“Deriving Clarity on Derivative Actions” – Analysis of the Federal Court Decision of Dato’ Seri Timor Shah Rafiq v Nautilus Tug & Towage Sdn Bhd [2024] MLJU 496
A derivative action under Section 347 of the Companies Act 2016 (the “Act”) enables a shareholder of a company to initiate, intervene, or defend proceedings on behalf of the company. Derivate actions are intended to address the difficulties brought about by the “proper plaintiff rule”, where a company is prevented from commencing an action by reason of a wrongdoer having the majority control over the company and to enable an aggrieved shareholder to bring an action in the company’s name.
Where leave of Court is required to initiate a derivative action in the company’s name, the Court shall take into account two (2) conjunctive tests pursuant to Section 348(4) of the Act, namely whether:
(a) the complainant is acting in good faith; and
(b) it appears prima facie to be in the best interest of the company that the application for leave be granted.
In Dato’ Seri Timor Shah Rafiq v Nautilus Tug & Towage Sdn Bhd[2024] MLJU 496, the Federal Court had the occasion to provide clarity on the relevant tests and elements to be considered by the Court hearing an application for leave to initiate a derivative action.
What are the facts?
- Dato’ Seri Timor Shah Rafiq was the Plaintiff in the High Court (“Plaintiff”) and a director of the Nautilus Tug & Towage Sdn Bhd (“Nautilus”), being a joint venture company set up to build, own and manage tugboats. The Plaintiff initiated two separate applications for leave to commence derivative actions on behalf of Nautilus on different sets of facts.
- Nautilus’ shareholders are Azimuth Marine Sdn Bhd (“AMSB”) (80% shareholding) and Nautical Supreme Sdn Bhd (“NSSB”) (20% shareholding). Nautilus’ board of directors comprised of majority directors representing AMSB and minority directors representing NSSB (the “Board”), where the Plaintiff was a director representing NSSB.
1st Application – The Sinking Claim
- Nautilus entered into a Harbour Tugs Services Agreement with Vale Malaysia Minerals Sdn Bhd (“Vale”) for the charter of seven harbour tugboats owned by Nautilus. Vale is the sole customer of Nautilus. Nautilus also had an agreement with one Azimuth Ship Management Sdn Bhd (“ASM”) for ASM to provide harbour tug services and to be appointed as the designated ship manager. The principal shareholder of ASM, Dato’ Seri Suresh Emmanuel Abishegam (“Dato’ Suresh”), is also one of Nautilus’ Board representing its majority shareholder, AMSB.
- On 19.09.2016, NTT Lumut, one of the harbour tugboats managed by ASM, sank. The Board was informed that the incident was purely an accident. The plaintiff proposed an independent inquiry to investigate the incident as Dato’ Suresh and AMSB are conflicted by virtue of ASM’s involvement in the incident, but the Board passed no resolutions to adopt this proposal. Subsequent updates were given to the Board that the Marine Department had concluded its investigations, indicating that there was no negligence.
- The Plaintiff engaged an independent consultant to investigate the sinking incident where the consultant opined that there is no evidence that any normal professional steps to prevent a sinking were implemented and, among others, the consultant felt that based on evidence he had seen, this casualty could have been prevented. The Plaintiff’s solicitors forwarded the questions posed by the independent consultant to the Board for answers as well as unrestricted access to inspect the wreckage of NTT Lumut.
- The Board was then informed that the insurance proceeds received by Nautilus exceed the value of NTT Lumut if it were to be repaired and chartered based on the Plaintiff’s valuation of USD 4.1 million. Upon deliberations, the Board refused the requests for answers and unrestricted access to inspect NTT Lumut.
- Upon the Plaintiff issuing the statutory notice under Section 348 of the Act on his intention to commence derivative action, the Board then mandated its Chairman (being a director representing the majority shareholder of Nautilus) to appoint surveyors to conduct an independent investigation into the NTT Lumut incident. The Plaintiff voted against this proposal and maintained that the Board’s sudden about-turn in agreeing to an investigation was motivated by bad faith and intended to stifle his effort to seek redress on behalf of Nautilus. The Plaintiff filed leave to commence derivative action.
2nd Application – Shareholders’ Advance Claim
- Nautilus entered into a sale and purchase agreement with Shin Yang Shipyard Sdn Bhd (the “Seller”) to build, sell, and deliver seven (7) tugboats to Nautilus for USD68.5 million, as required by Vale Malaysia Minerals Sdn Bhd (“Vale”).
- Nautilus secured financing for 70% of the purchase price of tugboats from Exim Bank, with the remaining 30% (“Balance Purchase Price”) to be financed by its shareholders advance (“Shareholders Advance”) in instalments where such advances would be a debt owed by Nautilus to the shareholders with interest. With reductions in the purchase price of the tugboats, NSSB was not required to pay its final instalment.
- However, the Plaintiff discovered that there were discrepancies in payment to the Seller when the Seller issued a letter to Nautilus claiming payments owed by Nautilus to it, indicating that only part of Exim Bank’s financing was paid to the Seller. The Plaintiff pressed for an answer from Nautilus, to which the Plaintiff claimed to have not received adequate explanation. The Plaintiff filed an application for leave to commence derivative action.
What were the decisions of the courts below?
- The 1st Application
The High Court dismissed the Plaintiff’s application for leave on the basis that the “good faith” element and “best interest” element were not satisfied. The High Court also found that several other proceedings initiated by the Plaintiff against Nautilus and its directors may impair one’s judgment leading to an inference of collateral purpose for leave intending to disrupt and destabilise the operations of Nautilus. The High Court held that leave to commence derivative action is not to be dealt with lightly or be treated on a lower threshold, similar to leave applications for judicial review. The Court of Appeal affirmed the High Court’s decision. The Plaintiff appealed to the Federal Court.
