What Is a Derivative Action?
A derivative action is a legal proceeding brought by a shareholder or director on behalf of a company, rather than in their own personal capacity. The cause of action belongs to the company, and any remedy or damages recovered goes to the company, not to the individual who brought the claim.
This mechanism exists because companies are separate legal entities that can only act through their directors. When the directors themselves are the wrongdoers, or when they refuse to take action against wrongdoers, the company may have no one willing to pursue its rights. Derivative actions provide a solution to this problem.
Why Derivative Actions Matter
In many Malaysian companies, particularly private companies, those who control the board may be the very persons who have breached their duties to the company. They are unlikely to cause the company to sue themselves. Without derivative actions, wrongs against the company would go unremedied.
Common situations where derivative actions become relevant include:
- Directors who have breached their fiduciary duties
- Directors who have misappropriated company assets
- Related party transactions that are unfair to the company
- Directors who have diverted corporate opportunities for personal gain
- Third parties who have wronged the company, but the directors refuse to take action
The Statutory Framework
Derivative actions in Malaysia are governed by sections 347 and 348 of the Companies Act 2016. These provisions replaced the common law derivative action and provide a clearer statutory procedure.
Who Can Apply
Under section 347, the following persons may apply to the court for leave to bring or intervene in proceedings on behalf of a company:
- A member of the company
- A former member of the company
- A person who is entitled to be registered as a member of the company
- A director of the company
- A former director of the company
The term "member" generally refers to a shareholder whose name is entered in the register of members.
The Requirement for Leave
A person cannot simply commence derivative proceedings. They must first obtain leave of the court. This is a safeguard against frivolous or vexatious claims that could disrupt company operations or be used as a tool for harassment.
The leave application is typically made by originating summons, supported by an affidavit setting out the facts and grounds relied upon.
When the Court Will Grant Leave
Section 348 of the Companies Act 2016 sets out the circumstances in which the court shall grant leave. The court must be satisfied that:
- It appears to be prima facie in the interest of the company that the application for leave be granted
- The applicant is acting in good faith
- There is a serious question to be tried
Prima Facie in the Interest of the Company
The court will consider whether pursuing the action would benefit the company. This involves weighing the potential recovery against the disruption, expense and distraction that litigation may cause. The court does not conduct a full trial at the leave stage, but it must see that the proposed action has sufficient merit to warrant proceeding.
Good Faith of the Applicant
The applicant must demonstrate that they are genuinely seeking to benefit the company, not pursuing a personal vendetta or collateral purpose. Evidence of hostility between the applicant and the defendants is not itself fatal, but the court will examine whether the dominant purpose is to advance the company's interests.
Factors that may suggest lack of good faith include:
- The applicant using the proceedings primarily to damage the reputation of directors
- The claim being brought as leverage in unrelated disputes
- The applicant having participated in or acquiesced to the conduct complained of
Serious Question to Be Tried
The applicant must show that the proposed claim is not frivolous, vexatious or bound to fail. There must be a genuine legal issue that warrants determination by the court. This threshold is not as high as proving the case on the balance of probabilities, but it requires more than mere speculation or suspicion.
Matters the Court Will Consider
In deciding whether to grant leave, the court may also have regard to various practical considerations:
- Whether the company has decided not to bring proceedings and the reasons for that decision
- Whether the applicant has given reasonable notice to the directors of the company of their intention to apply for leave
- The views of the independent directors or shareholders, if any
- Whether the wrong has been or may be ratified by the members
- Whether the company has resolved not to pursue the claim
The requirement to give notice to the directors before applying for leave allows the company an opportunity to investigate the complaint and decide whether to take action itself, potentially making the derivative action unnecessary.
Conduct of the Proceedings
If leave is granted, the applicant may bring or continue the proceedings on behalf of the company. The court has broad powers to make orders as to how the proceedings are to be conducted, including orders about:
- The payment of costs
- Any indemnity the company should provide to the applicant
- The conduct of the proceedings
- How the proceedings should be settled or discontinued
Any settlement or discontinuance of derivative proceedings requires the approval of the court. This prevents the applicant from compromising the company's claim without proper oversight.
Relationship with Other Remedies
Derivative actions exist alongside other remedies available to aggrieved shareholders. Section 346 of the Companies Act 2016 provides for personal remedies where conduct is oppressive to shareholders or in disregard of their interests. The key distinction is that oppression remedies address wrongs done to the shareholder personally, while derivative actions address wrongs done to the company.
In some cases, the same facts may give rise to both types of claims. Shareholders should carefully consider which remedy is appropriate, or whether both should be pursued.
Practical Considerations
Before pursuing a derivative action, careful thought should be given to the strength of the underlying claim, the evidence available, and whether the action genuinely serves the company's interests. The leave stage provides an important filter, but preparation for that stage requires thorough investigation of the facts and the legal basis for the proposed claim.
Shareholders and directors who believe the company has been wronged should document the relevant conduct, preserve evidence, and consider whether the matter can be resolved through internal company processes before resorting to litigation.