THE COMPANIES ACT, 2013

A R T I C L E 0 8

Derivative Action

Foundational Doctrines — Wrongs to the Company

Sec 245

CLASS ACTION

Companies Act 2013

Wallersteiner

v. MOIR

Costs principle

CASE LAWS

Modern jurisprudence

For Judicial Service Aspirants & Law Students

RJS DJS PCS-J HJS UPJS BJS MPCJ

— When a shareholder may sue on behalf of the company itself —

Derivative Action

Introduction

A derivative action — sometimes called a 'derivative suit' or 'shareholder's derivative action' — is a peculiar procedural device of company law. It is a lawsuit brought by a shareholder on behalf of the company, to enforce a right that belongs to the company itself. The shareholder does not sue in his personal capacity or for personal loss; he sues as a representative of the company, to redress a wrong done to the company, in a situation where the company (controlled by the wrongdoers) will not or cannot sue for itself.

The derivative action sits at the intersection of two principles: the Rule in Foss v. Harbottle, which says that wrongs to the company must normally be litigated by the company itself, and the equitable exceptions to that rule, which permit individual shareholders to sue in certain defined circumstances. The derivative action is the procedural mechanism through which the 'fraud on the minority' exception (and the related 'wrongdoers in control' exception) is given practical effect.

This article examines the origin, rationale, operation, and procedural requirements of the derivative action — with particular focus on the landmark cases of Edwards v. Halliwell, Burland v. Earle, and their Indian application. It also addresses the modern statutory alternatives — particularly the class action suit under Section 245 of the Companies Act, 2013 — that have supplemented and in many cases supplanted the classical derivative action.

Part I — Conceptual Foundation

What is a Derivative Action?

A derivative action is an action brought by one or more shareholders — often called 'derivative plaintiffs' — in their own names, but for the benefit of the company. Its essential features are:

The cause of action belongs to the company (not to the shareholder personally);
The wrongdoers are typically in control of the company, making it impossible or futile for the company to sue in its own name;
The shareholder-plaintiff is essentially a procedural vehicle — the action is 'derivative' because it is derived from the company's right;
Any recovery accrues to the company, not to the shareholder-plaintiff personally (though the plaintiff may in some cases recover costs);
The defendant is typically the wrongdoing director or majority shareholder.

The Nominal Party

A peculiar feature of the derivative action is that the company is usually joined as a nominal defendant. Procedurally, the company is defending itself against a claim brought on its own behalf — an apparent paradox. In reality, the joinder of the company is procedural: the company is a party because the action directly concerns its interests, and any judgment will directly affect its rights. The real defendants are the controlling wrongdoers.

Distinguishing Derivative Action from Class Action

Feature	Derivative Action	Class Action
Cause of Action	Belongs to the company	Belongs to a class of members/depositors
Plaintiff	One or more shareholders suing on behalf of company	Class representative suing for the class
Recovery	Accrues to company	Accrues to class members
Source	Common law / equity	Statutory (Section 245, CA 2013)
Typical Relief	Accounting by directors, restoration of property to company	Damages, compensation, injunction
Key Cases	Edwards v. Halliwell, Cook v. Deeks, Burland v. Earle	Section 245 jurisprudence (emerging)

Distinguishing from Personal Actions

A derivative action must be distinguished from a personal action brought by a shareholder to vindicate his personal membership rights (see Exception 3 to Foss — personal rights). Where a personal right is violated, the shareholder sues in his own name for his own benefit. Where a corporate right is violated (and the company cannot sue), the shareholder sues derivatively for the company's benefit. The two actions have different purposes, different remedies, and different procedural requirements.

