It is a general rule that companies have their own legal personality and are thus required to litigate in their own name to protect their own legal interests. There is however an exception to this rule in the form of derivative action which can be utilised by certain interested parties on behalf of the company when the company refuses or fails to take the necessary steps to protect its own interests.
An example of such refusal may arise when there is wrongful conduct performed by a company’s own shareholders or directors who hold a controlling share or voting rights in such company. To protect the interests of the company, those shareholders and/or directors would be required to authorise the company to act against themselves in their capacities as shareholders and/or directors, which is improbable.
This article sets out what derivative action is, how it is instituted and recent case law on how a demand for derivative action can be set aside.
The common law action:
The common law action known as “derivative action” originates from English Law and can be described as proceedings instituted by persons who stand in to litigate in their own names for and on behalf of the company in respect of wrongs done to the company.
This common law action was made available to members of the company when two conditions were met, namely –
- the wrong complained of involved conduct which was either fraudulent or ultra vires; and
- the wrong was perpetrated by directors or shareholders who were in the majority and so controlled the company.
The common law derivative action has since been abolished by the Companies Act No. 71 of 2008 (“Companies Act”).
The codified action:
Section 165 of the Companies Act has replaced and codified the common law right to derivative action and provides that –
- a shareholder or person entitled to be registered as a shareholder of the company or a related company;
- a director or prescribed officer of the company or related company;
- a registered trade union or any other representative of the employees of the company; or
- a person who has been granted leave of the court on the basis that the court is satisfied that it is necessary or expedient to protect the legal right of the company,
may serve a demand on a company to commence legal proceedings, continue legal proceedings or take related steps to protect the interests of the company.
The company, upon receipt of the abovementioned demand, may within 15 (fifteen) days of such demand, apply to the court to set aside the demand on the basis that the demand is frivolous, vexatious or without merit.
Should the company elect to not make an application to court to set aside the demand, it must take one of the following two steps –
- appoint an impartial person or committee to investigate the demand and report to the company’s board on the facts or circumstances which gave rise to the cause of action or relate to the proceeding contemplated in the demand, costs of the proceedings, and whether it is in the best interests of the company to proceed with the demanded proceedings; or
- refuse to comply with the demand by way of notice within 60 (sixty days) of receipt of the demand.
A person who has made the abovementioned demand may then apply to court for leave to bring or continue proceedings on behalf of the company if the following requirements are met –
- the company –
- refuses the demand;
- fails to appoint an independent person or committee to investigate the report and report to the board;
- accepts an inadequate report in terms of its preparations or has come to unreasonable or irrational conclusions or recommendations; or
- acts in a manner that is inconsistent with the report; and
- the court is satisfied that the applicant –
- is acting in good faith;
- the proceedings involve a serious question which are of material consequence to the company; and
- the proceedings are in the best interests of the company.
In exceptional circumstances, an application to court to bring or continue proceedings on behalf of the company may be brought without prior demand. More specifically, this is possible when a delay could cause irreparable harm to the company or substantial prejudice to the person bringing the application or to another person, when there is a reasonable probability that the company may not act to prevent the harm or act to protect the interests of the company and the abovementioned requirements to make such an application are met.
Applicants must note that there is a rebuttable presumption that bringing or continuing proceedings on behalf of a company without prior demand is not in the best interest of the company, which presumption is applicable in the following events –
- when the proceedings are brought by the company against a third party or by a third party against the company;
- when the company has decided to not bring, defend, discontinue, settle or compromise the proceedings; and
- when all the directors who participated in the decision acted in good faith, did not have a personal financial interest or were related to a person who had a personal financial interest in the decision, informed themselves of the subject matter to the extent they deemed reasonably appropriate and reasonably believed the decision was in the company’s best interests.
The grounds on which a company may apply to the court to set aside the abovementioned demand submitted to the company have recently been considered by our courts.
Recent case law:
In the case of Marib Holdings Proprietary Limited v Parring NO and Others 2020 (22058/2019) ZAWCHC 74 (the “Marib Case”), the Parring Family Trust served a letter of demand on Marib Holdings Proprietary Limited (“Marib Holdings”) demanding that it institute action against its directors to recover renumeration paid to them. The renumeration was not authorised by a special resolution of the shareholders. In reply to this demand, Marib Holdings proceeded to bring an application to court on the grounds that the demand was frivolous, vexatious or without merit.
The court considered the below in determining the meaning of the terms frivoulous, vexatious and without merit.
The term frivolous refers to contemptuous attitude adopted by the litigant and the use of intemperate language during proceedings or gross impertinence whereas, the term vexatious refers to proceedings instituted by a litigant which is designed to frustrate and harass a defendant or proceedings instituted to cause annoyance to a defendant.
The court in the case of LF Boshoff Investments v Cape Town Municipality 1969 (2) SA 256 (C), described frivolous or vexatious proceedings to be proceedings which are obviously unsustainable as a matter of certainty and not merely on a balance of probabilities.
The court in Amdocs SA Joint Enterprise Proprietary Limited v Kwezi Technologies Proprietary Limited 2014 (5) SA 532 (GJ) (the “Amdocs Case”), stated that the words frivolous and vexatious should be given their ordinary meaning and an applicant should be able to succeed if he is able to show that the demand is without merit in the sense that it cannot succeed. The court in the Amdocs Case was of the view that the correct approach is to consider the material portion of the demand and ask whether the company might conceivably succeed in the demanded actions and that the burden of persuasion borne by an applicant is a heavy one.
The case of Lewis Group Limited v Woollam 2017 (2) SA 547 (WCC) (the “Lewis Case”) expressed its reservations to the court’s view in the Amdocs Case and stated that the onus on an applicant is the one which normally applies in civil litigation, namely that the company must prove on a balance of probabilities that the demand is frivoulous, vexatious and without merit.
The court in the Marib Case agreed with the decision in the Lewis Case and stated that the company bears the onus to show on a balance of probabilities that a demand is lacking in merit and thus contemplates an action which cannot succeed. The court found that the renumeration paid to the directors without the necessary special resolution approving such renumeration is ultra vires and the fact that the renumeration payments were made unlawfully are in the court’s view a legal interest of Marib Holdings. Additionally, court stated that Marib Holdings has a duty to observe high standards of corporate governance and that complying with the Companies Act is an interest which Marib Holdings would be obliged to protect, and its directors have a fiduciary duty to ensure Marib Holdings complies with its statutory obligations.
In light of the above, Marib Holdings failed to discharge the above onus and was therefore unsuccessful with its application.
Derivative action is a useful tool which is available to a wide range of persons to protect the rights of a company, as such persons can demand that the company commence legal proceedings, continue legal proceedings or take related steps to protect the company’s interests.
A company which receives such a demand is allowed to apply to court to set it aside on the grounds that the demand is frivolous, vexatious or without merit. These terms have been interpreted by our courts to mean that the demand is lacking in merit and resultingly contemplates an action which cannot succeed.
Minority directors, shareholders and other stakeholders may therefore consider derivative action to protect the company’s rights in the event that the controlling members do not do so, or do not wish to do so.
VDMA’s team of experts is at your disposal for any assistance that you or your business may require with corporate law or litigation matters.
Published 18 October 2021