi-partnership company, such as that in Ebrahimi, would continue to constitute unfairly prejudicial conduct. Diverting corporate assets and business opportunities61 would continue to provide good grounds for a petition, as would excessive remuneration to directors enabled by having voting control over the company.62

REFORM AND MINORITY PROTECTION

Reform and s 459

In 1997 the Law Commission published its report on shareholder remedies in which it made detailed recommendations in respect of ss 459–461 of the Companies Act 1985, the common-law rule of Foss v Harbottle and its exceptions.63

The Commission’s empirical research indicated that the more common remedy sought by minority shareholders was for unfairly prejudicial conduct under ss 459–461. Furthermore, research indicted that this remedy was almost exclusively sought by shareholders in very small companies. Of the court files relating to s 459 petitions presented to the Companies Court between January 1994 and December 1996, 233 out of 254 were inspected.64 Of these, 70.4 per cent of the petitioners were minority shareholders and 96.6 per cent involved private companies. 33.9 per cent of petitions involved companies with only two shareholders and 48.1 per cent of

61Re London School of Electronics Ltd [1986] Ch 211.

62Re Cumana Ltd [1986] BCLC 430. The Appeal Court concurred with Vinelott J’s findings at first instance that the two-thirds majority shareholder and director had procured for himself remuneration far in excess of what he had earned.

63The Law Commission (Law Com No 246) Shareholder Remedies. 1997 Report on a Reference under s 3 (1)(e) of the Law Commission Act 1965.

64Ibid, p 177 Appendix J, Statistics relating to the filing of s 459 petitions.

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petitions involved companies with fewer than five shareholders.65 Only 4.3 per cent of petitions involved companies with more than 10 shareholders.66 In 35.6 per cent of the petitions, Ebrahimi considerations of mutual trust and confidence were pleaded and in 64.4 per cent exclusion from management was alleged. The main relief sought under s 461 was the purchase of the petitioner’s shares, totalling 69.5 per cent of all petitions inspected.67 The Law Commission, therefore, proposed reform which would reflect need and give better access to the overwhelmingly commonest form of shareholder complaint and remedy – a s 459 petition submitted by a minority shareholder in a company with fewer than 10 shareholders, who complained of exclusion from management in a company previously characterised by mutual trust and who sought the remedy of share purchase.

The Commission’s recommendations were partly informed by the costs in s 459 proceedings which could often far exceed the value of the shareholding in question. The Commission cites the case of Re Elgindata Ltd,68 in which the parties incurred costs of £320,000 after 43 days in court, in an action relating to shareholdings that were eventually valued at £24,600. However, for the most part the Commission concluded that the excessive costs could be dealt with by active judicial case management, being developed at the time in the then Draft Civil Proceedings Rules.

In the earlier Consultation Paper, the Commission had proposed a new additional unfair prejudice remedy for smaller companies if two Ebrahimi conditions had been satisfied. The first condition was whether the ‘association formed or continued on the basis of a personal relationship, involving mutual confidence’. The second condition was the question of whether there was ‘an agreement, or understanding, that all, or some (for there may be “sleeping members”), of the shareholders shall participate in the conduct of the business’.69

However, following concerns from respondents to the Paper the Commission put forward an alternative recommendation that might achieve the same result for those shareholders in an Ebrahimi type situation. This involved the inclusion of two presumptions in proceedings under s 459. The first presumption was that if the shareholder had been excluded from management, such conduct would be presumed to be unfairly prejudicial if the company in question was a private company limited by shares. This presumption would apply ‘where the petitioner has been removed as a director or has been prevented from carrying out all or substantially all of his functions as a

65Ibid, p 178.

66With 3 per cent stated as not known.

67Ibid, p 179.

68[1991] BCLC 959 cited at p 3 note 14.

69Ibid, p 25.

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director’.70 Furthermore, it would only apply if the company was ownermanaged and the petitioner held no less than 10 per cent of the voting rights ‘capable of being exercised at general meetings of the company on all, or substantially all, matters . . . in his own name’.71 This presumption also required that all or mostly all of the shareholders were also directors so that it would be reasonable to assume that the petitioner expected to be involved in the company’s management.

The second presumption proposed was that if the first presumption was satisfied then the petitioner’s shares should be valued on a pro rata basis rather than discounted on the basis that it was a less valuable minority holding. This should apply unless the court otherwise directed.