Part II — Landmark Cases

Edwards v. Halliwell, [1950] 2 All ER 1064 (Court of Appeal)

📖 Edwards v. Halliwell, [1950] 2 All ER 1064

Facts: The National Union of Vehicle Builders (a trade union, treated by the Court as analogous to a company for Foss purposes) had a rule requiring that any increase in membership contributions be approved by two-thirds majority of members in a ballot. The executive committee of the Union nevertheless passed an increased contribution resolution by simple majority. Two union members brought an action challenging the resolution and the increased contributions. The Union contended that the matter was governed by Foss v. Harbottle — any grievance must be pursued by the Union itself, not by individual members. Held: The Court of Appeal (Jenkins LJ) held that the action was maintainable. Jenkins LJ systematically restated the Foss rule and its exceptions, classifying the exceptions as follows: (i) Acts ultra vires the association; (ii) Acts requiring special majority not obtained; (iii) Infringement of personal rights of members; (iv) Fraud on the minority coupled with wrongdoers in control. The present case fell within exception (ii) — the rule requiring two-thirds majority had not been complied with; simple majority could not cure this defect. The members were therefore entitled to bring the action. Principle: (a) The modern classification of Foss exceptions (four main categories, sometimes expanded to five or six); (b) Where a rule requires a special majority, individual members may sue for breach; (c) The derivative action is the vehicle for pursuing the company's (or association's) rights where the majority is in breach.

Edwards v. Halliwell is the most influential modern articulation of the Foss exceptions. Jenkins LJ's classification has been adopted in almost every common law jurisdiction, including India, and appears in every standard textbook. The case firmly established that where the exceptions apply, the derivative action is the proper procedural mechanism.

Burland v. Earle, [1902] AC 83 (Privy Council)

📖 Burland v. Earle, [1902] AC 83

Facts: A shareholder brought a derivative action against the directors of a company (Colonial Assurance) for various alleged breaches of duty and misappropriation. The directors moved to dismiss on grounds that the action was barred by the Foss rule. Held: The Privy Council (Lord Davey) held that a derivative action could be maintained, but carefully delineated its scope. The essential feature of the derivative action, according to Lord Davey, was that it lay only where the wrong complained of could not be ratified by the majority and where the wrongdoers were in control. Where the wrong was something the majority could ratify (and was willing to ratify), no derivative action could lie. Where the wrongdoers were not in control — so that the company could realistically sue — the company itself, not an individual shareholder, was the proper plaintiff. Principle: (a) Derivative action lies where (i) the wrong cannot be ratified by majority, and (ii) the wrongdoers are in control; (b) Both conditions must be satisfied — absence of either prevents a derivative action; (c) The court has discretion to permit or refuse the action based on all relevant circumstances.

Burland v. Earle is cited in Indian jurisprudence as one of the earliest authoritative statements on the limits of the derivative action. The two-fold test — inability to ratify + wrongdoers in control — is frequently repeated in later cases.

Other Key Authorities

📖 Menier v. Hooper's Telegraph Works, (1874) LR 9 Ch App 350

(Discussed in the article on Foss v. Harbottle.) A majority shareholder used his control to wind up the company to benefit himself personally, depriving the minority of a valuable government contract. The Court of Appeal permitted the minority to bring a derivative action. Principle: Where the majority uses its control for personal benefit at the expense of the minority, a derivative action lies.

📖 Cook v. Deeks, [1916] 1 AC 554 (Privy Council)

(Discussed in the article on Foss v. Harbottle.) Three directors diverted a corporate opportunity to themselves and then used majority control to ratify the diversion. The Privy Council held that the ratification was void; the minority could bring a derivative action to recover the diverted opportunity. Principle: Diversion of corporate opportunities is a breach of fiduciary duty that cannot be ratified by the controlling majority; derivative action available.

📖 Pavlides v. Jensen, [1956] Ch 565

A derivative action was brought alleging that the directors had sold a mine at an undervalue. The English court held that mere negligence, without fraud or self-benefit, was not sufficient to support a derivative action — such wrongs are capable of ratification by the majority. Principle: Mere negligence is not enough; there must be fraud, self-benefit, or some element that makes ratification impossible.

📖 Daniels v. Daniels, [1978] Ch 406

A director sold company property to herself at an undervalue. The English court held that even in the absence of 'fraud' in the strict sense, a derivative action lay where directors benefit themselves in breach of duty. Principle: Self-dealing in breach of duty suffices for a derivative action, even without proven fraud.

