DERIVATIVE ACTION IN COMPANY LAW

Derivative action claims are those claims brought to court by the shareholder of a company on the company’s behalf in relation to a breach of duty by the director(s), (or a third party dealing with the company) of the company. It seeks to protect the company from delinquent acts or omissions by directors or major shareholders of the company to promote corporate governance. Derivative action claims originated as an exception to the rule established in the case of Foss v Harbottle, where two minority shareholders brought a claim to court on behalf of the other shareholders against two directors (who were also majority shareholders) who were alleged to have sold land to the company at a higher cost than the land was valued, therefore accruing deficits to the company’s accounts. The court dismissed the claim, stating that in any action where a wrong is alleged to have been done to a company, the proper claimant is the company itself, since the company has its own legal identity, as was established in the landmark case of Salomon v Salomon.

In these types of claims therefore, shareholders have the right to bring a case on the company’s behalf, despite the company being a distinct legal entity. These claims are governed by Part XI, sections 238-242 of the Companies Act of Kenya, 2015. There are certain conditions that have to be met before one can bring a derivative action claim to court and these include;

  1. Locus standi – Derivative action as a remedy is only available to persons connected to the company by virtue of being shareholders (whether beneficial, current or former)
  2. The purpose of the claim must solely be to seek relief on the company’s behalf. A litigant must be acting in the best interestof the company. One must demonstrate that the relief(s) sought are consistent with the objects of the company. The reliefs sought must also promote the greatest good for the greatest number of shareholders.
  3. The claim has to be brought subject to leave of court. In Mohamedin Mohamed & another v Ibrahim Ismai Isaak & another, it was stated that the purpose of court approval was to dismiss/avoid frivolous claims.
  4. The claim has to arise from an actual or proposed act or omission involving negligence, default of an action or a breach of duty or trust by the director(s).

Before the coming into Action of the Companies Act of Kenya 2015(the statute), derivative action was governed by common law as derived from the rule in Foss v Harbottle. Post 2015, derivative action claims have normally followed a two-stage process. The first stage is passed by a shareholder making an application to court for an order to continue with the suit. This application has to be supported by providing evidence that there is a case to be heard. In Ghelani metals Ltd & 3 others v Elash Ghelani Natwarlal[1], the applicant filed a derivative action claim without applying for leave of the court first. The respondents filed a preliminary objection on those grounds, and the preliminary objection application was granted.

The second stage involves the main trial itself, where the derivative action claim is heard and determined. In Mohamedin Mohamed & another v Ibrahim Ismail Isak and another[2], the defendants were the directors and major shareholders of a construction company, with both having 900 of the available 1000 shares. The plaintiffs claimed that although the company had undertaken and completed several projects, the defendants had not declared profits and submitted dividends or called for a general meeting in a while. They had also not submitted financial accounts to the minority shareholders for accountability purposes. It was also claimed that they had fraudulently pocketed company money and hired out company equipment thereby inconveniencing the minority shareholders. The court granted leave to continue with the matter and all the orders sought were granted.

As per section 242 of the Companies Act, a company member could also be allowed to pursue a claim originally initiated by the company under the following circumstances:

  1. The company’s actions in filing the suit were an abuse of the judicial process,
  2. The company has not pursued the case properly, and it would be more appropriate to continue as a derivative action claim.

Such an application may be dismissed by the court if the evidence presented does not fully support it, or it may be allowed to continue.

It is also possible for an individual to continue a matter started or taken over by another member of the firm under the following grounds:

  1. Where the claim was brought in an improper manner and continues to be an improper means of bringing a claim
  2. Where the claimant has not pursued the matter diligently, and the applicant should litigate it.

Again, for the claim to proceed the applicant has to demonstrate enough evidence to support the case before court, failure to which the claim is dismissed.

In conclusion, although Derivative Action claims have helped advance and/or protect the rights of minority shareholders in a company, some shortcomings still remain in filing of these types of claims. One, there is no clear provision on the time leave applications should be filed. Some courts have held that one can file the application after the suit has started while others have stated that one can file the application at any stage of the suit. It is also not clear whether one files the application together with the suit. In Hotstar Investments Limited vs Peter Kuria (2019)[3] the applicant filed a derivative suit without applying for leave of court, resulting in the respondents filing a preliminary objection on the grounds that claim was instituted without first seeking leave. The applicant submitted that in Amin Akberali Manji & 2 others vs Altaf Abdulrasul Dadani & another, the court held that leave shall be obtained before filing of the derivative suit but it may also be obtained to continue with the suit after it is filed. The court dismissed the Preliminary objection application, stating that the suit was properly filed even though leave was not sought before the suit was filed.

Another challenge is that the statute is silent on who bears the cost of litigation which in most cases ends up being an extremely high amount due to the two-stage process of filing derivative suits.

*This writing is meant for general information only and should not be relied upon without seeking specific legal advice. In the event of queries on this article feel free to contact the undersigned on the contacts provided hereunder.

Dennis Juma.

0703240153 – Dennis Juma (Partner)

0723403673 – Moses Kibathi (Partner)

[1] Ghelani Metals Limited & 3 others v Elesh Ghelani Natwarlal & another [2017] eKLR

[2] Mohamedin Mohamed & another v Ibrahim Ismail Isaak & another [2021] eKLR

[3] Hotstar Investments Ltd v Peter Kuria [2019] eKLR

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