Delving deeper into the territory of derivative actions

derivative actions
09 Oct 2020

A derivative action is an action instituted by a person on behalf of a company to protect the legal interests of a company. It is an exception to the general rule that, if the company has suffered any wrongdoing, it is the company, being a separate legal entity, that must institute action to redress such wrong.

As was noted in the case of Lewis Group Ltd v Woollam and Others 2017 (2) SA 547 (WCC)

“The term ‘derivative action’ comes from the English law. In the corporate context, it relates to proceedings instituted by persons given standing to litigate in their own names for and behalf of the corporation in respect of wrongs done to the corporation. Such proceedings were entertained in the limited circumstances that gave rise to the recognised exceptions to the rule in Foss v Harbottle (often also called ‘the proper plaintiff rule’). The label ‘derivative’ was applied because although the litigation was instituted and prosecuted in A’s name, the right of action concerned was derived from B. Moreover, the benefits of any judgment obtained in favour of A in such an action, accrue to B, not A.”

The nature of a derivative action, as highlighted in the Lewis case, differs from a personal action as it is a remedy exercised in the defence or advancement of the company’s rights or interests, and not the personal rights of the plaintiff.

Section 165 of the Companies Act 71 of 2008 (Act) abolished the common law derivative action of a person other than a company to bring or prosecute legal proceedings on behalf of that company, and substituted it with the statutory provisions set out therein. Section 165 of the Act provides for any director or prescribed officer, shareholder, registered trade unions or any other person with leave of court, to serve a demand upon a company to commence or continue legal proceedings, or take related steps, to protect the legal interests of the company. Importantly, and as discussed in further detail in relation to the recent case of Marib Holdings (Pty) Ltd v Parring NO. 2020 JDR 1576 (WCC) (handed down on 7 August 2020), the Act sets out the basis on which a court may set aside such a demand. Section 165(3) of the Act states that a company served with a demand may apply within 15 business days to a court to set aside the demand only on the grounds that it is frivolous, vexatious or without merit.

If such application is not made or if the court does not set aside the demand, the company is required to appoint an independent and impartial person to investigate the demand and, inter alia, report to the board on the facts and circumstances that might give rise to a cause of action or relate to proceedings contemplated in the demand and whether it appears to be in the best interests of the company to pursue such cause of action and initiate proceedings to protect the legal interests of the company. If the company fails to take such steps or serves a notice declining to comply with the demand, the person that made the demand can apply to the court for leave to bring or continue proceedings in the name and on behalf of the company.

In the Marib case, the Western Cape High Court, delved deeper into the concepts of “frivolous, vexatious, and without merit” and considered whether a demand served on the company, Marib Holdings Proprietary Limited (Marib) under section 165 of the Act constituted a demand that was frivolous, vexatious and without merit and thus be set aside. Marib applied to the court in terms of section 165(3) of the Act to set aside the demand served on it by the trustees of The Parring Family Trust (Trust), demanding that Marib commence legal proceedings against its directors (who also constituted the majority of the shareholders of Marib) to recover all directors remuneration paid to them, which they alleged was paid contrary to the provisions of section 66(9) of the Act, in order to protect the legal interests of Marib. Marib was involved in the Entilini project which related to the operating of a tollgate on the Chapmans Peak Drive in Cape Town. It was a shareholder of the Entilini entities, Concession Proprietary Limited and Entilini Operations Proprietary Limited until 2016. The first respondent (Parring) and the current directors were all directors of Marib. Parring was also its representative on the Entilini entities, however, Parring’s directorship on the board of Marib and such entities ended in 2014 due to allegations by Marib that Parring had, inter alia, contracted through an associated company and breached his fiduciary duties to Marib. It was common cause that, subsequent to Parring ceasing to be a director of Marib, the current directors received payments in the form of directors fees and that no special resolution was passed to approve such payments in terms of the Act. Marib alleged that such payments were for services rendered by the directors to the Entilini entities with Marib merely acting as a conduit for such payments, which ought not to be classified as revenue. According to Marib, no special resolution was required under the Act as the payments were not paid as a consequence of any legal obligation on Marib’s part to do so and as such the demand of the respondents were thus frivolous, vexatious, and without merit. The respondents averred that once Parring was removed as a director, the situation regarding the payment of directors’ fees changed from one where the management fees earned by Marib from services rendered by its directors to the Entilini entities were retained as earnings (resulting in dividends to the shareholders) to one where those fees were disbursed as directors’ fees to the directors concerned and that such management fees and the revenue earned ought to be retained by Marib either as earnings and/or disbursed as dividends.

