12 August 2010

The Prudential principle and reflective losses

The principle established by the Court of Appeal in Prudential Assurance Co Ltd v Newman Industries Ltd (No 2) [1982] Ch 204 is that a shareholder cannot sue to recover damages for themselves in relation to wrongs done to the company. The proper course is to bring a derivative action on behalf of the company. Any recovery will flow through to the shareholders in the form of an increase in the value of their shares. The primary justification for the rule is said to be to avoid double recovery.

Application of this principle arose for consideration in David Ballard v Multiplex Limited [2008] NSWSC 1019 with respect to two heads of damages: liability as a guarantor; and deprivation of income and dividends. Mc Dougall J held that the principle did not apply in the first case but did in the second.

In relation to the guarantee, this was a liability that the shareholder was legally obliged to pay because the company was incapable of meeting its obligations. If the shareholder were to recover judgment for the payments, there would be no question of the defendants being exposed to double liability. Nor would there be any question of the company's assets being depleted by the recovery.

However McDougall J classified the shareholder's claim for loss of income and dividends arising because the company had lost earnings (as a consequence of the actions of the defendants) as a reflective claim. The shareholder submitted that because the company had been wound up and dissolved, there was no prospect that it would sue or recover the underlying losses, so that the policy reasons underlying the Prudential principle did not apply and nor should the principle. The court rejected that submission.


The Prudential principle was considered by the House of Lords in Johnson v Gore Wood & Co (a firm) [2002] 2 AC 1. In that case, the House of Lords recognised that there were exceptions to the principle, one of which applied where the shareholder's claim was based on lost dividends or a fall in value of the plaintiff's shares, but the company did not have a cause of action. The reason for the exception was that on these unusual facts there is no risk of double recovery. Indeed if the shareholder were unable to pursue their personal action, there would be no recovery at all (direct or indirect). However, the House of Lords qualified this exception by saying that the shareholder can sue to recover their losses assuming they are quantifiable; not too remote; and there is a separate duty owed to the shareholder.

This final requirement, namely that there be a separate duty owed to the shareholder, arguably explains the court's decision in Ballard v Multiplex. Another way of expressing the policy operating in this situation might be to say that the loss to the shareholder is caused by the company's failure/inability to pursue its remedy and not by the defendant's wrongdoing.

In some situations, the effect of this decision might be able to be overcome by reinstatement of the company.

Three recent decisions on the statutory derivative action

The three cases are Wood v Links Golf Tasmania Pty Ltd [2010] FCA 570, Fehring v Brighter Directions Pty Ltd [2010] VSC 287 and Vinciguerra v MG Corrosion Consultants Pty Ltd [2010] FCA 763. Each case adds to the former understanding of the operation of the statutory derivative action. The case that has the greatest potential to invigorate the provision is Wood v Links Golf Tasmania Pty Ltd. However, that potential remains under a cloud as a result of the failure of later cases to refer to it.

Wood v Links Golf Tasmania Pty Ltd - costs

This was a decision regarding costs, following the granting of leave to bring an action on behalf of the company. Under s 242 of the Corporations Act the court is given power to make "any orders it considers appropriate" about costs, including an order requiring indemnification for costs. The possibility that a court would make an order indemnifying the applicant for the costs of bringing an action on the company's behalf was one of the key reasons put forward for replacing the rule in Foss v Harbottle with a statutory derivative action. However, the approach taken by the courts to exercising their power under s 242 has been the reverse, namely to require the applicant to pay the company's costs and indemnify the company against any adverse costs order.

Finkelstein J was referred to this practice, but disagreed with it, referring the court's unconfined discretion and to the passage from the Explanatory Memorandum relating to the intended operation of the court's power under s 242. His Honour concluded that the starting point should be an expectation that the company would bear the costs of the action, but that this could be overridden by the circumstances. As an example of a case where an order for the company to indemnify the applicant might not be appropriate Finkelstein J referred to Fiduciary Limited v Morningstar Research Pty Ltd [2005] NSWSC 442, where the company's claim was only one aspect of a much wider dispute between the parties.

However, there were no countervailing circumstances on the facts. Accordingly, Finkelstein J ordered that the company meet the fair and reasonable costs of running the action, noting that the order could be recalled if, at a later time, the action turned out to be unmeritorious.

Fehring v Brighter Directions Pty Ltd – ex parte interim leave

This case also dealt with a relatively confined point, namely the procedure for applying for leave when a limitation period is about to expire and reasonable notice has not been given to the respondents.

