DERIVATIVE ACTION IN INDIA

ORIGIN AND DEVELOPMENT

Parvathy R Anil
Tamil Nadu National Law School
 SCOPE

Derivative action against Directors

breach of duty.
 What is derivative action?

Derivative action in brief is a process wherein,

the shareholders (on behalf of the company)
are given a right to sue the directors for breach
of their duty towards the company.
 Contents
Need for Derivative Action
Origin
Derivative Action in India
Position in Indian law
Flaws in the law pertaining to Derivative

Action in India
Suggestions
Conclusion
 Need for Derivative Action
A company being a legal personality has the right to sue
if there is a wrong committed against it.

Every company is headed by a Board which is

responsible for the management of the company and they
have a duty to act in the best interest of the company.

Due to the very same reason the Board is vested with the
right to sue in case of a wrongful act against the company.
 Need for Derivative Action
The problem arises when the entire Board or a single
director has breached their duty or committed a wrong
against the company.

In such a case it is impractical to assume that the board

will take action against themselves for their breach of
duty towards the company.
 Need for Derivative Action
As a result, it is essential to authorize a body (other
than the Board of Directors) to take action against the
directors for their breach of duty. This is when
derivative action becomes relevant.

The doctrine of derivative action empowers the

shareholders to step into the shoes of the board in those
circumstances where the entire Board (or a director of
the board) has breached its duty towards the best
interest of the company.
 Origin of Derivative Action
The doctrine of Derivative action originated in the English
case of Foss v. Harbottle.

As per this case, the company is an independent legal

personality distinct from its shareholders. As a result, any
breach of duty by the directors will be a wrong towards the
company and only the company can be the plaintiff to that
case.

However, certain exceptions were laid down in the same case

wherein certain legal personalities (shareholders) derive
power from the company to take action against the directors.
Origin of Derivative Action
The doctrine of derivative action came into existence
through these exceptions.

The exceptions laid down in Foss v. Harbottle opines

that shareholders can take action under any of the
following circumstances:
In case of a wrong doing by the Board or any member of the
board, the power to take action vests on the majority
shareholders.
The majority shareholder in such a situation has two options,
either to sue or to ratify the wrong doing.
 Origin of Derivative Action
But in those circumstances where the majority shareholders
are also the directors, the power to sue is vested on the
minority shareholders (irrespective of ratification by
majority shareholders).

The minority shareholders can also sue in those

circumstances where the majority shareholders did not ratify
the wrong doing or take any steps to sue.
 Origin of Derivative Action in India
Though the Companies Act,1956 (Section 397 and 398)
had laws for prevention of oppression and
mismanagement, it did not provide any details as to
taking action against directors for their breach of duty.

The reason for origin of derivative action in India can

be attributed to the Satyam scam popularly known as
Indias Enron.
Origin of Derivative Action in India
As an aftermath of the Satyam scam, the shareholders
in the United States filed derivative suits against the
company along with its directors and chairman for
claiming damages.

In such a scenario, the Indian shareholders were left

with no remedies to claim damages or compensation.
This led to the inclusion of Section 245 in the
Companies Act, 2013.
Position in India
Section 245,Companies Act, 2013
Section 245 of Companies Act, 2013
Section 245(1)(g)(1) enables member(s) or depositor(s)
to file a suit for claiming damages or compensation or
any other appropriate order against directors for any:
fraudulent, unlawful or wrongful act or omission or conduct or
any likely act or omission or conduct on their part.
 Requirements for filing a suit
Section 245 (3)
In the case of a company having a share capital,

not less than 100 members or

1/10th of the total no. of members (whichever is less) or
any member or members holding 1/10th of the issued share
capital
In the case of a company not having a share capital,
not less than one-fifth of the total number of its members.
 The NCLT
Every suit is placed before the National Company Law Tribunal
(NCLT).
According to S. 245 (4), the NCLT has to pay regard to the
following:
whether the member(s) or depositor(s) are acting in good faith
whether the cause of action is an act or omission that is yet to
occur
whether the act or omission could be, and in the circumstances
would be likely to be authorized by the company before it
occurs
whether the act or omission could be ratified by the company
after it occurs
 The NCLT
The burden to prove the case lies with the applicant.

If any application filed before the Tribunal is found to

be frivolous or vexatious, it will be rejected and the
applicant shall pay to the opposite party such cost, not
exceeding one lakh rupees. (S. 245 (8))
 Penalty 245 (7)
Any company which fails to comply with the order
passed by NCLT shall be punishable with fine not less
than five lakh rupees but which may extend to twenty-
five lakh rupees

Any officer of the company who is in default shall be

punished with imprisonment for a term which may
extend to three years and fine not less than twenty-five
thousand rupees but which may extend to one lakh
rupees.
 Pros of Section 245
Introduced the concept of derivative action in India
enabling members and depositors to take action against
directors who breach their duty.
S. 245 strikes a reasonable balance between
independence of directors and keeping checks and
balances on them.
This is done by restricting the class of legal
personalities that can sue the directors and by ensuring
that the members act in good faith.
 Pros of Section 245
This particular Section enables even the minority shareholders
to come together and take action as a class in case of breach of
duty by directors.

This was held in the 2015 case of Darius Rutton Kavasmaneck

v. Gharda Chemicals Limited and Others, where the Bombay
HC was of the opinion that the minority shareholders do have
a right to sue the directors or any other wrong doers of a
company when the directors are not taking any action.
 Pros of Section 245
Another positive highlight is that the suits are filed
before the National Company Law Tribunal thereby
making it more efficient and time sensitive than the
normal court system. This however is just a hypothesis
since the NCLT just came into force and its
effectiveness is yet to be determined.
 Flaws and Suggestions - I
In case the applicant loses the case and the director is not
held liable for breach of his duty, an amount not exceeding
one lakh should be paid by the applicant to the other party.

In such a situation it is not practical to expect the members

to file a suit considering the fact that any damages gained (if
the suit is won) goes to the company and not the applicants.

This issue can be resolved by rewarding the applicant with

shares or a bonus sum in those cases where the suits are
successful.
 Flaws and Suggestions - II
A suit against the directors are to be filed by the members
or depositors.
Considering the fact that the members (majority of them
being shareholders) are not necessarily people who are
placed in the company, it is not practical to assume that
they can monitor the activities of the directors for any
breach of duty.
Also, in the case it is a minority shareholder who notices
the breach of duty, he will have to gather the minimum
shareholders required to initiate a suit.
 Flaws and Suggestions - II
This is again practically difficult since the shareholders
might not agree to be parties to the suit since in case of
a failed suit they will have to meet the cost.
This issue can be resolved by including other

stakeholders (like creditors) and the auditing firm to the

class of people who can take action against the
directors.
 Conclusion
The effectiveness of Section 245 cannot be determined
since the Section is yet to be notified.
However from the case of Gharda Chemicals Limited,

it is clear that the Indian Courts have recognized the

principle of Derivative Action though there are no
active provisions.
Yet another conclusion that can be derived is that the

incorporation of Section 245 is one step closer to

achieving corporate governance through checks and
balances.
Thank you!