Majority Rule from Foss v. Harbottle

(Completed on 26.09.2015)

Introduction

A company is a juristic person which is conferred with a legal personality distinct from the members who form it. Decisions of the company represent the animus component of its personality and are taken by the Member Shareholders and the Board Members on behalf of the Company. The company also takes decisions regarding pursuing litigation.

Courts do not in general interfere in the management of the company on the insistence of shareholders in matters of internal administration as long as the directors are acting within the powers conferred to them under the Articles[1]. Judges have for long been reluctant to interfere in the internal affairs of companies[2]. For redressal of wrongs done to a company, it is believed that the action should prima facie be brought by the company which was laid down in Foss v Harbottle[3] and Mozley v Alston[4]. This rule is the foundation of common law jurisprudence regarding who may bring an action on behalf of the company. The rule in Foss v Harbottle is prudent since it is unnecessary to give recourse to the courts in regard to a matter which a company can settle on its own, or an irregularity which it can ratify or condone through its own internal procedure[5]. Without this rule, there would be such a large amount of frivolous litigation that the normal functioning of companies would be threatened.

However, a balance must be struck between the effective control of the company and the interests of the individual shareholders[6]. In certain circumstances therefore, an individual member is also allowed to bring an action on behalf of the company to compel the company to comply with its constitution and seek for remedy even when no wrong  has been done to him personally and the majority of members do not wish for the action[7]. There may also be collective litigation by a group of shareholders.

 

Foss v. Harbottle

Facts

The Victoria Park Company was formed by an Act which received assent in May 1837 whose purpose was to purchase around one hundred and eighty acres of land and create a park which would have houses, attached gardens and pleasure grounds. This land belonged to Joseph Dennison, a defendant, and others. Between the time that initial plans were made and the Act to form the joint stock company was passed, Dennison and some others who had agreed to form the joint stock company purchased land from the original owners rapidly so that at the time of passing of the act the Defendants owned more than half of the total land to be developed and re-sold it to the company greatly exceeding the price at which they purchased it. Also, the plaintiffs, defendants and several other persons subscribed for shares. The lands were transferred to the company in three ways. Transfer occurred by conveyance of the property to Victoria Park Company, to some defendant directors in trust for the company or by agreement.

The company was soon incorporated and significant construction took place. Several plots of land and buildings were let out. Four of the defendant directors did not pay up the calls and retained large sums collected from other members by calls. They appropriated these amounts to themselves and others in lieu of reduction of the increased chief rents.

The defendants also borrowed large sums of money from their bankers upon the credit of the company. They also wanted to mortgage the land belonging to the company. However the Act stated that this was not allowed till one half of the share-capital was paid. The defendants thus conveyed the property which was conveyed to them in trust and those properties given through agreement, to other person so that they could be mortgages. Three directors soon became bankrupt and their shares were transferred to the remaining defendants. The Property of the company was misapplied and wasted. The debts of the company were accumulating in the meanwhile. Thus, they profited from the establishment of the company at the company’s expense[8].

A bill was brought by two shareholders Richard Foss and Edward Turton on behalf of themselves and other shareholders except those who were defendants. It was alleged that the defendants purchase the land through an arrangement by which they concerted at or after the formation of the company with the object of deriving a profit or personal benefit from the establishment of the company.

Issue

The only issue dealt with was that of maintainability.

Arguments

Plaintiffs

The plaintiffs argued that the company should not be treated as an ordinary corporation. It was actually a partnership in the guise of a company. The directors were supposed to act as trustees of the plaintiffs. The Act of incorporation was to benefit the company, not to any of the rights of the proprietors inter se. The Act enabled proprietors to sue and be sue and excused them from following the exact form of proceeding applicable to a pure corporation. The remaining directors had refused to institute a suit since it was in fact against their personal interest.

Defendants

The defendants demurred and argued that the Plaintiffs did not have locus standi to represent the Corporation. Even if the plaintiffs had used the name of the corporation, the governing body of the company could have applied for a stay and an investigation would have followed. The case of fraud and equity was not made out by the plaintiffs.

 

Judgement

The demurrers were allowed and the defendants were not held liable. The bill was not maintainable. The court did not decide on whether the acts of the defendants were unlawful.

Ratio

The existence of board of directors de facto is apparent from the facts. The powers of the body of the proprietors is still in existence. If the court were to declare the acts complained of as void, and the plaintiffs are the only two proprietors who disapprove of it, the governing body of proprietors may call a special general meeting and approve the same acts which would binds the plaintiffs as well. It is for the board to decide which activities would be beneficial to the company and not the court.