The applicants sought an interim order of leave, subject to various undertakings directed to ensuring that the company would not be prejudiced if leave were granted but later revoked on a contested hearing of the application. They chose this path out of an abundance of caution, rather than filing the statement of claim and seeking leave nunc pro tunc. However, Davies J expressed obiter agreement with the decision of Middleton J in South Johnson Mill Ltd v Dennis & Scales [2007] FCA 1448 that the court had power to grant leave nunc pro tunc.

Vinciguerra v MG Corrosion Consultants Pty Ltd – critera for leave

This is the most recent of the three cases and raised issues regarding a number of the criteria for granting leave.

Probable that the defendant will not itself bring the proceeding

This is the first criterion under s 237 of the Corporations Act, and is usually established by the company's response when the plaintiff gives it notice of the intention to apply for a grant of leave. Here, however, the company's response was equivocal. It stated that it intended to appoint an additional independent director, and that the two independent directors would then investigate the allegations to see whether they warranted the company taking action against the third director. As part of its investigation, the company commissioned its own report, which refuted many of the claims made in a report prepared on behalf of the plaintiff.

On the facts, Gilmour J concluded that this element was satisfied. His Honour found that the first so-called independent director was not in fact independent. This finding undermined the probative value of the company's report, since Gilmour J was not prepared to accept that the company's expert was fully instructed with all relevant material for the purpose of preparing his report.

Good faith

The company put forward a number of factors as alleged bases for a finding of lack of good faith. These included:

  • That the plaintiff left the running of his application to his solicitors;
  • That the plaintiff's purpose was to cause the defendant to pursue a cause of action which, if successful, would increase the defendant's assets and consequently the value of the plaintiff's (30%) shareholding;
  • That the plaintiff had rejected an offer to buy his shares at fair value;
  • That the plaintiff had indicated that one option, after conclusion of derivative action, would be to wind up the company;
  • That after his employment with the company had ceased, he had competed with the company;
  • That the plaintiff declined to have his expert meet with the company's expert; and
  • That the plaintiff was complicit in the matters complained of in the statement of claim.

The court rejected all of these arguments and was satisfied that the plaintiff was acting in good faith. Specifically it found that:

  • Leaving matters to one's solicitors does not distract from good faith;
  • This was not a case where the plaintiff was seeking to further his personal interests other than as a shareholder of the company rather than the interests of the company as a whole. In this regard Gilmour J contrasted the case of Goozee v Graphic World Group Holdings Pty Ltd [2002] NSWSC 640 (at [68]) where the court had found that the applicant had the collateral purpose of seeking to persuade other shareholders to concur in and procure the payment of dividends by the company or the purchase of the applicant's shares in the company;
  • The offer to purchase the plaintiff's shares was unreasonable because it provided for the shares to be purchased at "fair value" as determined by an accountant, without providing any means for the purchase price to compensate the plaintiff for the amounts claimed to have been paid out by the company in breach of the director's duties;
  • There was no reason why a proposal to wind up the company must demonstrate bad faith. The plaintiff was merely trying to realise his interest in the company by the most expedient means available. He may have said some ill-advised things in anger, but the objective circumstances were a better guide to good faith;
  • It is not unlawful of itself to work for a competitor of a former employer, and the evidence did not establish that the plaintiff had attempted to sell the company's customer list and business without board approval while still employed by the company;
  • In the circumstances, the fact that the plaintiff's expert considered that nothing could be gained in him meeting the company's expert did not cast doubt on the plaintiff's good faith; and
  • The matters complained of occurred after the plaintiff had ceased to be a director.

It is in the best interests of the company that the plaintiff be granted leave

Gilmour J referred to previous cases but concluded that there was no fixed test for this criterion. However, his Honour regarded it as significant that none of the company's directors had provided any evidence as to any impact that the pursuit of a derivative action might have on the company's ongoing business.

Gilmour J also rejected the submission that the redress sought by the plaintiff could be achieved by other means, noting that the oppression remedy was not apt in this case, and that s 233 of the Corporations Act does not contemplate an order for payment of damages or compensation by a director to the company for breach of statutory and/or fiduciary duties.

In relation to this criterion, the court also:

  • considered that there was no evidence from the defendant that it would not be in a position to meeting any judgement debt;
  • rejected a submission that the plaintiff had a conflict of interest; and
  • found that the plaintiff had the financial resources to indemnify the defendant against any liability it might incur as a result of any adverse costs orders made in the derivative action. [Note in this regard that the court was acting on the basis that leave would be conditional on the plaintiff undertaking to pay the company's costs and to indemnify it against adverse costs orders.]

Serious question to be tried

Finding this criterion to be satisfied did not require the court to enter into the merits of the proposed action to any great degree or to reach any conclusion as to the strength of the arguments of the parties.