Shareholder Derivative Action Suits in India: Avoiding the Influence of Foss v. Harbottle and Taking Cue from the UK Law

Introduction

In the modern world, various people tend to invest their money by buying shares in the corporate entities as they provide higher profits and at the same time higher security to the investors' money. However, most of these corporate entities were majorly controlled by the management or the majority shareholders who had the power to appoint majority of the directors in the board of directors. Therefore, in all these entities the rights of minority shareholders always remain at peril. Although indirectly the minority shareholders also benefit whenever there is a benefit to the corporate entity. However, the problems arise when those in management tend to take decisions against the interest of the company or the minority shareholders for their own benefit. Therefore, there is a need for an effective mechanism to protect the interests of minority shareholders. The minority shareholders have various rights ranging from direct action suits, class action suits, derivative suits. Unfortunately, in India there is no clarity on the usage of derivative action suits. Therefore, such suits remain mostly unpopular in India. Therefore, there is a need to adopt effective mechanism to increase the popularity of derivative suits in India. Especially with the increasingly dispersed shareholding model that is increasingly becoming dominant in India, the derivative suits have the potential to become popular in India.

Pre-conditions for the popularity of derivative action suits in India

In order to increase the popularity of derivative action suits in India, there are certain preconditions that must be kept in mind. These suits are brought by the shareholder on behalf of the corporate entity and not for any personal grievance for which there are alternative remedies with individual shareholder. Therefore, there is no direct incentive with the shareholder to bring such suits. In the lack of a direct incentive for the shareholder to bring such suits, the law should be made such that it does not impose heavy costs on the shareholders.¹ An efficient law on this point can be one that reduces the costs of bringing such suits to a minimum. The costs that a shareholder might have to accrue while bringing such suits can be majorly divided into two parts: ex ante costs i.e. the costs that are incurred before the suits commences and the ex-post costs i.e. the costs incurred after the commencement of the suit.² Since the cost of the proceedings is majorly borne by the company in such suits, the costs of paying the attorney for the entirety of such suits are very less; hence, the ex-post costs are very less in this regard. Therefore, our major focus should be on reducing the ex-ante costs of the proceedings. The requirements of admitting such suits should not be made unnecessarily harsh as it might lead to increasing ex ante costs and hence, reduce the efficiency of the law. When we look into the Indian legal regime, the major problem lies in these costs being very high and hence leading to the unpopularity of such suits in India. Firstly, I will explain the problems in the current legal framework in India and then will explore the possibility of an alternative law that can be highly efficient.

Does Section 245 cover derivative action suits

Before the enactment of the Companies Act, 2013³, several recommendations were made to include derivative action suits in the new Act.⁴ However, there was no explicit provision related to the derivative suits in the new Act. There is a clear legislative gap on the point of derivative action suits. However, there was an introduction of “class action suits” in Section 245 of the Act⁵. The question arises whether Section 245 can act as a provision for the class action suits? It must be noted that Section 245 deals with an alternate remedy of class action suits that is available to the minority shareholders. Although certain elements in Section 245 overlap with that of “derivative action suits”, it does not mean that Section 245 is a provision related to derivative action. The major difference between the “class action suits” and the “derivative action suits” lies in the fact that the former is usually an option available to the shareholder to sue on behalf of the entire “class” of shareholders with common interest whose rights have been infringed.⁶ On the other hand, “derivative action suit” is usually an option for the shareholder to sue on behalf of the corporate entity when the directors or management in the company has been acting against the interest of the company.⁷ Thus, the aspect of having a separate class with common interest is completely absent in the derivative action suits, even a single shareholder can file a derivative action suit.

Section 245 of the Act, however, does not fulfil this basic requirement that a single shareholder can file a suit in court. There is a requirement of having 100 members to join together to file the suit under Section 245.⁸ Another important point to note is that in a “derivative action suit”, the suit is filed on behalf of the company against the management.⁹ However, Section 245 even allows the petitioner to claim damages against the company itself which goes against the fundamental principle of “derivative action suits”.¹⁰

It is agreeable that Section 245 does have certain elements of derivative action suits like the provision that the company will pay for the cost of litigation¹¹ or allowing the shareholders/depositors to sue for the interest of the company¹². Nonetheless, since the basic requirements of the derivation action suits in the section are not fulfilled, it cannot be considered a provision for derivative action suits.