Obiter Dicta

It was not a matter of course for any individual member of a corporation to assume to themselves the right of suing in the name of the corporation. The conduct with which the defendants are charged is an injury to the whole corporation. The corporation should sue in its own name and in its corporate character. It is not for an individual member to assume to themselves the right of suing in the name of the corporation when convening a general meeting was still possible and there was nothing in the circumstances which prevented the company from obtaining redressal in its corporate character.

If a case should arise of injury to a corporation by some of its members, for which no adequate remedy remained, except that of a suit by individual corporations in their private characters, justice would prevail over mere technicalities. However, a clear case of urgency must be made out.

Development of Majority rule

On application of the majority rule of Foss v Harbottle in subsequent cases, interpretation has led to the recognition of two principles from the case.

Internal Management

In England, the courts of equity were hesitant in interfering between partners unless it was for the purpose of dissolving the partnership itself and this rule was gradually extended to include companies too. Courts were averse to enforcing duties which arose out of internal regulation. These internal regulations could be altered by the majority. In MacDougall v. Gardiner, a bill filed was by a minority shareholder on behalf of himself and other shareholders except the directors against the company and the directors. The articles gave the Chairman of any general meeting to adjourn a meeting and also the power to take a poll if demanded by five shareholders. The court concluded that if the thing complained of is a thing which majority of the company is entitled to do or when the thing complained of was done irregularly or illegally which the majority is entitled to do regularly and legally, there can be no use in having litigation about it the ultimate end of which is that a meeting is called and the majority approves the action[9]. Ultimately the majority the majority has the maximum control over the use of the company’s name in litigation[10].

 

Proper Plaintiff

The source of this principle stems from the separate legal personality of the company. The company is a separate legal entity distinct from that of its member shareholders. Injuries cause to the company by outsiders and its own directors due to breach of duties owed to the company must be remedied by the company itself.

In Edwards v Halliwell the proper plaintiff in a wrong affecting to the company was held to be the company itself[11]. Where an alleged wrong is a transaction which might be made binding on the company by a simple majority of members, no individual member of the company may bring an action against it because if a majority of members is in favour of what has been done, then cadit quaestio and it is considered that no wrong has been done to the company and there is no longer any reason for anyone to sue. Thus for erring directors, there may be absolution if all the shareholders are satisfied. The court also recognize that where the act is ultra vires, is a fraud on the minority or where the wrongdoers are in control, the majority rule cannot apply.

Derivative claim

Certain actions of the management are not eligible for ratification. In such instances, every shareholder is instilled with a right to bring action on behalf of the company.

A derivative claim arises only when the directors themselves are in breach of duty and there exists a risk of improper or conflicted decision-making by the board members. In a derivative claim the company is added as a defendant even if it is the company’s rights which are being asked for. It protects the interests of the members-and not merely their rights- which may be affected by the wrong done to the company.

The emergence of derivative claims are a reflection of the shift in the very jurisprudential foundation of minority rights. Minority rights were not the focus of common law jurisprudence. Rather, the focus on companies managing their own matters by expressing the will of the majority.

The majority rule of Foss v Harbottle is the common law principle on who may sue on behalf of the company which has, in England, been diluted by the statutorily governed derivate claim. Derivative claims provide an alternative for minority shareholders who simply need to approach the court with good faith. Courts will not dismiss their petitions mere because they are not the majority shareholders but will look into whether they fulfil statutory requirements even if they are not majority shareholders and do not exercise a substantial control over decision making. Since derivative claims in England can only be brought under the Companies Act, the rule in Foss v Harbottle is consigned to the dustbin[12].

It cannot be determined whether derivative claims should be available only in exceptional circumstances. In this regard it should be noted that he majority rule has not been struck down. English Common has always been more impressed by the risk of derivative claims being motivated by personal objectives than the risk that confining derivative claims would lead to less litigation than required for the benefit of the company[13]. Shareholders should not be allowed to involve companies in litigation without just cause because otherwise their benevolence would become detrimental to the company.

Exceptions to the majority rule

Common law allows shareholders to sue collectively by affirming litigation through an ordinary resolution in instances where the board does not wish to sue because if the board had exclusive right to initiate litigation in the company’s name there would be less litigation than what would actually be beneficial to the company[14].

 

Ultra Vires

A shareholder may bring action against a company in those instances where an act is ultra vires the Articles of Association. These actions cannot be made legal through ratification by majority members. The court held in Bharat Insurance Co Ltd v Kanhaiya Lal[15] that although a company is the best judge of its affairs with regard to its internal management, ultra vires application of its assets cannot be considered as internal management and any member may bring action.

Good faith is a key ingredient in determining maintainability in such instances since his action is for the purpose of doing justice to the company. If the plaintiffs conduct is also tainted or if there is inordinate delay, his claim may not be accepted.

