MICHAELIDOU & CONSTANTINOU L.L.C

Derivative actions in Cyprus

Limited Liability Companies are governed through two instruments which also confer all the powers of a company: the general shareholder meeting and the board of directors.

As a general rule, the majority vote principle applies. In other words, when the necessary number of votes is gathered, and a majority vote is created, and a decision is made on any subject, the minority voters are obliged to follow and carry out the decision of the majority voters.

The ruling of Foss v Hardbottle (1843) 2 Hare 461 , states that the plaintiff in a case for an offence ( civil, breach of contract etc) which was committed against a company, is the company per se and none of its members individually is not eligible to raise an action in relation to this offence. This means that where a third party causes damage to the company through its actions or its omissions, the majority of the members of the Board of Directors will instruct accordingly the lawyers of the company to raise an action against the third party in the name of the company. This doctrine, which derives from Common Law and especially, the well-known case of Foss v Hardbottle (1843) 2 Hare 461, includes two rules; firstly, that the majority rule applies and secondly, that the proper plaintiff in an action which affects the rights of the company, is the company itself.

The exception to the above rule is the derivative action. The true nature of this action is that a person who is a shareholder of the company, raises an action on behalf of the company, in order to defend the company’s rights.

The derivative action originates from the Law of Equity and it has been available to the English Courts since the early 19th century. ( Court of Chancery) and it was introduced as an action available for partnerships. Carlen v Drury (1812) V & B 154. Waters v Taylor (1807) 15 Ves 10; Ellison v Bignold (1821) 2 Jac & W 503 at 511.

Soon, it expanded in companies as well as was in Mozeleyv. Alston (1847) 1 Ph 790  at 800. See also Exeter & Crediton Railway Co. v Butler (1847) 5 Rail Ca211; and Edwards v Shrewsbury Railway (1848) 2 De G & S 537. ( WILLIAM M. FLETCHER , FLETCHER CYCLOPEDIA OF THE  OF THE LAW OF PRIVATE CORPORATIONS 5940 (penn.ed.rev.vol.1995):

Our legal system identifies the derivative action as an exception in the Foss v Hardbottle (1843) 2 Hare 461, 67 E.R. 189 (Ch.). The questions of what a derivative action is and what are its prerequisites was analyzed in the decisions of the Supreme Court ( see Pirillis and others v Kouis (2004) 1 AAD 136 , Thoma and others v Eliades (2006) 1 (B) AAD 1263 , Cheimonides v Investylia Public Co Ltd PE 82/07 dated 12.11.2008.

Any damages that are ordered by the Court  to be remunerated, will be ordered to be remunerated to the company and not to the benefit of the shareholder irrespectively as to whether due to the relevant offence the company lost money and therefore the shareholders were deprived of the opportunity to receive earnings. Prudential Assurance Co Ltd b Newman Industries (1980) 2 All ER 841.

The derivative action focuses on the situations where the majority abuses its rights and powers against the company as well as the minority vote shareholders , enjoying unfair benefits and the minority shareholder seek a form of remedy and/or court protection. The derivative action as a product of equity, serves as a measure of protection of the company from the actions of the majority, where the company cannot protect itself, preventing a complete failure of justice.

The prerequisites for raising a derivative action are:

• The action is raised by a minority shareholder
• The action is raised on behalf of the company
• The shareholders or directors who are liable for the offence, control the company, resulting the company not to be able to claim its rights. (It should be noted that the action must be raised on an invalidity claim, and to mention in the statement of claim that due to the fact that the company is directed by the offenders, it cannot claim its rights -  Birch v Sullivan (1957) 1 WLR 1247)
• Raising the derivative action includes the legal fees. The question is who will compensate these expenses. In the case of Wellerteiner v Moir (No. 2) (1975) Q.B. 373, the ruling was that when a derivative action is raised in the name of the company, and the action is raised is admissible by the Court , the plaintiff is eligible for remuneration from the company for the legal fees paid on behalf of the company.

In order to clarify how the relevant exception applies in practice, we will refer to two significant decisions of the Supreme Court as examples. It should be noted in advance that the definition of deceit in this concept, is broadly interpreted by the Court and not restrictively, taking into consideration the general factors of an indecent behavior in the context of carrying out commercial trading.

The first case concerns the Civil Appeal 11387, Pirillis v Kouis. The ruling dated the 23/01/04, was made by the Supreme Court, by the Supreme Court judges J. Nicolaides, J. Eliades  and J. Gavrielides. Eleftherios Kouis founded along with  Theodoros Pirillis, who was his relative, formed an informal partnership in order to operate a butcher business in a space within a supermarket , in Paralimni, paying a monthly rent £300.00.

The agreement was to receive a £500.00 monthly salary each and to share the earnings equally. The operations began on the 01/11/93 and they were successful, and in March 1994, the two partners rented another shop, in Protaras Avenue in Paralimni, which they fully equipped for the storage and preparation of meat.