Therefore, it is quite clear that there is no explicit mention of the derivative action suits in the “Companies Act, 2013”. The lack of an explicit provision itself increases the ex-ante costs as the petitioners or the shareholders do not get clarity as to how to approach the courts on this issue and what standards the courts will apply while admitting or rejecting such suits. The interpretations given by the various High Courts in India has further confused the entire issue.

Contradictory judgments by the courts that further increase the costs

In this section, I explain the various contradictory judgments of different High Courts in India, that further led to increasing the ex-ante costs of the derivative action claims. These contradictory judgments create further confusion in the law which is already in the muddled state owing to lack of a clear statutory law on this point.

Firstly, there is no clarity in the Indian law as to the standard that must be applied while admitting such suits. Sometimes the Courts have used “clean hands doctrine” in rejecting some derivative suits at the outset. For example, if we look at the judgment of the Bombay High Court in Darius Rutton Kavasmaneck v. Gharda Chemicals Ltd.¹³, the Court applied the “clean hands doctrine” and rejected the matter at a preliminary stage.¹⁴ However, in some other cases the Indian courts have been much more liberal, for example, in the Delhi High Court judgment in Rajeev Saumitra v. Neetu Singh¹⁵, the Court refused to apply the “clean hands doctrine” laid down in Darius¹⁶, based on the facts of the present case.¹⁷ Therefore, as opposed to strict restrictions imposed by Darius¹⁸, the Court was quite liberal in the fact scenario of this case. Such contradictory stance by the different High Court often create confusion in the mind of the petitioners as to whether their suits will be admitted or not because there is no uniform standard applied by the Indian courts in this regard. A lack of clear standard often increases the ex-ante costs of bringing such suits that further disincentivises the shareholders to bring such suits.

Secondly, in the Indian courts, the grounds that are available to bring derivative action suits are very narrow. This is because the Indian courts still decide the cases¹⁹ on derivative actions by relying on the common law precedent of Foss v. Harbottle²⁰.²¹ In Foss²², there are mainly three exceptional situations when the shareholder can bring a suit on behalf of the company. These three exceptions are illegality or ultra vires act, fraud and any act that requires special resolution. These three grounds are very narrow and do not provide much scope to the shareholders to bring a derivative action claim.

The Delhi High Court in ICP Investments (Mauritius) Ltd. v. Uppal Housing (P) Ltd.²³ made an attempt to move from such a common law approach, however, rather than enlarging the grounds, it further narrowed them. The High Court in this case linked the derivative action claims with Section 241 of the Companies Act, 2013²⁴.²⁵ However, Section 241 is basically a shareholder centric remedy dealing with oppression to individual shareholder. This concept of oppression to individual shareholder is entirely different from the concept of derivative action suits on a principled level.²⁶ While the Court in this case made a laudable attempt to move away from the restrictive approach provided in Foss judgment²⁷, however, in this process it further narrowed the scope of derivative action claims to oppression and mismanagement. Moreover, the approach is also flawed because it is against the scheme of the Companies Act as the remedy of Section 241 is for individual shareholders and not to those claims that are brought by the individual shareholders on behalf of the company.

Therefore, these precedents show that how even the grounds for bringing a derivative action claim are being narrowed down by the Indian courts. Lack of uniform standards in admitting a derivative claim coupled with narrow grounds for bringing such suits, highly increases the ex-ante costs that decreases the popularity of such suits in India.