The court considered the meaning of “frivolous” and “vexatious”, noting that “Frivolous” usually refers to the contemptuous attitude adopted by a litigant and the use of intemperate language during proceedings or gross impertinence and that “Vexatious” may refer to proceedings instituted by a litigant designed to frustrate and harass a defendant or proceedings instituted to cause annoyance to a defendant. The court referred to the LF Boshoff Investments v Cape Town Municipality case where frivolous or vexatious proceedings were described as proceedings which are “obviously unsustainable and this must appear as a matter of certainty and not merely on a preponderance of probabilities”.

The court also considered the case of Amdocs SA Joint Enterprise Proprietary Limited v Kwezi Technologies Proprietary Limited, which held that such words be given their ordinary meaning whereby one would succeed under section 165(3) of the Act if they can demonstrate that the demand is without merit in the sense that it cannot succeed. The Amdocs case noted that the approach would entail asking whether “on the available evidence, a company might conceivably succeed in their envisaged action/s. I specifically say “might conceivably” for it seems to me that issues of probability cannot properly be taken into account at this stage. The threshold which a complainant has to cross is a low one. Conversely, the onus and burden of persuasion which an applicant for relief in terms of section 165(3) bears is a rather heavy one”.

The court, however, noted that the case of Lewis Group Limited v Woollam expressed reservations regarding the views set out in Amdocs that the onus on the company is a “heavy” one and instead remarked that the nature of the onus is that which ordinarily applies in civil litigation, being that the company must prove on a balance of probabilities that the demand is frivolous, vexatious, or without merit and that according to Binns-Ward J, “(h)eaviness does not enter the equation: there is no presumption in favour of the complainant that its demand is not frivolous, vexatious, or without merit, anymore than there is one in favour of the company that it is. The statutory provision do not give rise to any inherent probabilities one way or the other”.

The court held that while it is correct that the nature of the onus would be that which ordinarily applies in civil litigation (being that of a balance of probabilities), it cannot be doubted that the evidentiary burden placed on a company is not an easy one to discharge given the narrow basis on which a demand may be challenged. It held that while section 165 of the Act does not expressly prescribe the requirements the demand must meet, the person making the demand must make out the basis of a cognisable claim and that it is clear from section 165 of the Act that the company bears the onus to show on a balance of probabilities that the demand completely lacks merit and that it contemplates an action that cannot proceed, with the function of the courts being a limited one whereby the court is not called upon to adjudicate the merits of the demand but merely to ascertain whether there is a serious issue that merits investigation. In reaching its decision, the court in Marib held that Marib had failed to prove on a balance of probabilities that the demand was frivolous, vexatious, or without merit.

It held that the directors of Marib appeared to have been alive to the fact that the fees paid to them fell to be classified as remuneration. The issue of directors’ fees was also discussed at certain shareholder meetings, one such meeting having dealt with the issue within the context of non-compliance with section 66 of the Act, and the need for a resolution to regularise the payment of directors’ fees. According to the court, the respondents had a cognisable claim as there was a serious question to be answered and it could not be said that the demand was without substance or merit as remuneration paid to directors without the requisite special resolution would be ultra vires the powers of Marib. That payments may have been made unlawfully was, in the courts view, within the ambit of what may be considered to be a “legal interest” of Marib, that it had a duty to observe high standards of corporate governance and that complying with the Act is one of the interests it would be obliged to protect. The Marib case provides some insight as to the manner in which courts might possibly evaluate such matters in determining whether a demand be set aside on the basis that it is frivolous, vexatious, or without merit.

See also:

(This article is provided for informational purposes only and not for the purpose of providing legal advice. For more information on the topic, please contact the author/s or the relevant provider.)

Dispute Resolution articles on GoLegal