Derivative action is an action commenced on behalf of a company, especially in cases of “fraud on the minority” and “wrongdoers in control”. The commencement of derivative action is now a statutory regime under the Companies Act 2016 (CA). A complainant may, with the leave of court initiate, intervene in or defend a proceeding on behalf of a company. This is not confined to the members of the company alone as it also extends to persons who are not members but entitled to be registered as one as well as former members, directors and the Registrar of Companies. Section 347(3) of the CA further abrogated the right of any person to bring, intervene in, defend or discontinue any proceedings on behalf of a company at common law.
Section 348 of the CA provides for the procedure to obtain leave of court to commence a derivative action. Amongst others, in deciding whether or not to grant leave, Section 348(3) provides that the court shall take into account whether:
(a) the complainant is acting in good faith; and
(b) prima facie, it appears to be in the best interest of the company that leave is granted.
In the Federal Court case of Dato’ Seri Timor Shah Rafiq v Nautilus Tug & Towage Sdn Bhd and another appeal [2024] 3 MLJ 433, there were 2 appeals heard together concerning leave applications under Section 348 of the CA to commence derivative action. The 2 appeals concern a company called Nautilus Tug & Towage Sdn Bhd (NTT).
NTT has 2 shareholders with a shareholding ratio of 80:20. The majority shareholder is one Azimuth Marine Sdn Bhd (AMSB”, whereas the minority shareholder is one Nautical Supreme Sdn Bhd (NSSB). The board of NTT was made up of nominees by the respective shareholder. The nominees of AMSB were Dato’ Seri Suresh, Dato’ Johari, Dato’ Latiff, Hari Dass and Jaya Sudhir. On the other hand, the nominees of NSSB were one Dato’ Seri Timor and Dato’ Wan. Dato’ Seri Timor was the applicant in the 2 leave applications.
NTT’s sole business was to provide harbour tug services for a project by Vale Malaysia Minerals Sdn Bhd (Vale) for 15 years and in this relation, NTT has to construct and own 7 tugboats. The 7 tugboats were delivered and operational as of June 2015. NTT in turn contracted with one Azimuth Ship Management Sdn Bhd (ASM) wherein ASM was appointed as ship manager of the 7 tugboats. Dato’ Seri Suresh was the principal shareholder of ASM.
The 1st Appeal
In the 1st appeal, one of the 7 tugboats (named NTT Lumut) sank in September 2016. The controversies lie in the position of Dato’ Seri Suresh as an owner of ASM and also as one director representing the majority shareholder in the board of NTT. Despite investigations have been undertaken by different parties (such as Vale, the insurers and the Marine Department) and the investigations concluded that there is no negligence on the part of ASM, Dato’ Seri Timor intended to have further independent investigation performed. In several board meetings of NTT, Dato’ Seri Timor’s request was rejected.
As the board refused his request and because no legal proceeding was taken against ASM, Dato’ Seri Timor filed an application for leave to commence derivative action against ASM. In the leave application, Dato’ Seri Timor relied on a report prepared by his appointed expert, one Mr Alan Loynd of Branscombe Marine Consultant Ltd in Hong Kong. Mr Loynd’s in his preliminary report opined that:
“In conclusion, there is no evidence that any of the normal professional steps to prevent a sinking were implemented in this case. The crew do not appear to have been competent to handle the emergency, and the managers appear to have neglected normal best practice, both in training the crew and in responding to the emergency. My feeling, based upon the evidence I have seen, is that this casualty could and should have been prevented.”
The High Court found, amongst others, that Mr Loynd’s report was not conclusive and did not suggest a reasonable cause of action for negligence. Further, the High Court held that even if there was a reasonable cause of action, it was demonstrated whether such legal action would be worthwhile when NTT had already been indemnified by the insurer. The leave application was therefore dismissed.
Dato’ Seri Timor then appealed to the Court of Appeal, where the appeal was dismissed. The Federal Court affirmed the decision of the courts below. The Federal Court made the following observations.
The dual elements of good faith and prima facie best interests must be assessed independently and an applicant must meet these 2 requirements which are requirements expressly stipulated under Section 348 of the CA.
On good faith, the Federal Court affirmed the enunciation of the Court of Appeal in Celcom (M) Bhd v Mohd Shuaib Ishak which followed the Australian case of Swansson- v RA Pratt Properties Pty Ltd & Anor that the test of good faith is two-fold. Firstly, there must be an honest belief on the part of the applicant that a good cause of action exists and has a reasonable prospect of success, secondly, that the application should not be brought up for a collateral purpose.
Honest belief of an applicant is purely a subjective assessment. The objective assessment applies when the court ascertains if the belief of the applicant is such that no reasonable person in the circumstances would hold that belief. As such, assessing honest belief comprises of both subjective and objective components.
Collateral purpose means to pursue an ulterior purpose unrelated to the subject matter of the proposed derivative action. In this regard, the Federal Court made it clear that if the applicant brings a derivative action for the benefit of the company, he will not be disqualified from doing so if there were other benefits which he will derive from the claim. In other words, the presence of a private interest cannot necessarily negate good faith if the same coincides with that of the company. Further, personal animus against the company or other members of the company cannot be usually considered lack of good faith, unless it can be found that his judgment was clouded by purely personal considerations.
On prima facie best interests, the Federal Court made it clear that the courts are not to go into the merits of the case but to consider whether the proposed action is legitimate and arguable. Leave applications may be rejected outright if the claim is considered frivolous or vexatious or devoid of merits. There must be some reasonable chance of success such that if the claim is proved, the company will stand to gain substantially in financial terms. Further, it was expounded that whether it is prima facie in the best interest of the company to bring an action is a wide one involving consideration of factors beyond the merits of the proceedings. This includes such as the costs of the derivative action, the likely recovery if the action is successful and the likely consequences to the company of the action is unsuccessful.