Fraud on Minority

This exception was recognized by courts since Edwars v Halliwell. In Greenhalgh v Arderne Cinemas Limited [16]a special resolution would be liable to be impeached if the effect of it were to discriminate between majority and minority shareholders to give the former an advantage which the latter would be deprived of.

The court stated that it will interfere to protect the minority in Cook v Deeks[17]. If directors have acquired for themselves property or rights which they must be regarded as holding on behalf of the company, a resolution that the rights of the company should be disregarded in the matter would amount to forfeiting the interest and property of the minority of shareholders in favour of the majority[18].

Wrongdoers in Control

Rights of a minority shareholder is not limited to cases of fraud alone. It also extends to instances of breach of duty. A controlling shareholder or director has a fiduciary duty toward the company. The majority cannot appropriate to themselves the property of the company or the interest of the minority shareholders. When two directors who were also majority shareholders sold property belonging to the company to one of the directors knowing that the sale was undervalued, it was held that there was a breach of duty of the directors to the company even if there was no fraud alleged[19].

Acts requiring special majority

A special resolution was introduced in a general meeting to increase the monthly allowance and commission of the Managing Directors which was decided by a show of hands since no poll was demanded[20]. The plaintiff sought a declaration that the resolution was not binding since it did not have the appropriate majority. The Chairman had declared that 218 had voted for and 78 had voted against the resolution which on the face of it shows that it failed[21]. The court rule in favour of the plaintiff.

Individual Membership Rights

These rights are personal or indiviguals rights vested in eacd shareholder either by Articles or by a statute. The articles and the stature form the rights which the shareholder may personally enforce in the court[22].

It was held in Nagappa Chettiar v Madras Race Club, a shareholder is entitled to enforce his individual rights against the company like the right to vote, right to stand in elections for director etc.[23]If the shareholder however intends recover damages alleged to be due to the Company, the action should ordinarily be brought by the company itself.

The nature individual right could be best illustrated with an example. In Henderson v Bank of Australasia, the plaintiff moved an amendment to the proposed resolution[24]. The Chairman refused to record the amendment in spite of the fact that it was seconded and the original resolution was passed without amendments. No reasons were given for this decision either. It was held that the shareholders have a right to move amendments to resolutions.

Class Action

Class action[25] gives a member, depositor, or a group of them falling a class locus to restrain the company and its directors from a manner prejudicial to the interests of the company, its members or depositors. They must total to 100 members or the prescribed percentage for a company having share capital or for a company not having share capital, the class must be at least one-fifth of the total number of members or if they are depositors they must be 100 depositors or the prescribes percentage of depositors. As long as the action is brought by a group satisfying the abovementioned statutory requirements, it doesn’t need to be a majority shareholder.

Oppression and Mismanagement

In instances where section 214 of Companies Act, 2013 applies or section 397 and 398 of Companies Act 1956 applies. This a statutory right granted to a shareholder which overrides the limitations of the majority rule. The application must be made by one hundred members or members having one-tenth of voting power in companies having share capital or the must constitute one-fifth of the members in the company’s register[26]. The tribunal would entertain matters where business of the company is conducted in a manner which defrauds the creditors, members or other persons, oppression of any member, company was formed for any fraudulent purpose, management is guilty of fraud or misconduct towards the company and its members or withholding of information regarding affairs of the company.

Application in India

The majority rule has limited application in India. Courts have been hesitant to apply in instances where larger public interests is at stake. Where the interests of workers and public finds are involved, courts do not apply the majority rule.

In National Textile Workers’ Union and Ors v P.R. Ramakrishnan and Ors[27], a constitutional bench of the Supreme Court held that workmen cannot be denied the right to be heard before an order adverse to them is passed by a company judge because this would violate audi alterram partem which is a basic rule of natural justice. It was recognized that the worker’s right to be heard in a winding up proceeding can be derived from the Preamble and Article 38 and 43-A of the constitution and from general principles of Natural Justice. , It was also held that a company is more than merely a legal device used by shareholders to carry out business but must also focus on maximising social welfare. Its management should not be left merely to the suppliers of capital but also the suppliers of labour. It also recognized that a line must be drawn. Doctrines popular in England should not be mechanically applied to interpret Indian laws.

The dissenting judges opined that the rule in Foss v Harbottle should be applied particularly since the statute[28] stated in clear terms an exhaustive list of who might be made parties to a winding up petition. However, all other judges felt that its application would be abhorrent to the company law jurisprudence India with its strong socialist traditions. The Delhi High Court had also concurred that a mechanical application of the majority rule to Indian conditions would be misleading[29]. This is because India has a substantial state supported funding. The Staate’s shareholding may be small but the financial institutions which provide most of the funding and support corporate activities are state controlled and are thus accountable to the citizens of the nation. Applying the majority rule strictly will lead to a situation where the majority shareholders will be given more weightage ignoring the financial institutions which are the driving force behind the company.