📖 Wallersteiner v. Moir (No. 2), [1975] QB 373

The English Court of Appeal (Lord Denning MR) held that in appropriate cases, a minority shareholder bringing a derivative action may be entitled to be indemnified by the company for his costs, particularly where the action is genuine and in the company's interest. Principle: The derivative plaintiff may recover costs where the action succeeds or is otherwise in the company's interest.

Part III — Requirements of a Derivative Action

To maintain a derivative action, the plaintiff shareholder must typically establish:

Requirement 1: A Wrong Done to the Company

The cause of action must belong to the company. The plaintiff must demonstrate that the company has suffered a wrong — breach of fiduciary duty by directors, misappropriation of company property, diversion of corporate opportunity, ultra vires transactions, etc. If the wrong is personal to the plaintiff (e.g., refusal to register share transfer), a derivative action is inappropriate.

Requirement 2: Wrong Not Ratifiable by Majority

The wrong must be of a kind that cannot be ratified by an honest majority. Acts that are ultra vires the company, or that constitute a fraud on the minority, or that involve diversion of corporate opportunities by directors, fall into this category. Mere negligence, poor business judgment, or technical breach of articles that a majority could lawfully approve do not qualify.

Requirement 3: Wrongdoers in Control

The wrongdoers must be in control of the company, so that it is futile to expect the company to sue in its own name. If the board or majority is independent and willing to prosecute the wrong, no derivative action is necessary. This requirement ensures the derivative action is a remedy of last resort — used only where normal corporate governance has broken down.

Requirement 4: Good Faith of the Plaintiff

The shareholder bringing the derivative action must be acting in good faith, in the interests of the company, not pursuing his own ulterior motives. Courts will refuse to permit derivative actions brought for collateral purposes — such as to harass directors, to extract settlement, or to advance the plaintiff's unrelated interests.

Requirement 5: Exhaustion of Internal Remedies (Demand Requirement)

In some jurisdictions (particularly the United States), there is a formal 'demand requirement' — the shareholder must first demand that the company (through its board) take action, and only if the demand is refused (or would be futile) may the shareholder sue derivatively. Indian law does not impose a rigid demand requirement, but the court will consider whether the plaintiff has attempted to use internal corporate remedies before approaching the court.

Part IV — The Derivative Action in India

Pre-2013 Common Law Position

Indian courts have historically applied the derivative action doctrine under the Companies Act, 1956 and earlier legislation. Key features:

The English classification (particularly Jenkins LJ's framework in Edwards v. Halliwell) was adopted;
Indian courts required fraud on the minority + wrongdoers in control;
Applications were typically brought before the Company Law Board or civil courts;
Remedies included injunction, accounting, restitution, and damages;
Costs could be awarded against the company in successful derivative actions (Wallersteiner principle).

The Modern Position under the Companies Act, 2013

The Companies Act, 2013 has significantly supplemented the common-law derivative action through three principal provisions:

Section 241 (oppression) — Individual members can seek relief before the NCLT for conduct prejudicial or oppressive to them or to the company;
Section 242 — Broad tribunal powers to grant relief;
Section 245 (class action) — Members and depositors may file representative suits for various wrongs, including fraudulent/wrongful acts by the company or its directors.

These statutory mechanisms have, in practice, largely absorbed the common-law derivative action. Most minority grievances in contemporary India proceed under Sections 241, 242, or 245 before the NCLT. However, the common-law derivative action remains available and is occasionally invoked — particularly in civil courts where the NCLT does not have jurisdiction, or in specific contexts where the statutory framework is ill-suited.

Section 245 — The Class Action Suit

Section 245 of the Companies Act, 2013 is a significant statutory innovation that expands beyond the classical derivative action. Key features:

Who may file: Requisite number of members (100 members or such percentage of total members as prescribed, whichever is less; or any number holding not less than 5% of issued share capital in case of non-listed companies and 2% in case of listed companies) or depositors;
Grounds for action: (a) the company's affairs are being conducted in a manner prejudicial to the interests of the company or its members/depositors; (b) fraudulent or unlawful acts; (c) acts contrary to the Act or articles; (d) misstatements in prospectus; (e) unreasonable auditor conduct;
Against whom: The company, its directors, auditors, experts, advisors, consultants;
Reliefs: Restraining acts, declaring transactions void, claiming damages, claiming compensation, and any other reliefs the Tribunal considers appropriate;
Procedure: Before the NCLT, which applies a preliminary screening; public notice is given; intervention is permitted;
Settlement: Court sanction required;
Costs: Ordinarily borne by plaintiff; recoverable from company if action succeeds.

