By Pamela A. Evangelou
Based on the principle in Salomon v Salomon, upon its incorporation a company acquires legal personality separate from its members and as such it is responsible for its own debts and obligations. It has the right to sue or be sued in its own name. This right is not always possible to exercise, as shall be analyzed further below. The powers of companies are exercised by its two management bodies, the general meeting of the company and its board of directors, both of which take decisions based on majority votes. These democratic procedures consequently favour the persons who control over half of the votes of the general meeting or the board of directors. Thus the members of a company belonging to the minority must, in most cases, accept the decisions taken by the majority.
Theoretically, these individuals can try if they wish to control a larger percentage of the votes, either through acquiring additional shares or through representations and arguments to other shareholders. In practice, however, this proves to be quite difficult.
A large public company usually needs large funds to secure a majority stake. In smaller private companies the majority shares are likely to be held by a single person. Theoretically the minority members could opt out of the company, however in practice the other shareholder may refuse to buy the shares or offer a reduced price for their acquisition.
In such cases it is reasonable that the law will offer some protection to the minority of the company. However, the law must maintain a delicate balance. On the one hand, it must protect minority shareholders from unfair and oppressive acts of the majority. On the other hand, it must allow the company to operate in accordance with its articles of association, without external interventions that may interrupt its otherwise proper operation.
The rule in Foss v Harbottle:
Company membership rights are rights which each member has agreed to subject to the will of the majority, provided that this will is expressed in accordance with the law and the company’s articles of association. In relation to these rights, the principle of sovereignty of the majority is applied, otherwise known as the general rule in Foss v. Harbottle.
The specific implications of this rule and the classical wording set out in Edwards v. Halliwell:
(a) The appropriate plaintiff in a lawsuit in relation to an alleged tort against a company is, at first sight, the company itself.
(b) Where the alleged tort is a transaction which could be binding on the company and all its members by a simple majority of the members, no member alone may be sued in connection with that matter because, if the majority ratify the transaction then the company has not been wronged.
(c) On the other hand, if the majority disputes the transaction, there is no good reason for the company not to sue.
One reason for this rule is to avoid multiple procedures. If a shareholder is allowed to personally sue on a matter that essentially concerns the company, then lawsuits could be filed on behalf of each of the company's shareholders.
Exceptions to the rule in Foss v Harbottle:
In cases where the majority acts illegally or oppressively towards the minority, it would be unfair if there was no avenue for the minority to go to court for protection. That is why the courts have established specific exceptions to the rule, acknowledging that if the right of the minority was denied, its complaint would never reach the Court, because the perpetrators, having control of the company, would not allow the latter to take legal action against them.
These exceptions usually fall into the following four categories (Edwards v Halliwell):
1) Acts that are ultra vires (i.e., exceed the powers of the company) or that are illegal;
2) Transactions which can be done only with the approval of a qualified majority of the general meeting of the company, e.g. amendment of the company's articles of association by the directors;
3) Where the personal rights of a specific shareholder have been violated, noting that this is not a strict exception to the rule, but a case in which a member whose personal rights have been violated has a personal right to sue; and
4) Where the act constitutes minority fraud and the offenders control the company.
The 4 categories were confirmed recently by the Supreme Court of Cyprus in the case of Emilios Thomas et al. v. Iakovou Iliadis Political Appeal No. 11784 / 24.11.2006. As for the meaning of the term "fraud", it must be inherent in the actions of the controllers of the company and this term has been widely interpreted by the courts and goes beyond the narrow parameters of conscious or dishonest behavior. An extensive analysis of the issue with examples from the case law was made in the case of Daniels and others v. Daniels and others. In Alexander v. Automatic Telephone Co, the company's directors acted in their own favour since in issuing new shares they forced the other shareholders to pay their price immediately while the same did not apply to the directors themselves. Although in their action minority shareholders were essentially claiming their own equal treatment rights, the case was nevertheless considered an exception to the Foss v Harbottle rule on the basis of a concept broader than mere deceit, i.e. breach of the directors’ duties vis-a-vis the company.
In Cook v Deeks, the directors secured for themselves the benefit of a contract that could have been entered into by the company. Although the allegation of fraud was not substantiated, minority shareholders were allowed to sue, essentially on the principle that directors comprising the majority should not direct for their own benefit operations which normally belong to the company they represent. On the other hand, mere negligence in the performance of the duties of directors, from which the directors do not secure any benefit, is not considered fraud. In Pavlides v Jensen, the issue in question was the sale of a mine in Cyprus, which was not fraudulent on the part of the board of directors, nor beyond the company's powers, and there was no question of acquisition of the company's assets by the majority shareholders. It was considered that there was no transferable right to other shareholders as it was up to the company itself to decide whether to take action against the directors if it was considered that due to negligence or misjudgment they had sold company property at a price below its value.
In Daniels v. Daniels Judge Templeman summed up by saying that the principle that emerges from these cases is that a minority shareholder who has no other remedy can sue where the directors use their powers intentionally or unintentionally, fraudulently or negligently, in a way that benefits themselves to the detriment of the company. In Θωμά v. Ηλιάδη the Supreme Court of Cyprus held that the actions of the appellants constituted fraud where "for the purpose of directly or indirectly removing from the company in which they were shareholders, money, property, advantages or rights which belonged to the company or in which benefits the defendant was entitled to participate". It was also stated (in a loose translation) "when an attempt is made to give the definition of fraud for the purpose of an exception to the rule in Foss v Harbottle we must keep in mind that fraud in this case also includes all cases where the offenders indirectly or directly try to embezzle money, property or benefits which belong to the company or to which the other shareholders are entitled to participate". As regards the “control” required in order to qualify for an exception to the rule, the test for this is satisfied when the lawsuit can only be brought forward because the other directors can with their control prevent the lawsuit from being raised.
In Prudential Assurance Co Ltd. v. Newman Industries Ltd (No.2) it was said that the control of the company is considered present, even if the offenders do not have a majority of votes but can take advantage of their position to mislead the shareholders thus ensuring that the company will not proceed with a lawsuit. Glass v. Atkin was a Canadian case where it was considered that in a company where the shareholding interests were equal to 50% in each class of shareholders, the plaintiffs who owned 50% could sue because the defendant and his wife, who together owned the other 50% could effectively prevent the general assembly from passing a resolution to sue. The rationale of this Canadian case was adopted in Cyprus in Theodoros Pirillis Enterprises Limited v. Kouis, where it was ruled that the test is whether the company could act alone or not to protect its interests.
As stated in Gower Principles of Modern Company Law, it is clear from jurisprudence that a shareholder has two avenues for action:
1) A right to personally sue the company if his personal rights have been infringed; or
2) the right to bring forth a derivative action on behalf of the company, due to the company’s inability to bring forth a claim to protect its own rights.
There are two things that must be satisfied before a shareholder can rely on in order to bring forth a derivative action: First, he must prove fraud and second, he must show that the offender is in control to the extent that he precludes the company from suing in its own name.