Tds

International Islamic University Islamabad

LL.M Corporate Law Thesis Proposal On

The Derivative Suits

(A means to protect the shareholder’s rights) Submitted by Zia ul Hassan LL.M Corporate Law 119-FSL/LLMCL/F06

Submitted to The Thesis Committee

Department of Law Faculty of Shariah and Law

Thesis Statement Shareholder’s rights are tied to the corporation. The well-being of the corporations has direct relation to the well-being of its shareholders. Loss of the corporation is loss of its shareholders. Doing wrong to the corporation is doing wrong to its shareholders. In any such case of wrong being done to the corporation and that too by those who owe a “fiduciary duty” or “duty of loyalty” to the corporation, it is the foremost, inalienable and equitable right of the shareholders (on behalf of their body corporate) to sue the wrong doers.

In any company operational procedure, cases of professional negligence, fraud, misconduct and/or deceitful practices may happen. Various scenarios also happen wherein a company's top executives are ignoring these unlawful dealings for some reasons: either they are the ones responsible of such misbehaviors or they are unaware of such illicit practices because no one dares to divulge the issue. Consequently, the company's growth and effectiveness are being put in jeopardy. The common question then, would be, who may file charges against the unruly parties for the sake of the company's well-being? Obviously, businesses would not want to be charged in courts. These legal actions would certainly destroy the image of the whole company and even instigate bad relations among the shareholders. Still, most of the times, it is better to stop a person's misdemeanor than to continuously affect the company's operations. Majority of the corporate legislations world over consists of provisions that allow a shareholder to pursue legal actions against company officers who has been abusive of their powers. This is because being a shareholder entitles a person to represent the whole company if such illegal acts endanger the business. As these legal actions are called, shareholder derivative lawsuits are based on the doctrine that the law as an entity having its own rights, privileges and responsibilities considers a business. It might as well sue and be sued just like any other person. Nevertheless, since a company cannot act on its own, a shareholder, as a part owner of the company, may pursue a case against the wrongdoers.

2

Despite the fact that the Pakistani corporate field is abundant in cases of managerial misconduct, but it is rather unfortunate that Derivative suits are rarely used for correcting this wrong to the shareholders. The reason is quite obvious; little has been written and talked about this effective mode of enforcement of rights.

Significance of the Topic The modern world is organized around the concept of the corporation. Wherever we turn, we either find a corporation aggregate or a corporation sole at the top of the structure. Corporations, no doubt, are extremely important in today’s society. The study of corporate laws is not only a valuable body of knowledge but also a key to an understanding of the world. Very few inhabitants of the planet are untouched by the activities of companies. Corporations are devices that have enabled human beings to avoid huge transaction costs. This is not possible, for example, through a partnership. The growth of the modern corporation has been largely responsible for the dynamic economic development of the economic giants of the world. Through corporations, people are able to invest money in a business enterprise without worrying about unlimited liability in case of loss or management responsibilities for running the business. Thus, corporation law gives business the capability to raise the capital necessary to achieve the economics of scale vital to economic efficiency. The concept of a corporation developed in early law, and with the passage of time it has become a device based on a powerful concept. There is no exaggeration in the assertion that modern life is not possible without the concept of the corporation. One advantage of the corporate form of business is that it makes it easier to hold property for long periods of time. This is because the corporation is treated as an intangible being with a life ‘separate’ from the lives of its owners. This is known to be the juristic personality of the corporation. Another important characteristic of the corporate form of business (and that is mainly because of the first characteristic of this form of business i.e. a separate legal entity) is that the liability of its members is limited to the extent of their unpaid shares in the business. If one the one side such new concepts have led to the booming of the activities in this form of business, these have many a times proved to be economically fatal and disastrous for all investors generally and for small investors specially as they are provided with not enough remedies in case of loss resulting in the winding up and liquidation of their source of livelihood. The loss feels more painful in case such is solely because of the negligent and sometimes rather mala-fide conduct of the managers and directors of the corporation. The corporation being an unnatural person its affairs and business activities have to be run by the directors and managers, there is every possibility they may risk the valuable of the shareholders and other stakeholders and sometimes may do so to make undue advantages for themselves.

3

Corporate Social Responsibility ( CSR ) Corporate social responsibility (“CSR”) has been defined as the “obligations of business enterprises to adhere to a common set of rules on ethical, social, and environmental issues.” CSR recognizes that business enterprises should owe duties to their stakeholders -- those affected by their operations such as the communities in which they operate -- and be accountable to them. CSR is often directly proportional to the power which stockholders have to compel it. Corporate social responsibility or CSR: an umbrella term under which • • • • • • • •

the ethical rights and duties existing between companies and society is debated. Issues regarding the moral rights and duties between a company and its shareholders: fiduciary responsibility, stakeholder concept v. shareholder concept. Ethical issues concerning relations between different companies: e.g. hostile take-overs, industrial espionage. Leadership issues: corporate governance. Political contributions made by corporations. Law reform, such as the ethical debate over introducing a crime of corporate manslaughter. The misuse of corporate ethics policies as marketing instruments. Corporate abuse and corporate crimes.

