Deadlocked Shareholders in a Company: Whether Statutory Derivative Action should be Allowed

deadlocked

Two shareholders of a company each holding equal shares were at loggerheads. One applied to the Court for leave to commence an action against the other through the company, alleging wrongdoing on the part of the other.    

The Singapore High Court in Wong Lee Vui Willie v Li Qingyun [2015] SGHC 297 reiterated the requirements for leave to be granted to bring a statutory derivative action (under Section 216A of the Companies Act), and held that in these circumstances, leave should not be granted, as no benefit was shown to accrue to the company if leave was given, having regard to various factors including the key fact that the present case was essentially one of disagreement about the management of the company by equal shareholders who were close to, if not actually at, a position of deadlock in the management of the company.

Facts

The 2nd Defendant (“the company”) operates in the construction business. The 1st Defendant was one of its founding directors. Shortly after incorporation, the Plaintiff became a director alongside the 1st Defendant. At the material time, both the Plaintiff and the 1st Defendant were equal shareholders (50:50) and were joint signatories to the company’s bank account. The 1st Defendant was also appointed Managing Director.

Disputes arose between the parties as to a number of matters, including the hiring of workers, the management of projects, and whether the 1st Defendant was making secret profits at the expense of the company. Subsequently, the Plaintiff filed an Originating Summons in the High Court seeking leave to commence an action on behalf of the company against the 1st Defendant under Section 216A.

The Requirements for Leave to be Granted under Section 216A

Section 216A(3) of the Companies Act states the requirements for leave to be granted for an action to be brought in the name of the company, i.e. no action or arbitration may be brought and no intervention in an action or arbitration may be made under subsection (2) unless the Court is satisfied that:

(a) the complainant has given 14 days’ notice to the directors of the company of his intention to apply to the Court under subsection (2) if the directors of the company do not bring, diligently prosecute or defend or discontinue the action or arbitration;

(b) the complainant is acting in good faith; and

(c) it appears to be prima facie in the interests of the company that the action or arbitration be brought, prosecuted, defended or discontinued.

The Court held that the first two requirements, i.e. the giving of notice and good faith, were satisfied. However, the Court was not satisfied that the third requirement (i.e. a prima facie case) was met.

The Test to Establish a Prima Facie Case: Reasonable Semblance of Merit

The Court first reiterated the test and relevant principles (citing various authorities) to raise a prima facie case that the action was in the interests of the company:

(1) the Plaintiff must show that there was “some reasonable semblance of merit in his claims,” (see [33]);

(2) a reasonable semblance of merit is not one that is “bound to succeed or likely to succeed, but that if proved the company will stand to gain substantially in money or money’s worth” (see [33]);

(3) a reasonable semblance of merit is not one which is frivolous, vexatious or bound to be unsuccessful (see [34]);

(4) the standard of proof required is low (see [34]);

(5) only the most obviously unmeritorious claims would be eliminated (see [34]);

(6) illegitimate actions would not be considered to be prima facie in the interests of the company (see [34]);

(7) a cautious approach is to be adopted. What is needed is that there be a reasonable basis for the complaint and that the action is arguable (see [34]).

Holding: Suspicion Alone Insufficient and the Element of Deadlock

In the present case, the Court found that the Plaintiff’s allegations, when considered against the explanations given by the 1st Defendant, only raised, at most, a “possible suspicion of wrongdoing” (see [35]), and held that his application for the commencement of a derivative action was unmeritorious. This applied to the three sets of claims into which the Plaintiff’s allegations could be grouped, namely: (a) the control and management of workers; (b) the making of secret profits; (c) the mismanagement of projects.

The Court went on to clarify that he was mindful that the requirements on the part of the Plaintiff should not be pitched too high since readily allowing rebuttal by a defendant on flimsy grounds would ill serve the needs of the Companies Act. However, suspicion alone could not be said to be a sufficient basis upon which to conclude that the action had a reasonable semblance of merit. To permit claims to proceed only on the basis of suspicion would create great difficulty in the administration of companies, especially once friction arises between the directors or shareholders, as it invariably does (see [36]).

The Court also held that in a case of such a nature, where the contesting parties are essentially deadlocked, or close to deadlock, it would not be appropriate to sanction a derivative action (see [48]). In this regard, the Court held that in examining the interests of the company, a number of factors readily come to mind:

  • the costs and benefits of the proposed action;
  • the likelihood of success of any action; and
  • the availability of alternative measures.

The Court needs to make a robust assessment balancing the different considerations and interests. Section 216A is intended to allow persons not in control of the company to act through the company to address wrongdoing against the company. However, such actions would have to be in respect of wrongs committed against the company concerning rights or interests which the company as a whole would want to vindicate (see [51]).

The Court was concerned that given the state of affairs, in particular the position of deadlock in the management of the company, it was conceivable that the 1st Defendant himself may conceivably seek his own derivative action by the company against the Plaintiff. To grant leave to one party would only invite the other to respond in kind, leaving the company in an extricable bind, and this would not be in the best interests of the company (see [52]).

Comments

This is an important decision for two reasons.

First, it clarifies that despite the low standard of proof required to establish a prima facie case in the interests of the company, “mere suspicion of wrongdoing” fell short of the requisite standard (see [39]). For example, while the Plaintiff alleged that the 1st Defendant had breached his director’s duties in respect of the control and management of workers, the Plaintiff did not directly allege a withdrawal or diversion of funds from the company’s accounts (see [38]-[39]. Another example is that the Plaintiff’s allegations that the 1st Defendant made secret profits were not sufficiently specific or concrete and they did not point to any specific instance of misconduct (see [44]). As for the Plaintiff’s allegation that the 1st Defendant mismanaged a project, the Court held that there was no evidence that the actions of the 1st Defendant as alleged could not have been taken by any reasonable director (see [46]).

Second, it held that in a case of such a nature, which is essentially one of disagreement about the management of the company by equal shareholders who were close to, if not actually at, a position of deadlock in the management of the company, it would not be appropriate to sanction a derivative action (see [48]). One of the key reasons for this is the potential for a tit-for-tat situation whereby both deadlocked parties respond in kind to seek their own derivative action, thus leaving the company in an extricable bind, which ultimately would not be in the best interests of the company.

The usual disclaimer: All opinions expressed on www.singaporelitigationlawyer.com are entirely my own. Importantly, my opinions do not constitute legal advice and you should definitely formally engage a lawyer to confirm, vary or refute my views.

To Sue or Not to SueDemystifying Litigation in Singapore@www.singaporelitigationlawyer.com © Dominic Chan, a Singapore litigation lawyer. All rights reserved.

The picture above is taken from www.wrestlestars.com

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