The Commission further recommended that there should be a time limit for bringing claims under s 459 and that winding up should be added to the list of remedies available under s 461 but that a petitioner should obtain leave of the court if he seeks winding up on just and equitable grounds under s 122, in addition to his s 459 proceedings. The Commission further recommended the incorporation of an ‘exit clause’ in Table A which was dismissed by the CLR in ‘Developing the framework’ as it ‘would not be used in practice because on commercial grounds it would not be incorporated in company constitutions by well informed founders . . . For ill-informed founders it would be a trap’.72

The CLR considered the Commission’s proposals in ‘Developing the framework’ and rejected both the two presumptions and the inclusion of a winding up remedy in s 461. On the presumptions the CLR stated that ‘on balance we are inclined to doubt whether a case for the presumptions has been made’.73 And, on the winding up remedy it stated that such an inclusion would endanger ‘the viability of companies’.74 These views were largely reached because of the decision in O’Neill which had not been heard when the Commission published its recommendations. This case, as previously noted, had held the scope of s 459 to be more restrictive than previously considered. As such, the CLR argued, the practical concerns voiced by the Commission which it had felt would be met by the presumptions, would instead be met by greater clarity in case law. Section 459 would be likely to apply to a much narrower range of cases following Lord Ho man’s reasoning in O’Neill.

In ‘Completing the Structure’ the CLR concluded that the O’Neill decision was sound and provided a clear and fair limit to the kinds of issue that

70Ibid, p 34.

71Ibid, p 35.

72‘Modern company law for a competitive economy: developing the framework’, para 4.103, p 120. Lord Ho man had in O’Neill previously dismissed these two presumptions as merely reflecting existing practice and therefore surplus to requirements.

73Op. cit., ‘Developing the framework’, p 121.

74Ibid.

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would be actionable under s 459.75 The CLR concurred with the House of Lords that a s 459 petition must be based upon a ‘departure from an agreement, broadly defined, between those concerned, to be identified from their words or conduct’.76 As this amply dealt with the problems of ‘lengthy and undisciplined’ proceedings, the Law Commission’s proposal on presumptions was impliedly rejected. Subsequent reports considered the issue on presumptions to be dropped.77

Reform and derivative actions

The Commission considered that the right for a shareholder to bring a derivative action in respect of a wrong done to the company was both sound and one that could be appropriately brought under statutory control. The Commission noted that New Zealand, South Africa and Japan had introduced a statutory derivative action and therefore in the context of global corporations it was ‘highly desirable’ for England to follow suit. The Commission proposed that a new statutory derivative action should be introduced in respect of ‘claims arising out of a breach of directors’ duties’. And while it considered that in some cases there may not be a breach of duty78 or that claims may not arise from a breach of duty but from the activities of a majority shareholder,79 it considered such cases to have a remedy under s 459. The new action should, the Commission argued, be limited to directors’ breach of duty only and should not be extended to employees or o cers other than directors.80

The Commission further recommended that the new statutory derivative action should include negligence as an actionable wrongdoing. As previously noted, a derivative action could only be bought on the basis of negligence if that negligence profited those in breach.81 And, as the Commission recommended explicitly allowing a breach to cover negligence as well as a statutory fault by a director, it proposed that the new derivative action should include a phrase similar to that already held in ss 310 and 727 of the Companies Act 1985: that of ‘negligence, default, breach of duty or breach of trust’. It also recommended that legislation make explicit that this new action would cover conflict of interest situations.

75‘Although the majority of views expressed in responses to ‘Developing the framework’ were in favour of reversing O’Neill and thereby extending the scope of the remedy, after careful consideration we came down against this’. Modern Company Law: Final Report, p 163.

76Op. cit., ‘Completing the structure’, para 5.79, p 97.

77Modern Company Law: Final Report, p 163 stated that as no support had been extended for the presumptions and winding up, the Review focused on the scope of O’Neill.

78Movitex Ltd v Bulfield [1988] BCLC 1040.

79Estmanco (Kilner House) Ltd v Greater London Council [1982] 1 WLR 2.

80Law Com No 246, p 84.

81Daniels v Daniels [1978] Ch 406.