Section 245 is broader than the common-law derivative action in several respects — it covers depositors (not just shareholders), it extends to auditors and experts (not just directors), and it provides for a wider range of reliefs. It is also subject to more formal procedural requirements before the specialised tribunal.

Part V — Procedural Aspects

Standing

In a common-law derivative action, the plaintiff must be a member at the time of the action and (in many jurisdictions) also at the time of the alleged wrong — the 'contemporaneous ownership' rule. Under Section 245, specific numerical thresholds apply (as described above). Procedural standing requirements are strict to prevent abuse.

Preliminary Sanction / Leave

Some jurisdictions (e.g., Canada under the Canada Business Corporations Act) require the plaintiff to obtain the court's leave before proceeding with a derivative action. Indian law does not have a formal leave-of-court requirement for common-law derivative actions, though courts exercise discretion in permitting such actions to proceed. Section 245 of the 2013 Act provides for a screening stage where the Tribunal determines the suit's admissibility.

Joinder of the Company

The company must be joined as a party — typically as a nominal defendant. The court's orders will directly affect the company, and its interests must be represented in the proceedings.

Conduct of the Litigation

The derivative plaintiff conducts the litigation on behalf of the company. Questions of settlement, compromise, and withdrawal typically require court approval to prevent the plaintiff from abandoning the action on terms disadvantageous to the company or in return for personal gain.

Recovery and Distribution

Any monetary recovery in a derivative action accrues to the company, not to the plaintiff shareholder. The company, having been 'made whole', then benefits all its shareholders (including the plaintiff). The plaintiff may recover litigation costs, as established in Wallersteiner v. Moir.

Part VI — Practical Scenarios

Scenario 1 — Directors' Misappropriation

The three directors of a private limited company (who together hold 70% of the shares) have been systematically channelling company funds into their personal accounts through fictitious invoices. A minority shareholder (holding 15%) discovers this through the annual audit. The directors, being in control, will obviously not cause the company to sue themselves.

Possible remedies: (a) Common-law derivative action — available where the plaintiff can establish fraud and wrongdoers in control; (b) Section 241 oppression petition — the mismanagement is prejudicial to the company's interests; (c) Section 245 class action — particularly if other minority shareholders will join; (d) Complaint to SFIO / Registrar of Companies for fraud under Section 447. In practice, most Indian litigants would proceed under the statutory framework rather than common-law derivative action, but all options remain available.

Scenario 2 — Diversion of Business Opportunity

A public limited company is approached with a lucrative government tender. The managing director secretly forms a personal company and bids for (and wins) the tender in his personal capacity. The MD's vote-control in the public company prevents any effective action by the board.

Analysis: This is a classic Cook v. Deeks situation. The diversion of corporate opportunity is a breach of fiduciary duty. Any minority shareholder may bring a derivative action (or alternatively a Section 245 class action) to recover the profits from the MD's personal company. Additionally, Section 166(4) of the 2013 Act specifically prohibits directors from making personal profit at the company's expense; breach is actionable under the Act.

Scenario 3 — Ultra Vires Investment

The directors of a textile manufacturing company decide to invest surplus funds in cryptocurrency — an activity not within the company's memorandum. A minority shareholder objects.

Analysis: The act is ultra vires. Under the first exception to Foss, any individual shareholder can sue — a derivative action is one option, though often a personal injunction action is simpler. Section 241 (conduct prejudicial to the company's interests) is also available. The shareholder should seek an injunction to restrain the investment and, if it has been made, an order to recover the funds.

