What is unfair prejudice, when can you claim for it and what remedies are available?

What is unfair prejudice, when can you claim for it and what remedies are available?

This blog post gives an overview of unfair prejudice, provides examples of what constitutes unfairly prejudicial conduct and details the remedies available.

What is unfair prejudice?

Under section 994 of the Companies Act 2006 (“CA 2006”), a member of a company may file a petition with the court for relief where:

• The affairs of the company are being, or have been, conducted in a manner that is unfairly prejudicial to the interests of members generally, or some part of its members, in their capacity as such (including at least the petitioning member).
• An actual or proposed act or omission of the company is or would be so prejudicial.

The case of Re a Company (No 004175 of 1986) confirmed that the complaint may be based on past, present or even anticipated future events, and the conduct may be unfairly prejudicial to all of the members or to only some or one of them.

Once a court is satisfied that a petition under section 994 is well founded, it may make an appropriate order. The most common order is for the shares of the petitioning member to be bought by other members of the company or (in rare cases) the company itself.

In addition to filing a petition for unfair prejudice, members of a company may also seek to:

• Bring actions in the name of the company (i.e. derivative actions).
• Petition for the winding up of a company on the grounds that to do so is just and equitable under section 122(1) (g) of the Insolvency Act 1986 (“IA 1986”).
• Exercise various other rights under the IA 1986 and the CA 2006.

Who may petition?

Unfair prejudice petitions may be presented by:

• Members of a company (under section 994(1) of the CA 2006);
• Non-members to whom shares in a company who have been transferred by the execution and delivery of a proper instrument of transfer (under section 994(2));
• Non-members to whom shares in a company have been transmitted by operation of law (for example, a trustee in bankruptcy of a bankrupt member or personal representative of a deceased member) (under section 994(2)).

A transferee of shares still has standing to bring a petition even where the company in question refuses to register the transferee as a shareholder and he has no grounds to challenge such refusal. This standing is concurrent with that of the transferor if the transferor remains the registered shareholder, albeit that a transferor may find it hard to establish prejudice having agreed a price in respect of his shareholding with the transferee.

The Secretary of State for Business, Enterprise and Industrial Strategy (BEIS) has power to bring a petition under section 995 of the CA 2006 where investigations or reports reveal that the company’s affairs are being, or have been, conducted in an unfairly prejudicial manner or an actual or proposed act or omission of the company would be so prejudicial (note that these petitions are rare).

Majority shareholders are not prevented from petitioning under section 994 but prejudice will not be unfair when the petitioner can readily rectify the prejudicial state of affairs himself (as per Re Baltic Real Estate Ltd (No 2) (1992)). In such circumstances, a petition may well be struck out (as it was in Re Legal Costs Negotiators Ltd (1999)).

If a company fails to register a member in the register of members and that member has not therefore acquired his share by transfer or transmission by operation of law, that member will not qualify as a “member” and will not be able to bring an unfair prejudice petition under section 994(1) of the CA 2006 (and section 994(2) does not apply as the membership has not been transferred or transmitted by operation of law).

In Starlight Developers Ltd, Re (2007), it was held by the court that the aggrieved “member” should apply for rectification of the register under section 125 of the CA 2006 and seek a stay of his petition in the meantime.

Companies to which sections 994 and 995 apply

A petition under sections 994 and 995 of the CA 2006 may be presented in respect of all companies falling within the definition in the CA 2006. Section 1 of the CA 2006 provides that a company is one that was formed and registered under the CA 2006 or which immediately before the commencement of Part 1 of the CA 2006 was formed and registered under the Companies Act 1985 (which companies shall be treated as if formed and registered under the CA 2006).

Accordingly, an unfair prejudice petition may not be presented in respect of the affairs of an overseas company.

Conduct must relate to the company’s affairs

The unfairly prejudicial conduct must be in respect of the company’s affairs. These words are to be construed liberally by reference to commercial reality rather than legal nicety.

