Can Derivative Action Be Instituted Against A Third Party?
A brief guide on “derivative action”
A derivative action is an exception to the common law rule in Foss v Harbottle (the rule in Foss v Harbottle provides that if a company suffers a wrong, prima facie it is the company itself that should institute an action to remedy the wrong done to it, and not any of its shareholders, as the company is a separate legal entity from its members). This exception was first expounded by the Court of Appeal in Abdul Rahim Bin Aki v Krubong Industrial Park (Melaka) Sdn Bhd & Ors, where the exception allows minority shareholders to institute proceedings, such as in respect of ultra vires which cannot, in any event, be confirmed by the majority and where there is fraud on the minority by the wrongdoer in control.
Our earlier article has established that a shareholder does not need to be a minority shareholder to institute a derivative action. The next question we would like to pose is this: is it possible to institute a derivative action against a person who is not a shareholder of the company i.e. third party?
The long answer
As pointed out in the High Court case of Ong Keng Huat v Fortune Frontier (M) Sdn Bhd & Anor, the answer is yes. In this case, Keng Huat brought a derivative action against Tan Boon Leong (both equal shareholders of Fortune Frontier) and a third party for causing losses to Fortune Frontier. One of the contentions was whether is it possible to institute a derivative action against a third party.
The court’s answer
The court replied in the positive. As for the why behind the what, the court has this to say:
It is noteworthy as it is elementary that the common law derivative action is often associated with the need to address a wrong done to the company by a controlling element. Thus, if the company is not prevented from suing a wrongdoer, any cause of action that a company may have against a third party is neither appropriate nor suited to be pursued by way of a derivative action. Although the statute itself is silent on this point, interpretation on its applicability and scope should be formulated towards achieving the objectives of the legislative change…In any event, based on my research, such action against third parties can be legally justified in principle if the cause of action against the third party arises from a breach by an insider or controlling element. There is an English case law authority that establishes the principle that although the UK legislative provision on derivative action is not expressly limited to proceedings against wrongdoers who are insiders such as directors, leave can only be granted to commence action on behalf of the company against third party wrongdoer if the cause of action against the third party arises from the relevant breach by the directors…The underlying philosophy should thus be that since derivative actions are for situations where the controller wrongdoer prevents actions from being taken, derivative actions would not be appropriate where first, there are no such constraints, and secondly where the company decides not to pursue against a third party wrongdoer if such decision is not in any way influenced by the third party. In other words, there ought to be some form of collusion or acting in concert between the insider wrongdoer and the said third party to invoke a section 181A action (i.e. a derivative action) against the latter…”
Simply put, the high court states that a derivative action can be initiated against a third party if the below conditions are fulfilled:
- Where the wrong-doer (one part of the shareholders/ directors of the company) prevents the others (majority or minority) from bringing an action against the wrong-doer; and
- If the decision to prevent the pursuance of litigation was influenced by a third party.
Another way of putting it is this: there must be some form of cooperation between one part of the shareholders and a third party in the wrongdoing. They band together to prevent the other shareholders from suing before a derivative action can be initiated against a derivative action third party.
Finally, it must be noted that the Federal Court had to chance to revisit (reaffirm and solidify the above principle) this issue in Auspicious Journey Sdn Bhd v Ebony Ritz Sdn Bhd & Ors. We have prepared another article on it for your consumption.