– Ameya Vikram Mishra* and Satya Jha**
The general rule recognised across jurisdictions is that if a wrong is alleged to be committed against a company, it is only the company that can initiate action to seek appropriate relief. (see: Foss v. Harbottle). However, an exception to this is permitting shareholders of a company to file derivative actions.
A derivative action is a claim by a shareholder on behalf of and for the benefit of the company for a wrong against the company. It is founded on the basis that if the company is managed by miscreant directors or shareholders, they will not institute any action to enforce or protect its rights. While the Courts in India have recognized and affirmed the maintainability of derivative actions through suits (see: Rajeev Saumitra v. Neetu Singh), derivative action arbitration remains largely unexplored.
Interestingly, in the U.S., in Frederick v. First Union Securities, Inc., in view of the existence of an arbitration agreement between the company and a third party, the shareholder was directed to initiate arbitration (instead of a derivative suit) on behalf of the company. Therefore, it appears that in the U.S., a shareholder is permitted to invoke arbitration on behalf of the signatory, i.e., the company (Gary Born, International Commercial Arbitration, 3rd ed., 2021). However, in Singapore, the decision of Kiyue Company Ltd v. Aquagen International suggests that derivative action claims under the Companies Act of Singapore are not arbitrable. The position in Russia is discussed here.
In light of the above, it becomes relevant to examine the position of derivative action arbitration in India, where the focus on corporate governance and ease of doing business is on the rise.
Given that the principle of arbitration is based on consent, this post will examine if a non-signatory shareholder can initiate arbitration on behalf of a company and if non-consenting parties can be bound by such arbitration. Additionally, the issue of arbitrability of derivative action claims will also be examined.
Locus of a shareholder to initiate derivative action arbitration
The Bombay High Court (“Bombay HC”) in Rashmi Mehra v. Eac Trading (“Rashmi Mehra”) considered the issue of maintainability of derivative actions in arbitration. The Bombay HC observed that:
(a) a person bringing the derivative action invokes the arbitration clause not for themselves but for and behalf of the company; (b) the action is for all intents and purposes, by and on behalf of the company; and (c) a shareholder who initiates such derivative action is equally entitled to invoke and be bound by the arbitral clause, qua such action.
Thus, the Bombay HC held that a shareholder could bring a derivative action in an arbitration proceeding.
Subsequently, in the case of Onyx Musicabsolute Pvt Ltd v. Yash Raj Films Pvt Ltd (“Onyx”), a shareholder of a joint venture company (“JV Company”) tried to bring an action against the other JV partner for and on behalf of the JV Company. The Bombay HC held that if there is a wrong done to the JV Company, only the JV Company can bring arbitration action, not the JV partner (shareholder). It was noted that the existence of an arbitration agreement is a pre-requisite for the constitution and exercise of jurisdiction by an arbitral tribunal. Thus, it was held that minority shareholders who are not parties to the arbitration agreement cannot initiate arbitration proceedings.
Similarly, in Starlight Real Estate (Ascot) Mauritius Ltd. & Anr. v Jagrati Trade Services Pvt. Ltd. & Ors., the Calcutta High Court held that minority shareholders who are not parties to an arbitration agreement cannot initiate proceedings to bring derivative actions on behalf of the company.
Therefore, a possible corollary to the aforesaid view is that if a minority shareholder is a party to the arbitration agreement, derivative actions can be brought by him. In order to understand the issue of locus of minority shareholders to bring derivate action by way of arbitration, it would be relevant to analyse Sections 8 and 45 of the Arbitration and Conciliation Act, 1996 (“the Act”). In terms of the said provisions, a party “claiming through or under a party to the arbitration agreement” can also initiate arbitration. However, for a minority shareholder (who is not a party to the arbitration agreement), it may be difficult to initiate arbitration since such a shareholder is neither claiming through nor under a party to the agreement. This is because, in a derivative action arbitration, a minority shareholder is: (a) instituting a claim for the benefit of and on behalf of the company (who is a party to the arbitration agreement); and (b) not claiming through or under the company. As a result, we believe that for a minority shareholder to initiate arbitration, it should be a party to the agreement.