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As a solution to some of the issues which emerged from their empirical work, the Commission recommended that the procedure to pursue a derivative action should be simplified and set out in the rules of court. The claimant should give 28 days’ notice to the company of his intention to pursue a derivative action and then be required to obtain leave of he court to pursue the claim. In respect of the issue of leave, the court should consider the ‘applicant’s good faith, the interests of the company; that the wrong has been, or may be, approved in general meeting; the views of an independent organ and the availability of alternative remedies’.82 Thus while an e ective ratification would continue to bar a derivative action, the fact that the wrong is ratifiable is only one of the factors which the court should consider when assessing leave. The court would retain the power to adjourn proceedings to allow a meeting of shareholders. It further recommended that any action started by the company which has not been diligently pursued could be continued as a derivative action by a member of the company.

In response to these recommendations the CLR expressed their broad support subject to a number of additional queries and clarifications. The first concerned the e ect of a company deciding not to sue and the second ratification or possible ratification of a wrongful act upon a derivative action. The third concerned the extension of actionable breaches of duty to negligent acts by a director in the absence of self-profiting.

The decision not to sue is usually a management one, thus if some or all of the management are associated with the wrong then a decision not to redress this wrong should be distinguished from other management decisions. Therefore, the CLR concluded that ‘in all ordinary circumstances the derivative procedure should be confined to cases where one or more members of the board of directors are implicated in the wrong or by some special association with the wrongdoer and the board fails to institute proceedings’.83 The CLR concurred with the Commission that employees’ wrongs and those of other o cers should be dealt with by the board and not under a derivative action.

In respect of ratification the CLR supported the Commission’s view that e ective ratification should remain a complete bar to a derivative action but sought to clarify the nature of ‘e ective’. What constituted ‘e ective’ and ‘lawful’ ratification? The CLR acknowledged that there were clear identifiable circumstances when ratification would not be lawful already established in law. These included ratification of an ultra vires act, ratification of a wrong in respect of a member’s personal rights, ratification of a wrong which constituted a breach of the articles,84 and ratification where the wrongdoers were

82Ibid, p 91.

83‘Developing the framework’ para 4.118, p 129.

84Edwards v Halliwell [1950] 2 All ER 1064.

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the majority shareholders, or at least in e ective control of the votes.85 All the above exceptions (except the fourth circumstance) involved wrongs that were inherently unratifiable. The question remained, therefore, if a transaction was inherently ratifiable could a director qua shareholder vote? The CLR maintained that ‘to be e ective, ratification should be carried out by a su cient majority of disinterested shareholders’.86

The CLR concurred with the Commission’s recommendation that a wrong should be extended to negligent acts by a director and that the basis of a derivative action should be set out in statute. It further agreed with the Commission’s recommended threestage procedure.87 Furthermore, the CLR proposed a simplified approach to ratification that they argued was necessary when negligence was included among actionable wrongs. Fraudulent wrongs are justifiably unratifiable because it is unacceptable in wider society. Outside of this, the question of whether to ratify or not or whether to sue should depend upon the court’s assessment of who is in the best position to assess what is in the best interest of the company. That is, is it the minority shareholder or some other body?

In ‘Completing the structure’, the CLR confirmed their adoption for a simplified ratification process so that

the question of the validity of a decision:

•By the members of the company to ratify a wrong on the company by the directors (whether or not a fraud); or

•By the members of the board or of the company not to pursue such a wrong;

should depend on whether the necessary majority had been reached without the need to rely upon the votes of the wrongdoers, or of those who were substantially under their influence, or who had a personal interest in the condoning of the wrong.88

85Op. cit., Prudential.

86Op. cit., ‘Developing the framework’, p 129.

87In addition the CLR suggested that further consideration should be given to situations when a shareholder su ered a separate loss from that which the company su ered and whether there should be an express provision to state that where the loss to the shareholder is contingent upon a direct loss to the company, the shareholder may only sue if the company improperly refuses to redress its own losses. Otherwise, such indirect loss is only recoverable by a shareholder by suit of the company.

This position was confirmed in the CLR’s subsequent paper although they reserved their position as the issue was coming up in the House of Lords in the near future thus provoking a shift in perspective. In the event, by the time that the CLR’s Final Report was published, the House of Lords had confirmed their provisional view and thus the Final Report made no other modifications.

88Completing para 5.85, p 99.