- The 2nd Application
The High Court dismissed the Plaintiff’s application for leave, but the Court of Appeal overturned this decision on the basis that the Plaintiff met the “good faith” element and “best interest” element as, among others, the action of the Board in failing to keep proper accounting records to substantiate material transactions could expose them to breach of statutory and fiduciary duties and Nautilus’ payment to the Seller was only evidenced by journal entries in Nautilus’ general ledger without independent supporting documents. Nautilus appealed to the Federal Court.
Federal court’s decision and findings
- The Federal Court affirmed the decisions of the Court of Appeal, and both appeals were dismissed. Below are the key findings of the Federal Court: –
- The Act has replaced the common law derivative rights
Under common law, the case of Foss v Harbottle [1843] 67 ER 189 spells out the “proper plaintiff” rule and the principle of “majority rule”, where only companies may sue for a wrong done to it, with certain exceptions. This common law right to commence or defend a derivative action has now been abrogated and replaced with the introduction of Section 347(3) of the Act. Nevertheless, common law principles in considering or interpreting the statutory elements of “good faith” and the “best interest of the company” within the meaning of Section 348 of the Act would still be relevant.
- The Test of “Good Faith” is two-fold
The test of “good faith” is (1) an “honest belief” on the part of the applicant that a good cause of action exists and has a reasonable prospect of success; and (2) that the application is not brought up for a collateral purpose. In assessing “honest belief”, there are both subjective and objective components, namely whether (1) the applicant honestly believes that a good cause of action exists and has a reasonable prospect of success (subjective component), and (2) the applicant may be disbelieved if no reasonable person in the circumstances could hold such belief (objective component).
- Evaluation of the “Best Interest of the Company” Contemplates Factors Beyond the Merits of the Proceedings
There are a wide range of factors beyond merits in proceedings which will be considered in deciding what is in the best interest of the company under the circumstances. A claim considered to be frivolous, vexatious, or devoid of merit will be rejected outright. Commercial considerations such as substantial litigation expenses, risk of damage to the company’s reputation and uncertainty of the putative defendants’ ability to satisfy any judgment obtained are also relevant in the determination of the “best interest of the company”.
- The Dismissal of the Plaintiff’s Appeal on the 1st Application Rests on Failure to Establish “Honest Belief” or the “Best Interest of Nautilus” Prima Facie
The Federal Court found that the Plaintiff’s independent consultant had not completed investigations on the incident of the sinking vessel and the opinion provided was inconclusive. The Plaintiff failed on the subjective component in establishing “honest belief” that a good cause of action exists. The Federal Court agreed with the Courts below that prima facie “best interest” was not established as Nautilus had genuine commercial considerations for not wanting to pursue claims as it did not wish to damage a good, long-term, and profitable relationship with Vale, being its sole customer, and who would have no alternative but to be drawn into the dispute. Further, Nautilus had received the insurance proceeds and compensation from Vale, which was higher than if compared to the vessel’s continuing operations. Where the Board has made a bona fide commercial decision, the courts should be slow to intervene.
- The Dismissal of Nautilus Appeal on the 2nd Application Rests on Findings of “Good Faith” and “Best Interest of the Company”
The Federal Court agreed with the Court of Appeal that the non-keeping of records and documents concerning material transactions raises grave concern over the manner in which the management of Nautilus maintained their accounting records. The Federal Court also agreed with the Court of Appeal that they were unable to see how the application was brought up for a collateral purpose. While Nautilus suggested that the Plaintiff did not come with “clean hands” as he has participated in the alleged wrongdoing of which he has received benefits, the Federal Court found there to be no basis in this contention as the Plaintiff had raised the irregularity on payments to the Seller and sought for explanations, which was not given. Crucially, the Federal Court held that what needs to be shown is that the applicant must not be pursuing an ulterior purpose unrelated to the subject matter of the claim and that, but for his ulterior purpose, he would not have commenced proceedings at all as this would amount to abuse of process.
Practical consideration
- The Statutory Regime on Derivative Actions Carry Less Stringent Requirements Than Prior Common Law Principles
Under the common law rule, derivative action is limited to specific circumstances, such as fraud on the minority and wrongdoers in control, which carries a steeper hurdle for an application for leave to commence derivative action. In contrast, the statutory regime under Section 348 of the Act provides a wider spectrum, allowing an applicant to obtain leave as long as the application was filed in good faith, and it serves the best interests of the company.
- “Good Faith” Requires Objective and Subjective Considerations
An applicant should be able to demonstrate and sustain his position of an honest belief that a good cause of action exists and has a reasonable prospect of success (subjective), and he may be disbelieved if no reasonable person in the circumstances could hold that belief (objective). While applicants may intend to act fast, it is crucial to ensure that the element of “good faith” is sufficiently addressed and that the material relied upon is convincing of a good claim.
- A “Pyrrhic Victory” is Not in the “Best Interest of the Company”
Not all claims commenced by a company or success in such claims may be in its best interest. At times, for commercial reasons, there may be justification for a claim not to be pursued. Whether the company stands “to gain substantially in money or in money’s worth” relates more to the issue of whether it is in the interest of the company to pursue the claim rather than whether the claim is meritorious. Victory in an initiated claim could very well amount to one that could devastate the company (whether via reputation, business, or finances), tantamount to defeat.
- Ascertain the Bona Fides of a Commercial Decision
There may be occasions when a minority shareholder/director representing a minority shareholder could have reason to question or challenge the decisions made by a board of directors primarily comprising representatives of a majority shareholder. Notwithstanding this, applicants should carefully evaluate the context, reasons, and bona fides in any decisions made by the board of directors. If the board has made a bona fide commercial decision that it is not in the interest of the company to commence the proceedings, the Court will be slow to intervene.