A powerful alternative remedy exist in favour of aggrieved shareholders in the form of a claim of oppression and mismanagement. The provision was held to be an alternative remedy independent of the rule in Foss v Harbottle and only the statutory requirement of locus standi must be fulfilled. It is not necessary for the plaintiff to show that he falls under an exception to the majority rule[30].

 

Analysis

It is still a widely held view that the majority decides matters of litigation. A meeting is called to decide whether the company wishes to involve itself in litigation and the majority prevails in the meeting.

Foss v Harbottle allowed individual shareholders to approach the court in a very limited basis. This avoided a slew of litigations which would be detrimental to the interests of the company. Companies do not always contemplate litigation when a director breaches his duty but rather they look into what would serve best interest of the company. Sometimes litigation may actually be detrimental to the company rather than beneficial. There is often a possibility that the judgement might not be in favour of the company, it may not be in a position to carry out the verdict or even suffer a loss of reputation which outweigh the gains of litigation. It would divert the company’s resources into a non-productive activity. It may also lead to the formation of rival factions in the managerial level. The decision not to sue, however, may influenced by a particular director’s benefit and not that of the company.

There is a peculiar paradox created by the majority rule in Foss v Harbottle. The rule itself in in use in several common law countries including India. It has be constantly affirmed and even in cases where the courts carve out an exception, they first acknowledge the rule and stress on its necessity. However, the doctrine itself has been considerable diluted. In England, where the doctrine originated, it is overshadowed by the massive development of derivative claims. In fact if the factual matrix of the case appears again, it will undoubtedly favour the plaintiff shareholders. This is because the law laid down in Foss v Harbottle has developed into a more complex set of principles. It is now read with the exceptions laid down through later judgements and statutory provision. It would squarely fall under the exceptions of breach of duty, fraud on minority and mismanagement.

The majority rule serves a dual purpose. Firstly, it prevents large scale litigation. Secondly, it makes possible for genuine grievances to be resolved by using its exceptions. The existence of the majority rule encourages the aggrieved shareholder to raise issues of poor management in General Meetings and communicate with the management regarding their need for redressal. This would give a bona fide management time to find out the individuals responsible. On the other hand an unsatisfactory reply or attempts to supress relevant facts would actually strengthen the case of the minority shareholder. A minority must not initiate litigation until it has first tried to get the company to do so.

 

[1] Rajahmundry Electricity Supply Corp Ltd v. A Nageshwara Rao, AIR 1956 SC 213 217.

[2] K.W. Wedderburn, Shareholders Rights and the Rule in Foss v. Harbottle 15(2) Cambridge Law Journal 194 (1957)

[3] (1843) 2 Hare 461.

[4] (1847) 1 Ph 790.

[5] L.S. Sealy, Foss v Harbottle: A Marathon where Nobody Wins 40(1) Cambridge Law Journal 31(1981).

[6] Avtar Singh Company Law  479 (16th ed., Eastern Book Company, Lucknow 2015).

[7] G.K. Kapoor and Sanjay Dhamija, Company Law and Practice 704 (19th ed., Taxmann, New Delhi 2013).

[8] Supra note 3, 469.

[9] (1875) 1 Ch. D 13, 25.

[10] Supra note 2, 201.

[11] [1950] 2 All E.R. 1064, 1066.

[12] Gower and Davies, Principles of Modern Company Law 615 (8th ed. Thompson Sweet and Maxwell, London, 2008).

[13] Supra note 21 at 610.

[14] Id., 607.

[15] AIR 1935 Lah 792.

[16] [1951] Ch. 286.

[17] [1916] 1 A.C. 554.

[18] Id. at 564.

[19] Daniels v Daniels, [1978] Ch. 406 409.

[20] Dhakeswari Cotton mills v Nil Kumal Chakravorty, AIR 1937 Cal 645.

[21] Id. at ¶9.

[22] S. Chumir, Challenging Directors and the Rule in Foss v Harbottle 4 Alberta Law Review 98 (1965)

[23] AIR 1951 Mad 831(2) ¶12.

[24] (1890) 45 Ch. D. 330 338.

[25] Section 245.

[26] Section 213(a).

[27] (1983) 1 SCC 228.

[28] Section 447, 450(2), 478(3), 517, 518, 542, 543, 549(1), 556, 557, Companies Act 1956. See also Rule 34,Company (Court) Rules,1959.

[29] Industrial Credit Investment Corporation of India Ltd. v Parasrampuria Synthetics Co. ILR (1998) 1 Del 136.

[30] S. Manmohan Singh v S. Balbir Singh ILR (1975) 1 Del  427.

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