Such conduct includes management decisions even where they do not involve the board of directors, as well as attempts by shareholders to exert greater control where this results in the disruption of management and detriment to the proper running of the company (as per Re Oak Investment Partners XII Ltd (2009)).

However, the affairs of the company do not extend to actions of other shareholders in their capacity as such. Therefore, while the actions of a shareholder who uses his shareholding to block his removal from management may constitute unfairly prejudicial conduct regarding the affairs of the company (as per Re Legal Costs Negotiators (1999)), in circumstances where a director has already been properly and lawfully removed from management, his refusal to dispose of shares cannot (as per Re Abbington Hotel Ltd (2011)).

In addition, a shareholder voting or selling his shares shall not constitute the affairs of the company, no matter how harmful to other shareholders the outcome of such actions may be.

Conduct must be prejudicial to members’ interests as members

The unfairly prejudicial conduct must relate to members’ interests as members. This requirement will not be narrowly or technically construed and consequently, prejudice to a member’s interests as a member has been found where:

• A person became a member of a company on the basis that he would be involved in its management and was subsequently excluded from management (as per O’Neill and another v. Philipps and others (1999)).
• A member lent money to the company in his capacity as a creditor, and the loan was made as part of the basis on which he became a member of the company (Gamlestaden Fastigheter AB v. Baltic Partners Ltd and others (2007)).

However, where the interests of a member other than his interest as a shareholder are prejudiced, and those interests are not connected to the basis on which he became a member of the company, this cannot found a petition under section 994. By way of example, in Re J E Cade & Son Ltd (1991), a shareholder failed in his attempt to advance a petition based on prejudice to his interests as the freeholder of land which the company in question had been granted a licence to farm.

The reference to conduct that is “unfairly prejudicial to the interests of the members generally (our emphasis) or of some part of its members” in section 994(1) (a) of the CA 2006 makes it clear that conduct affecting all members of a company equally may be unfairly prejudicial. There is no need for a petitioner to establish that he has been treated differently to other shareholders (albeit that this is a factor likely to strengthen his claim of unfair prejudice).

Petition may be presented on the basis of a single act or omission and in respect of potential conduct

Single acts or omissions

A single unfairly prejudicial act or omission may amount to unfair prejudice if sufficiently serious. However, if the unfairly prejudicial conduct has been cured and cannot recur (for example, an improper refusal to disclose information, which information has been provided by the date of the petition) there is unlikely to be any scope for the court to grant relief and a petition will in these circumstances be dismissed.

Further, a petitioner cannot complain of a past action taken before he became a shareholder to which all shareholders at the time had consented (as per Re Batesons Hotels (1958)).

Potential conduct

Section 994(1) (b) of the CA 2006 expressly contemplates that a petition may be brought in respect of proposed acts or omissions. However, the court is unlikely to conclude that such acts or omissions are sufficiently imminent simply because a body of shareholders (when in the minority) had attempted to act in a prejudicial manner and, for this reason alone should be regarded as likely to act in a manner prejudicial to minority shareholders on obtaining a majority.

It is the petitioner’s responsibility to provide evidence that an act or omission is imminent. It is not sufficient to simply rely on the petitioner’s fear that a future act or omission may occur.

Prejudice must be suffered and must be unfair

Both prejudice and unfairness must be shown for relief to be granted – there is no need to show discrimination as well as unfair prejudice.

For example, a member can clearly show prejudice if the economic value of his shares has significantly decreased or is put in jeopardy by the conduct of which the complaint is made (as per Re Brenfield Squash Racquets Club Limited (1996)).

However, prejudice justifying a petition is not limited to such economic detriment.

Examples of what constitutes unfairly prejudicial conduct have been set out below, and these are fairly broad in scope. Despite this breadth, it will nevertheless prove fatal for a petition if the petitioner is no worse off as a result of the conduct complained of. An example of such a case is Rock (Nominees) Ltd v. RCO (Holdings) Plc (2004), which concerned a sale of a company’s wholly owned subsidiary to its majority shareholder in breach of fiduciary duty. No prejudice was proved because the sale took place at the best reasonably available price.