Increasing the popularity of the “derivative action suits” in India

Owing to the lack of any statutory basis for the derivative action suits, the entire Indian law on derivative action suits becomes unclear. It is submitted that there is a need for bringing a clear provision in law enabling derivative action suits. The Indian legislature must take a cue from the United Kingdom (UK) where there are major changes done in the provisions related to the derivative action suits in “the UK Companies Act, 2006”. If certain provisions from the UK are brought into the Indian legal regime, then they can prove to be highly economically efficient and hence can help in increasing the popularity of derivative action suits in India.²⁸

Major changes that can increase the efficiency of the Indian law on derivative suits

The three major changes that were made in the UK are that first, the scope of the suits was increased wherein a petitioner can file suit on the basis of numerous grounds like negligence, breach of duty and trust. ²⁹Second, the “clean hands doctrine” has been replaced by the “good faith” doctrine.³⁰ Third, the standard of proof at the first stage was that of prima facie standard.³¹

If these three changes from the UK are brought in the Indian law, it can help in increasing the efficiency of the derivative suits in the country. This is because such steps will help to increase the incentive for the shareholders to bring the derivative action claims by reducing the ex-ante costs therein. Ex ante costs can be reduced by reducing the requirements of admitting the derivative suit. The three changes from the UK can help in achieving this purpose to some extent. Firstly, expanding the grounds of filing a petition will provide a greater incentive for the petitioner to approach the court on behalf of the company. Secondly, the “good faith doctrine” and the prima facie standard can help in reducing the ex-ante costs to a sufficient extent. This is because if there are some strict requirements imposed on the petitioner at the start of the trial itself, then it highly increases the costs, and the petitioner may not have any incentive to file such suits. Prima facie standard helps in not only decreasing the costs but also helps the court in identifying frivolous petitions and rejecting them at the outset. Similarly, “clean hands doctrine” imposes unnecessary burden on the petitioner. Since derivative suits are filed by the petitioner on behalf of the company, there is no particular need to look at whether the petitioner came with clean hands or not, rather we must just look at the merit of the petition. Therefore, these provisions from the UK can help in maintaining an optimal balance between avoiding frivolous petitions and reducing the costs of litigation for the petitioner. Therefore, such an efficient legislative model of derivative action can be adopted in India that will help in providing a direct incentive to the shareholders to come to the courts for derivative action claims.

Can derivative suits be successful in India —Countering some criticisms

Even if the abovementioned procedural changes are done in the Indian context, some criticisms need to be addressed. This is because there are claims by some scholars that the derivative action suits may not be successful in India owing to some existing structural problems in the Indian legal regime. Firstly, it is argued that the derivative action suits may not be successful in India because there are other remedies related to oppression and mismanagement available under the Companies Act.³² However, this criticism can be refuted because these remedies are majorly for direct action claims by a single shareholder whereas derivative action suits are different from such direct suits. Therefore, there is no way in which we can equate these two different sets of remedies. Secondly, it is claimed that there are no proper duties assigned to the controlling shareholders.³³ It is acceptable that lack of an explicit set of duties does cause certain problems. However, the minority shareholders can very well sue the majority in case their rights are violated under Section 241 or Section 245. The presence of these sections itself deters the majority shareholders from completely disregarding the interests of the other shareholders. Thirdly, the English rule is also considered as a major impediment in the success of derivative action suits,³⁴ however, this rule merely acts as deterrent for frivolous petitions and not against all type of petitions. If the derivative claim has some merit, then the Indian courts are unlikely to impose costs on the petitioner even if such petitioner loses the suit.

It is therefore submitted that most of these criticisms against the popularity of the derivative action suits can be easily addressed because the real reason for the less popularity of such suits lies in there being high ex ante costs of taking such suits to the courts owing to lack of legal clarity on this point. An effective law on this issue will automatically help in increasing the popularity of such suits.

Conclusion

In this paper, it is argued that there is a lack of explicit legislative provision related to derivative action suits. Section 245 of the “Companies Act, 2013” cannot act as a substitute for the derivative suits. The Indian courts still rely on the common law precedents and most of the judgments on this issue are contradictory in nature which makes the entire law even more confusing. There is a need to adopt a procedure that can reduce both the ex-ante and ex-post cost of litigation. It is argued by the author that enacting a clear legislation on this point by taking some of the elements of the UK law can help in reducing the ex-ante costs to a considerable extent that can help in increasing the popularity of such suits in India. Finally, this paper has countered certain criticisms against the success of derivative action suits in India and has argued that if proper strategy is adopted then the derivative suits can surely be successful in India regardless of such criticisms.