Part VII — Modern Trends and Challenges

Preference for Statutory Remedies

In modern India, most minority grievances are brought under Sections 241, 242, or 245 rather than as common-law derivative actions. The reasons include:

NCLT's specialised expertise in corporate matters;
Statutory framework provides clearer procedure and wider remedies;
Lower procedural barriers than civil court litigation;
Class action mechanism permits cost-sharing among multiple plaintiffs;
Faster disposal than regular civil litigation.

Challenges in Practice

Eligibility thresholds under Section 244 (100 members or 1/10th) can be difficult to satisfy in companies with dispersed ownership;
Section 245 class actions are still a relatively nascent area in Indian jurisprudence, with limited reported decisions;
Costs of litigation remain a deterrent;
Evidentiary burden is high — particularly in proving fraud or wrongdoers in control;
Directors' and officers' liability insurance can reduce practical enforcement against individual wrongdoers.

Reform Proposals

The Companies Act, 2013 has already made significant reforms. Further reforms being debated include:

Streamlined leave-of-court procedure for derivative actions;
Lower eligibility thresholds for class actions;
Better cost-recovery mechanisms for successful derivative plaintiffs;
Clearer standards for 'good faith' in derivative action proceedings;
Enhanced disclosure requirements to facilitate detection of wrongdoing.

Part VIII — Exam-Focused Summary

📌 Core Principles to Remember

(1) Derivative action = action brought by shareholder on behalf of company, for wrongs done to company. (2) Procedural vehicle for enforcing the exceptions to Foss v. Harbottle, particularly the 'fraud on minority' + 'wrongdoers in control' exception. (3) Edwards v. Halliwell (1950) — Jenkins LJ's classification of four main exceptions to Foss. (4) Burland v. Earle (1902) — two-fold test: (a) wrong not ratifiable by majority; (b) wrongdoers in control. (5) Requirements: (i) wrong to company; (ii) not ratifiable; (iii) wrongdoers in control; (iv) plaintiff's good faith; (v) exhaustion of internal remedies (broadly). (6) Recovery accrues to company; plaintiff may recover costs (Wallersteiner v. Moir). (7) Modern Indian framework: Sections 241 (oppression), 242 (remedies), 245 (class action). (8) Section 245 class action is statutory supplement — broader scope than classical derivative action. (9) Key cases — Cook v. Deeks (diversion of corporate opportunity); Menier v. Hooper; Daniels v. Daniels (self-dealing); Pavlides v. Jensen (negligence alone not enough).

Part IX — Conclusion

The derivative action is one of the most interesting procedural inventions of the common law — a device designed to solve a real-world problem where corporate wrongdoing cannot be remedied through normal corporate governance. Where the wrongdoers control the company, the company cannot sue them. Without the derivative action, the wrongs would go uncorrected. The derivative action fills this gap, allowing shareholders to stand in as procedural representatives of the company and to vindicate the company's rights.

In India, the derivative action has been substantially supplemented (and in many cases effectively replaced) by the statutory framework of Sections 241, 242, and 245 of the Companies Act, 2013. Most minority grievances today proceed under these statutory provisions before the NCLT — a specialised, efficient forum with wide remedial powers. The common-law derivative action remains available as a backup, but is less commonly invoked.

For the judicial aspirant, the derivative action is important both as a historical doctrine (tracing back to Edwards v. Halliwell and Burland v. Earle) and as the conceptual basis for modern statutory remedies. Mastering the topic requires understanding of the underlying Foss v. Harbottle framework, the four or five exceptions, the classical cases of Cook v. Deeks and Menier, and the statutory framework under the 2013 Act. The derivative action stands as a powerful reminder that the law of corporations must always balance majority rule with protection against majority abuse.

📚 Related Thematic Notes

(1) Rule in Foss v. Harbottle and Its Exceptions — the substantive framework (separate article). (2) Oppression and Mismanagement (Sections 241-242) — the primary statutory remedy in Indian practice. (3) Directors' Fiduciary Duties — the substantive duties whose breach triggers derivative actions. (4) Class Action under Section 245 — modern statutory supplement. (5) Salomon v. Salomon — the foundational principle of corporate personality.