The authorities and regulators in this regime of corporations have to appreciate such means which could reach to the end i.e. the protection of the rights of the stakeholders. One such mean is definitely the mechanism of “derivative suits”, which we are going to study in this paper.

The Derivative Suits (Also called the “Shareholder’s Derivative Suits” Or “Class Actions”) Technically “Derivative Suits” can be defined as: “A lawsuit brought by a shareholder of a corporation on its(Corporation) behalf to enforce or defend a legal right or claim, which the corporation has failed to do”. WHAT IS A DERIVATIVE ACTION? A derivative suit is one that is brought by a stockholder, on behalf of the corporation, to recover for harm done to the corporation. This legal device was originally construed in common law countries as a special and ingenious accountability mechanism. Derivative suits were conceived of as “double suits”, i.e.

4

two suits in one: (1) a suit in equity against the corporation seeking an order compelling it (2) to bring a suit for damages or other relief against some third person who had caused legal injury to the corporation. Today, derivative actions have been transformed in a suit, where the shareholder sues on behalf of the corporation for harm done to it. Therefore, any damages recovered in the suit are paid to the corporation (and ultimately the shareholder’s rights are protected).

The Cause of Action Shareholder Derivative Suits are suits brought by an existing shareholder on behalf of the company against the officers and directors of the company. The cause of action for this kind of suit is grounded on the allege breach of fiduciary duty. A derivative suit is more complex than a direct suit brought by a shareholder to enforce a claim based on the shareholder's ownership of shares. In direct suits brought about by shareholders, it involves suits relating to contractual or statutory rights of the shareholders, the shares themselves, or rights relating to the ownership of shares. Such direct suits include actions to recover dividends and to examine corporate books and records which are straightforward compared to derivative suits. Due to the complexities of Shareholder Derivative Suits, individual defendants are usually represented by lawyers (pleaders) other than the lawyers(pleaders) for the corporation. Also, the corporation may play different roles in a derivative suit. It may be an active party in the litigation, be entirely passive, or side with the individual defendants and argue that their conduct did not harm the corporation. Aside from breach of fiduciary duty, Shareholder Derivative Suits also encompass • • • • • • •

Insider trading, excessive officer compensation, proxy violations, option plan violations, related party transactions, misappropriation of corporate opportunities and corporate waste.

In a derivative suit, the shareholder is the nominal plaintiff (generally, the plaintiff shareholder is not required to have a large financial stake in the litigation), and the corporation is a nominal defendant, even though the corporation usually recovers if the shareholder prevails. Nevertheless, derivative litigation is essentially three-sided because the defendants include the persons who are alleged to have caused harm to the corporation or who have personally profited from corporate action. The claim of wrongdoing against these defendants is the central issue in a

5

derivative suit, and the interest of the corporation is usually adverse to these defendants. Thus, individual defendants are usually represented by attorneys other than the attorneys for the corporation. The corporation may play different roles in a derivative suit. It may be an active party in the litigation, be entirely passive, or side with the individual defendants and argue that their conduct did not harm the corporation.

Essential Distinctive Features of Derivative Suits In a successful derivative suit, damages are paid to the corporation, not the shareholders. Even though the right being asserted in a derivative suit “belongs” to the corporation, it is not immediately obvious why the recovery is not paid to the shareholders as the corporation’s owners. One reason is that, if the corporation has been injured, awarding recovery only to the shareholders would bypass the creditors, whose securities have been devalued by the breach. Indeed, if the corporate assets have been severely depleted, giving the damages directly to the shareholders could have the same effect as an illegal dividend by an insolvent corporation. On the other hand, applying this theory to a solvent corporation would seem to be inconsistent with the theory that the directors owe fiduciary duties only to shareholders and not to creditors. A second rationale for the peculiar aspect of the derivative suit which gives the damages to the corporation rather than directly to the shareholders (i.e., the nominal plaintiff) is that this avoids the problems involved in fashioning direct relief to shareholders. Public corporation shares trade at various times before or after disclosure of the wrong at prices that may or may not reflect the full extent of the loss or the probability of recovering damages. If shareholders were to be paid directly, the court would have to undertake the difficult task of determining which shareholders were harmed by the wrong and by how much. The derivative remedy avoids these complications.

