How Does A Company Derivative Work?

How Does A Company Derivative Work?

It can be known as a company derivative, derivative action, statutory derivative or shareholders derivation action. Read on to discover what a company derivative is and how it works.

Table of Contents

What is a Company Derivative?

A company has a legal identity of its own, just as any person does. A company has legal rights and it can sue others for any wrong or damage done to it. But what happens when the wrong done to a company happens at the hands of the company directors? Are the shareholders able to protect their company interests when the directors do some wrong to the company itself?

In short, yes. A company derivative can provide this type of protection to a company and its shareholders.

Therefore, shareholders can protect the companies interests against the adverse wrongs of its company director(s) by way of derivative action.

What Amounts to a Wrong?

The wrongs that can give rise to derivative action are a director’s infringement of company rights. This is where the board of directors or director fails or refuses to abide by their legal duties. Directors are under legal duties to:

  • Act in good faith,
  • Act with care and diligence,
  • Exercise their powers for a proper purpose,
  • Use of information properly,
  • Prevent insolvent trading.

For more detail about directors duties, see here.

Generally, if a director breaches one of these duties it will amount to a wrong. This wrong will give rise to a derivative action by the companies shareholders.

Who Can Bring a Company Derivative?

Shareholders can bring this action either on behalf of the company or in the name of the company. One shareholder can bring this action. However, it is very common for a group of shareholders to bring the action as a class action.

Why Do Company Derivatives Exist?

Commonly, if a company is suing someone for any wrong or damage caused, it is suing a third party. However, at times the people in control will be the cause of damage or wrong to the company. This is why company derivatives exist. It allows shareholders to bring actions against its own directors, in the name of the company.

Legal Requirements for a Company Derivative Application:

The rules set out in Part 2F.1A of the Corporations Act 2001 (Cth) governed how shareholders are to bring this action.

However, the court must grant the shareholders permission for the proceedings to start. There are a range of factors the court will look to in deciding whether to grant shareholders permission to commence a derivative action.

(1) Shareholders Must Act in Good Faith:

Acting in good faith is extremely important in these circumstances. If the shareholders have not acted in good faith, the Court is unlikely to grant permission to initiate proceedings. Thus, a derivative action can only be brought if the shareholders have a proper, good and honest motive. An honest motive for the action will be: to pursue the best interests of the company, the action must have a reasonable prospect of success, and the belief of that success must be a reasonable belief. Conversely, if the motive is purely for personal gain, the Courts will refuse the shareholders request for the action.

(2) The Action is in the Best Interest of the Company:

This links into factor (1). The Court will refuse the request if the action is not in the best interest of the company. The following factors demonstrate that the action is in the best interests of the company if:

The Proceedings Do Not Involve a Third Party:

This means that the action should only involve the company. Therefore, if the wrong in question is committed by some other company (a third party), the Courts will refuse the derivative action.

The Directors Who Participated in the Wrong Did Not Act in Good Faith:

If the directors did not act in good faith, the wrong may be of a kind suitable for this cause of action. If a director does not act in good faith they may be acting in their personal interest, they may be making ill-informed decisions for the company or making decisions for improper purposes.

(3) It is Probable that the Company Will Not Bring Proceedings Itself:

This is a critical factor that must be satisfied. If it can be proven that the company will not bring the proceedings itself, then the court will likely grant the shareholders permission for derivative action. For instance, it is safe to say that companies will not bring proceedings against themselves when its director(s) or board of directors have caused the wrong or harm in question. Another instance where companies will not bring proceedings is where the company does not have the money available to bring the action.

Thus, the shareholders must prove that the directors of the company will not take legal action against themselves for their wrong doings.

What Does Derivative Action Achieve?

If the Court decides to grant the shareholders leave (based on the above factors) then proceedings will beginning on behalf of the company, or in the companies own name.

Final Thoughts:

Company derivatives are a great cause of action that shareholders can take when its directors have acted in a way that causes some wrong to the company. It is a way for shareholders to protect the company interests and initiate proceedings against its directors. Shareholders must prove the factors as discussed above before the Court will decide that some action or remedy is needed.

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