In appraising unfairness and prejudice a court must:

• Take an objective approach applying established equitable principles.
• Adopt as a starting point the basis on which the petitioner agreed to become a member of the company (for example, the articles of association of the company, any agreements between the shareholders and any subsequent amendments).

While the prejudice must be unfair, bad faith is not required and the petitioner need not establish the existence of a conscious intention to cause prejudice to the petitioner (as per Re Sunrise Radio Ltd (2009)).

Examples of unfairly prejudicial conduct

Breaches of fiduciary duty

Breach of fiduciary duty by a director is not of itself unfair prejudice. Real prejudice must have been suffered as a result of the breach (see Rock (Nominees Ltd v. RCO (Holdings) plc (2004)).

However, if prejudice is occasioned, breaches of fiduciary duty have been said to be paradigmatic of conduct that is unfairly prejudicial to the interests of the members generally (see Atlasview v. Brightview (2004)).

Relevant prejudice caused by breaches of fiduciary duty may include damage to the parties’ relationship of trust and confidence.

More obviously, breaches of duty entailing the misuse or misappropriation of company assets or the procurement of an allotment of shares to dilute a minority’s interests will be unfairly prejudicial. A good example is Re Woven Rugs Ltd (2010), where a company’s director and majority shareholder caused the company to borrow money from a third party to finance the repayment of the loans he had made to the company in preference to the repayment of loans that had been made to the company on the same terms by the petitioning minority shareholders.

The bringing of an unfair prejudice petition will usually be precluded if the articles of association release the directors from the breach of fiduciary duty relied on by the petitioner. However, the fact that a breach of fiduciary duty has been ratified under section 239 of the CA 2006 will not always provide a complete answer to a petition: a ratifying resolution will itself be an act of the company which may amount to unfair prejudice.

That the proper claimant for a breach of fiduciary duty is the company is not of itself a bar to an unfair prejudice petition.

It should also be noted that the directors must exercise their fiduciary duties and powers of management in the interests of the company as a whole. Sometimes doing so will require the taking of steps that are prejudicial to some of the members to secure the future of the company. Those steps will not be regarded as unfair.

Mismanagement

A court will not interfere in questions of commercial judgement. However, where mismanagement is established, rather than a mere difference of opinion on the desirability of different commercial decisions, this may constitute unfair prejudice. Whether or not such mismanagement is sufficiently serious falls to be appraised by reference to the following criteria:

• The scale of financial loss arising.
• Frequency and duration of acts or omissions constituting mismanagement.

Failure to pay dividends

Setting the level of dividends payable to shareholders is a commercial decision with which courts are normally reluctant to interfere. The absence of dividends cannot, of itself, constitute unfair prejudice: the decision to pay dividends should always be driven by commercial objectives.

However, unfair prejudice may be established where:

• The payment of a certain level of dividend (if justified by the company’s financial position) was part of the basis on which the petitioner became a member of the company and payments below this level are received without justification;
• The directors:
  • have abdicated their responsibility to consider paying or increasing dividends; or
  • have refused to pay dividends for improper purposes such as enhancing the capital value of their own shareholdings while deriving an income from directors’ fees.
• The only reason dividends have not been paid is because all distributable profits have been exhausted by the drawing of excessive remuneration, especially where such excessive remuneration has been paid to shareholder directors.

Payment of excessive remuneration

The level of remuneration is also a commercial decision which the court is normally unlikely to second guess.