6

Objectives of the Study The Pakistani corporate sector is no exception to the abuse of stakeholder’s rights at the hands of the corporate management and those who are at the helm of the affairs in the corporate business. The Pakistani corporate history reveals many such cases, where booming corporations gradually started suffering losses and then went into oblivion. Such disasters were prima facie cases of managerial misconduct and “insider trading”, resulting huge losses to the stockholders and derailing their source of livelihood. The concept of Derivative suits is a new arrival to the Pakistani corporate field. It is so new a concept as to be used as yet in so many well ripe cases of managerial misconduct, willful negligence and insider trading. Although, in both direct suit by the shareholder and in Derivative suits, the title of the suit might be same, i.e. Shareholder (Plaintiff) V Corporation ABC Limited (Defendant), but the essential difference between the two suits should be kept in mind. The difference lies in certain points; among them are: that in Direct suit against the corporation if the judgment comes in favor of the shareholder, damages and other claims are paid to him, while in case of a Derivative suit, damages are only paid to the corporation, and the reason has been provided in detail above. The second essential difference between the two modes of actions is that in a Direct suit by the shareholder, he must have locus standi i.e. his claim must be personal and not on behalf of some other stockholders and not being their agent, while in case of a Derivative suit it is not necessary that some certain right of the shareholder has been infringed. It is sufficient locus standi for the plaintiff shareholder in a Derivative suit that he owns some stocks in the corporation, although he might not have personal claim against the Directors and other officers of the corporation. As the concept is still in air, I deem it necessary, rather obligatory being specializing corporate law, to have a thorough study of it and search out its causes of action in Pakistani corporate sector. This work will also serve as a guideline for the prospective plaintiffs of derivative suit and class actions litigants in Pakistan.

7

Resea rch Methodolog

y:

In the compilation of this thesis, I would follow the methodology given below: The first and most reliable source of information is definitely books. I have so far searched quite a number of good books specifically dealing with the topic. For this purpose I will visit different libraries beside the libraries present inside our university’s campus. Securities and Exchange Commission of Pakistan (SECP) is the ultimate governing body over the corporations. My visits shall include visits to the SECP as well. I will also make access to the different reported cases whether by the SECP or the other courts in Pakistan. I also intend to carry out a survey and for this would distribute a questionnaire among the members of different companies, who are visiting the stock markets and by this it would be hopefully determined how many stakeholders know about their rights generally and about Derivative suits specifically. Internet has, no doubt, become the mega source of information and an ocean of knowledge. I would also conduct research on the web to have a broader picture of the concept.

8

Chapterization: THE DERIVATIVE SUITS INTRODUCTION •

Introducing the Concept

•

Purpose and Objective of the Study

Chapter 1:  Corporation’s personification and the issue of Ownership  Who drives a Corporation?  Fiduciary Duty or Duty of Loyalty  Corporate Social Responsibility (CSR) Chapter 2: 

Causes of Action in Derivative Suits



Incentives in Derivative Actions



Personal V Derivative Suits

Chapter 3:  Procedure in Derivative Suits •

Demand from Directors

•

Wrongful refusal of Directors

•

Special Committees failure

•

Class litigation

•

Award of Damages

Chapter 4:  Case Law •

Some most cited cases of Derivative suits from the West

9

Conclusion (With Recommendations in Pakistani context of Class actions) Bibliography

SELECT BIBLIOGRAPHY ♦ Shareholder Suits: The Roles and Motivations of Minority Shareholders and Directors in Derivative Suits By: Alessandro De Nicola ♦ Shareholder’s Rights By: Robin Hollington, Sweet and Maxwell Publishers ♦ Shareholder Activism Handbook By: Eisenhofer J.W ♦ Class Actions and Other Multiparty Litigation, Cases, and Materials (American Casebook Series) By: Klonoff Bilich ♦ Law in a Nutshell: Class Actions and other Multiparty Litigation By: Klonoff ♦ Class Actions: The Law of 50 States By: Dickerson ♦ The Economics of Corporate Enterprise By: N.S Buchanan ♦ Finance and Investment Handbook Barrons Publishers ♦ Principled Profit: Marketing that puts people first By: Shel Horowitz ♦ Conscience and Corporate Culture By: Kenneth Goodpaster ♦ Business: Its Legal, Ethical and Global Environment By: Marianne Moody Jennings ♦ Ethics and Conduct of Business By: John R. Boatright

10

♦ Company Law By Janet Dine, Maxwell and Sweet Publishers ♦ The Concept of Corportation By Peter F. Drucker ♦ Company Law By J. H. Farrar, Butterworths & Co. ♦ Company Law By R R Pennington ♦ Business Law By: Robert W. Emerson, J.D (4th Edition) ♦ The Companies Ordinance, 1984 G.W Chaudry ♦ Islamic Law of Business Organization; Corporation By Imran Ahsan Khan Nyazee, Islamic Research Institute IIUI ♦ Company Law By E. Marshall and M.S. Oliver ♦ The Company Secretary's Handbook By Helen Ashton BA ACIS ♦ Company Law Fundamental Principles By Stephen Griffen

WEBLIOGRAPHY • • • • • • • • •

http://www.law.lexisnexis.com/commentary/Business/Derivative-Suits http://www.thefreelibrary.com/Advisen+Analyzes+Impact+of+Shareholder+D erivative+Suits+on+Corporate http://www.cid.harvard.edu/ http://www.cyclopedialaw.com http://www.cnapro.com/pdf/shareholderDerivativesuits_Advisen.pdf http://www.legal-dictionary.thefreedictionary.com/derivative+suit http://www.abanet.org/litigation/committees/classactions/home.html http://www.mesrianlaw.com/shareholder-Derivative-suits.html http://www.findlaw.com/shareholder-Derivative-suits.html

11