Additionally, a derivative action arbitration will involve multiple parties, including shareholders (both majority and minority) and the directors of a company. The Supreme Court in Afcons Infrastructure Ltdv. Cherian Varkey Construction Company Pvt held that all parties must consent for initiating the arbitration. In view thereof, it may be argued that the claims sought by a derivative action cannot be referred to arbitration unless all the parties explicitly consent to it. In the event that a shareholder is not in a position to give its consent to resolve the dispute through arbitration (on account of not being a party to the arbitration agreement), a derivative action instituted by another minority shareholder may not bind such non-consenting shareholders. As a result, there may be a risk of such non-consenting shareholders instituting parallel proceedings concerning the same dispute leading to conflicting decisions.
In the event that a minority shareholder seeks to proceed against a shareholder/director who is not a party to the arbitration agreement, the arbitral tribunal may be reluctant to pierce the corporate veil in such cases. The Delhi High Court in Sudhir Gopi v. Indira Gandhi National Open University and Orsheld that an arbitrator does not have the power to lift the corporate veil to bind non-signatories to the arbitration agreement since failure to fulfill contractual obligations cannot be a ground for piercing the corporate veil. The Court opined that an arbitration agreement can only be extended to non-signatories if: (a) there is an implied consent; and (b) there exists reasons to disregard the corporate personality and make such shareholder(s) answerable for the obligations of the company.
Arbitrability of the derivative action claims
Another important facet of derivative action arbitrations is the issue of arbitrability of the subject matter. The nature of derivative actions is such that it may have socio-economic implications as corporations are often viewed as social institutions (see: “For whom are corporate managers trustees” by Professor E. Merrick Dodd). As a result, mismanagement of such corporations can affect the public interest. Thus, this may necessitate that any claim concerning its management ought to be heard by a public forum.
The above understanding is in sync with the principles laid down by the Supreme Court in the recent decision of Vidya Drolia v. Durga Trading Corporation, which laid a test to determine arbitrability of disputes. In view of this test, we are of the opinion that derivative action claims may not be arbitrable if:
(a) The claim sought by way of derivative action affects the right of third parties, such as those of other shareholders, who are not parties to the arbitration agreement. (b) It has an in rem effect and requires adjudication by a public forum. (c) It is a matter of public policy or relates to inalienable sovereign functions. (d) The subject matter of the derivative actions are expressly or by necessary implication non-arbitrable in view of a statutory remedy such as under the Companies Act, 2013.
Additionally, it is relevant to note that a derivative action may be sought for violation of statutory provisions or contractual provisions. For disputes arising out of violation of statutory provisions such as the Companies Act, 2013, it is likely that such disputes may not be arbitrable. For instance, the Bombay HC held that disputes pertaining to oppression and mismanagement are not arbitrable. On the other hand, for disputes arising out of a contract such as a shareholders’ agreement(s), the remedies sought are generally contractual. Such disputes may be held to be arbitrable.
Further, some cases may involve an intersection of violation of both statutory and contractual provisions. However, such claims cannot be bifurcated, given the settled position of law. Accordingly, such claims as a whole may not be arbitrable.
Derivative action claims are in a rather unique position in the context of arbitrations as it involves initiating action on behalf of another, i.e., the company. We are of the view that minority shareholders, who are not a party to the arbitration agreement, should not be permitted to institute derivative action arbitration. The sanctity of an arbitration agreement ought to be maintained, and permitting non-signatory shareholders to initiate arbitration seeking derivative action is contrary to the cornerstone of arbitration, i.e., consent. The Act allows parties “claiming through or under a party to the agreement” to refer disputes to arbitration but does not permit a (non-signatory) party to initiate arbitration on behalf of another. This is in sync with the position taken by the Courts in India, which have consistently emphasized the requirement of consent of parties to initiate arbitration.
Further, the arbitrability of derivative actions is also in a tricky position as, inter alia, it may involve third-party rights and have an in rem impact. Thus, it would be difficult to pass the muster with the principles of arbitrability of disputes laid down by the Supreme Court. Therefore, considering the inherent nature of derivative action, it may be best suited for adjudication by public fora and not through arbitration.
* Ameya Vikram Mishra currently works as an Associate in the office of Justice (Retd.) A K Sikri, and is a graduate of West Bengal National University of Juridical Sciences, India (Batch of 2017).
** Satya Jha currently works as an Associate (Disputes Team) in the New Delhi branch of Shardul Amarchand Mangaldas and is a graduate of West Bengal National University of Juridical Sciences, India (Batch of 2019).