Can one party sue on behalf of a company where the company is in deadlock

19/06/2019

It is an all too familiar scenario:  Two close friends pool their resources, knowledge and contacts to bring a business idea into reality.  The business grows and the two entrepreneurs, each a shareholder and a director of the company have different ideas about where the company should be headed. Disagreements become more frequent over lost opportunities, tension turns into suspicion and before long, outright hostility.

The once friends, find it impossible to work together.  Convinced that the joint venture has ended, one party begins withdrawing funds and taking trade stock which they believe to be their rightful share.

Before long, words like “misappropriation”, “theft of intellectual property” and “running a competing business” find their way into the already acrimonious relationship.

But how would one director hold the other ‘rogue’ director to account?  The allegations made against each of the directors give rise to claims that can be brought by the company against the defaulting director.  The company cannot act because it is deadlocked.

The Corporations Act allows certain persons including a former and current shareholder or director to apply for leave of the Court to sue on behalf of a company, provided that the claim is one which the company is entitled to prosecute in its own rights and is able to enjoy the fruits of the litigation. 

In contrast, the Court would not permit a director of a company to sue for loss suffered by the company’s wholly owned subsidiary.  It is the subsidiary that has the cause of action in respect the wrongs done to it and would enjoy the outcome of successful litigation.  The parent company merely has the standing to bring a derivate action as a shareholder.

Furthermore, the leave applicant must satisfy the criteria set out in subsection 237(2) of the Act before he or she will be allowed to stand in the shoes of the company.

Subsection 237(2) provides as follows:

“(a)     It is probable that the company will not itself bring the proceedings, or properly take responsibility for them, or for the steps in them; and

(b)      The applicant is acting in good faith; and

(c)      It is in the best interests of the company that the applicant be granted leave; and

(d)      If the applicant is applying for leave to bring proceedings – there is a serious question to be tried; and

(e)      Either:

(i)        at least 14 days before making the Application, the Applicant gave written notice to the company of intention to apply for leave and of the reasons for applying; or

(ii)       it is appropriate to grant leave even though subparagraph (i) is not satisfied.”

In most cases involving a deadlocked company (where the parties in dispute hold equal shares and equal number of votes on the company board) the applicant depending upon the circumstances, may satisfy the Court that the company will not commence proceedings.

The applicant then must show that he or she is acting in good faith.  The test of good faith is two-fold: firstly, the applicant must demonstrate a genuine belief in the existence of a cause of action that has reasonable prospects of success; and secondly, there must not be a collateral purpose in the applicant seeking to bring legal action on behalf of the company.

An applicant who has more than a token shareholding in the company would usually be accepted as acting in good faith.

In considering whether the applicant is acting in good faith the Court is not required to consider the merits of the claim because that is a separate element to be considered under subsection (2)(d).

The Court, however, would examine whether on an objective view of the facts the Applicant’s belief of a good cause of action is reasonable in the circumstances.

The fact that the applicant stands to benefit from the outcome of the company’s litigation, or the fact that the applicant may be motivated by ill-feelings against the other party, do not of themselves amount to evidence of a ‘collateral purpose’.

In considering whether granting leave would be in the company’s ‘best interest’, the Court would consider:

• the character of the company (whether it is a large listed company or a small family own business);
•  the effect or impact the proposed litigation would have on the company;
• whether the outcome the applicant hopes to achieve by litigation could be obtained by alternative means that do not require the company to be brought into litigation; and
• the likely costs and recovery if the proceedings are successful; the likely consequences if the proceedings are unsuccessful, etc.

Generally, where it is alleged that the company has suffered loss as the result of the director’s wrongful conduct, the Court will consider whether the application is in the interest of the company.

Where the applicant undertakes to pay for the costs of the proceedings and offers security to indemnify the company against any adverse costs (in the event the proceedings are not successful), the Court would be more willing to find it in the best interest of the company to grant leave.

As to whether or not there is a serious question to be tried, if the applicant can demonstrate a legal or equitable basis on which a claim can be brought against the intended defendant, the criterion of ‘a serious question’ will probably be satisfied.

In the present scenario, where:

(a)       the company is deadlocked;

(b)       each of the directors holds 50% of the shares in the company (i.e. more than a mere token shareholding);

(c)       there are allegations of directors benefiting at the detriment of the company and therefore, prima facie, claims of breach of the directors duties under the Act;

the Court would still need to consider whether it is in the best interest of the company that one of the directors be allowed to sue the other director on the company’s behalf.

If the once great business partnership with your friend/acquaintance has turned hostile and you are find yourself in the very difficult position of having to dissolve the business, Watson & Watson Solicitors have the experience and knowledge to advise you in relation to an application for leave to bring proceedings on behalf of a company, whether you are the party seeking leave or opposing it.  Seek the appropriate advice and contact Richard Watson Accredited Specialist Commercial Litigation or his Personal Assistant Shereen Da Gloria to discuss your concerns.

This is only a preliminary view and is not to be taken as legal advice without first contacting Watson & Watson Solicitors on 9221 6011.