In respect of the 1st appeal, the Federal Court agreed that Mr Loynd’s opinion was not final and conclusive such as to provide a good cause of action and show a reasonable prospect of success against ASM as Mr Loynd had not completed his investigation and it was merely his “feeling” that the incident could have been avoided. On this basis, it was held that Dato’ Seri Timor could not have an honest belief that a good cause of action against ASM exists and had a reasonable prospect of success.
The Federal Court however could not agree with the Court of Appeal that there existed some collateral purpose on the part of Dato’ Seri Timor. As stated earlier, mere disagreements between directors are common and are not by themselves indicative of collateral purpose or bad faith.
Further, the Federal Court found that there were genuine commercial considerations for NTT not to pursue the action. Amongst others, Vale did not wish to be drawn into the dispute and NTT had also been paid a sum under an indemnity insurance which the value was higher than if compared to the vessel’s continuing operations. Even if the derivative action was successful, it may turn out to be a pyrrhic victory for NTT.
Ultimately, leave was not granted to commence derivative action in the 1st appeal.
The 2nd Appeal
The 2nd appeal concerns dispute on the funding of the construction of the 7 tugboats, amounting to USD68,500,000.00. NTT procured a loan facility to fund substantial portion of the construction costs and the remaining costs were to be funded by the shareholders i.e. AMSB and NSSB. Pursuant to an equity payment schedule, AMSB was required to fund USD12,370,000.00, whereas NSSB was required to fund USD1,864,176.00. A negotiation with the shipbuilder, Shin Yang, was subsequently performed by Dato’ Seri Suresh where the costs of construction was reduced. The last tugboat was delivered to NTT in June 2015.
In August 2015, Dato’ Seri Timor was alerted by a letter of demand from Shin Yang claiming for payment due and owing in the sum of USD21,439,421.72. This meant that the full purchase price of the tugboats was not paid. Dato’ Seri Timor was then pressing for answer as to how much have been paid by NTT to Shin Yang but to no avail. He then discovered that payment about USD19,900,000.00 had been captured in the audited accounts of NTT as shareholders’ advance.
Via a court order obtained by Dato’ Seri Timor, Crowe Horwath inspected the records of NTT and opined that there were no records to substantiate the said payment of shareholders’ advance amounting to about USD19,900,000.00. Dato Seri Timor’s requests for payment records was of no avail. As such, Dato’ Seri Timor filed an application for leave commence derivative action against nominees of AMSB who sat on the Board as well as NTT’s financial controller.
The High Court dismissed the leave application, amongst others, on the basis that the reports of Crowe Horwath did not arrive at a conclusive or final determination of any identifiable breach of procedure of wrongdoing on the part of the company and that Shin Yang had subsequently acknowledged the receipt of full payment of the tugboats. The Court of Appeal reversed the decision and allowed the leave application. The Court of Appeal’s decision was affirmed by the Federal Court.
The Federal Court did not accept NTT’s argument which relied on Shin Yang’s acknowledgement of payment via letters which came subsequent to its demand. It was held that there were no documents to prove the amount which AMSB was alleged to have paid as shareholders’ advance. There were also no documents to show that NTT had agreed to allow AMSB to make direct payment to Shin Yang. In Shin Yang’s acknowledgement letters, it did not state who had had made the payments. The Federal Court further found that Crowe Horwath’s supplementary report stated that the shareholders’ advance from AMSB was not substantiated by proper payment documentation. It was held that the subjective and objective component of the assessment had been satisfied to demonstrate an honest belief that a reasonable cause of action exists against the intended defendants.
The Federal Court reiterated that hostility between the opposing directors alone was insufficient to amount to collateral purpose.
On best interests, the Federal Court stated that NTT would gain substantially in money terms of being relieved of the debt through the proposed derivative action in the event such action was successful. If the action was successful, NTT would also stand to recover the shareholders’ interests already paid to its shareholders out of the shareholders’ advances, which amounted to around RM14,619,166.47.
The Federal Court further held that the argument of availability of alternative remedies does not serve as a bar to the granting of leave to commence derivative action. In fact, it was held that there was nothing to prevent the institution of a derivative action concurrently with that of an alternative remedy. It was also made clear that the principle of “clean hands” will not apply as a test. Notwithstanding so, the notions of equity can be relevant when considering the element of good faith. The contention in the appeal was that NSSB’s nominees had approved the payment of shareholders’ interest and NSSB had itself accepted the shareholders’ interest. The Federal Court dismissed the argument on the basis that the minutes of board meetings have demonstrated that the approval and acceptance of shareholders’ interests by nominees of NSSB was conditional and without prejudice to the disposal of the current dispute.
Leave was granted to commence derivative action in the 2nd appeal.
Conclusion
The Federal Court made it clear that the dual elements of good faith and prima facie best interests under Section 348 of the CA must be assessed independently and both must be present in order for leave to commence derivative action to be granted. From the above, it appears that other factors (e.g. notions of equity) may be considered but they do not form the test for a leave application, unless it is relevant to ascertain good faith.
Good faith entails an honest belief on the part of the applicant of the existence of a reasonable cause of action (to be assessed subjectively and objectively) and the proposed action cannot be commenced with an ulterior motive or collateral purpose. A mere disagreements or hostility between opposing members of a company is not sufficient to constitute collateral purpose. On the other hand, the requirement of prima facie best interests contemplates only a reasonable prospect of the cause of action, and the court is not concerned with the merits of the proposed derivative action at leave stage. Amongst others, it could be implied from the decision of the Federal Court that “best interests” are best gauged from the economical outcome of the proposed derivative action.
31 May 2024