Kouis had no previous experience as a butcher, contrary to Pirillis.

Subsequently, in January 1996, Pirillis suggested to Kouis to incorporate a company which would continue with the operations since their work was increasing.

As a result, in March of 1996, they founded the company KOUIS & PIRILLIS BUTCHERY LTD. They converted their partnership in a private limited liability company  in which they had the same number of shares. Additionally, they tied their assets to the company for 500 shares each , and they kept operating through their joint account in the bank without changing its name. The invoices and receipts were issued in the name of the company and the cheques were deposited in the joint account. Their monthly salary increased to £600 while two directors were appointed. According to Kouis’ claims , a few months after the incorporation of the company, Pirillis begun creating issues in their relationship by acting in a authoritative behavior and insulting him in their work place in various occasions . Therefore, and due to the strain on their relationship, attempts were made to buy each other’s  share, but they were not fruitful.

In April 1997, Kouis, due to the pressure he received from Pirillis, he took a one – month leave from work until the situation was improved and a solution was found. During the entire period where their relationship was strained, they did not speak to each other therefore the successful operation of the company, as was for example the arrangement of a Board of Director’s meeting or the extraordinary general meeting was impossible.  

While Kouis was in his leave, he realized that Pirillis started selling meat by himself, using another company of his, the Theodoros Pirillis Enterprises Ltd. Pirillis was using the equipment and the assets of KOUIS & PIRILLIS BUTCHERY LTD . After this discovery Kouis attempted again to sell his share to Pirillis without any outcome.

Without having any other options, Kouis raised an action against Pirillis, his company Theodoros Pirillis Enterprises Ltd , as well as the company KOUIS & PIRILLIS BUTCHERY LTD, in which he was also a shareholder ( we will see the reason below) seeking damages. During the hearing, evidence were provided by a specialist that the company KOUIS & PIRILLIS BUTCHERY LTD was worth £ 122.000 on the 31/03/97.

Pirilli’s side gave a completely different version of events and presented his own specialists in relation to the company’s worth. Essentially, Pirillis’ position was that Kouis willingly left and was not interested in the company nor was he signing the necessary cheques for the company to operate.

The district Court decided in favor of Kouis accepting his version of events and his position regarding deceitful behavior of Pirillis and of illegal provision of services of the company KOUIS & PIRILLIS BUTCHERY LTD to Theodoros Pirillis Enterprises Ltd. The District Court ruled for £90.00 in favor of the company KOUIS & PIRILLIS BUTCHERY LTD which was Defendant 3. It also ruled on punitive damages of £5.000 against Pirillis personally and against its company, and in favor of Kouis.

In the Supreme Court several matters were discussed, the first concerned the claims imposed by Pirillis’ lawyers that the action was incorrectly raised instead of filing an application for suppressing the minority vote based on article 202 of the Company Law. The Supreme Court accepted the position of the District Court that this concerned a derivative action which was raised by Kouis in his capacity as a shareholder of Defendant 3, meaning KOUIS & PIRILLIS BUTCHERY LTD.

In other words, the Supreme Court agreed that in reality KOUIS & PIRILLIS BUTCHERY LTD was entrapped under Pirillis’ control and could not react, therefore Kouis was eligible to raise the action and on behalf of the company to claim the appropriate remedy.

This concerns an incredibly distinctive situation of claiming rights in the area of private law, where the weakness of a person is identified, in this case, of a legal person, to claim its rights itself, therefore it is necessary for the rights to be claimed through another person. For this reason, it was considered justified and necessary for a shareholder who cannot control the company to act on behalf of the company.

On several occasions, in order to understand how this doctrine applies, we ask the question “Had the company have a voice and could speak, would it complain about Pirillis’ actions, who, essentially embezzled the company’s assets?” If the answer is yes, then  the minority shareholder of the company is justified to raise a derivative action.

Furthermore, the Supreme Court accepted, in Kouis case, that there could be a valid derivative action, even in the case that the shareholders of a company possess an equal number of shares, meaning 50-50.

Pirillis’ decision was followed by the Supreme Court’s decision in the Civil Appeal 11784 Emilios Thoma and others v Iakovos Eliade.

The Supreme Court repeated once more the  doctrine deriving from the Foss v Hardbottle case, by laying out the  grounds upon which the Court can , exceptionally, can satisfy the requests from minority shareholders of a company.

In conclusion ,we need to state that it is apparent that the derivative action procedure can be a valuable tool in the hands of the shareholders of a company for the protection of their rights in case that there is deceit by other shareholders and/or directors of the company.

Using the derivative actions more often could possibly limit the arbitrary decisions and generally the wrongful use of the principle of the separate entity concept regarding the legal entities, by the shareholders and/or the directors.

"“Remember, upon the conduct of each depends the fate of all." 

–Alexandre the Grate

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