However, the following are exceptions to this:

• Where remuneration is not calculated by reference to the value of the services provided by directors who are in control of the company, and is instead a disguised payment of dividend or dressed-up return of capital, this will be unfairly prejudicial conduct even where approved by the shareholders at a general meeting.
• Where remuneration is a genuine reward for service, but can be objectively shown to be excessive in the light of expert evidence on comparable remuneration or the trading condition of the company, a decision of the board of directors to approve that remuneration may be found to have been taken in breach of fiduciary duty for the improper purpose of self-enrichment. However, if such remuneration is approved by the shareholders at a general meeting there will have been no breach of duty and no petition may be brought unless it is shown to be a dressed-up return of capital.
• Where remuneration has not been approved by the board of directors, shareholders or otherwise in accordance with the articles of association, a greater degree of judicial scrutiny is permitted. Whether or not such remuneration is unfairly prejudicial is a question of fact, appraised by reference to whether or not the remuneration is within the bracket that executives carrying out the sort of responsibility and discharging the sort of duties that the director in question was carrying and discharging, would expect to receive (a court will usually require expert evidence to reach a decision in this regard).
• The drawing of any remuneration will constitute unfair prejudice if done contrary to an understanding that directors will not be remunerated, or as to the permissible levels of remuneration.

It may be that a director is so critical to the survival of a company and its business that paying remuneration in excess of what is considered within the normal range is justifiable, and as stated above whether or not such remuneration is unfairly prejudicial is a question of fact that will be determined on a case by case basis.

Diluting the minority’s shareholding

Allotting further shares in the company for the improper purpose of diluting a minority shareholder’s shareholding is an obvious example of unfair prejudice (see Re Coloursource Ltd (2004)).

Unfair prejudice may also be established in the context of a rights issue (i.e. an offer of new shares or other securities made to existing shareholders in proportion to their shareholdings) which a petitioning minority shareholder is, in principle, free to take up, if:

• It is known that the petitioning minority shareholder cannot take advantage of the issue.
• In breach of fiduciary duty, the directors fail to properly consider the price that could and should be extracted from those willing and able to subscribe for shares.

This is especially so where the directors are also shareholders in a position to benefit from the making of the rights issue.

Failure to abide by the articles of association or agreements between shareholders and non-compliance with the Companies Act 2006

Failure to abide by the articles of association or agreements between shareholders and non-trivial failures to comply with the CA 2006 constitute a breach of the basis on which a member subscribes for shares in a company and may justify the bringing of an unfair prejudice petition.

Examples of such conduct include:

• Failure to hold annual general meetings, to provide accounts and to disclose interests in a transaction with the company contrary to the CA 2006.
• Making loans to directors without complying with the requirements of section 197 of the CA 2006 or otherwise ratifying the same.
• Registering new members in breach of restrictions on transfers to non-members contained in the articles of association.
• Actions that are inconsistent with the express and implied terms of contracts entered into by shareholders and subsequent agreements, understandings or established patterns of behaviour governing the basis of their involvement with the company.

However, petitions may not be advanced in respect of trivial or technical infringements that give rise to no real prejudice.

Inequitable conduct

Examples of inequitable conduct include:

• Exclusion from management where participating was part of the bargain between shareholders and such exclusion is not justified by the petitioner’s misconduct or otherwise.
• Failure to consult with, or provide information to, a petitioner where it was agreed that the petitioner would be consulted or provided with such information.

Remedies

The court has a wide discretion to make such order as it thinks fit to remedy any unfair prejudice that the petitioner is able to establish (as per section 996(1) of the CA 2006). Without limit to the court’s broad discretion, section 996(2) specifically permits the court to make orders that:

• Regulate the conduct of the company’s affairs in the future. This could be simply ordering a single meeting to be held or going so far as setting out a code of conduct for future company business.
• Require the company to refrain from an act or to carry out an act that it has omitted to do (including ordering the company to amend its constitutional documents and resolutions – see section 999(2) of the CA 2006).
• Authorise civil proceedings to be brought in the name of the company even where the strict preconditions of the statutory derivative action cannot be established, albeit that the principles applicable to derivative actions and prohibiting the recovery of reflective loss will be borne firmly in mind.
• Prohibit changes to the company’s articles of association.
• Provide for the purchase of the shares of a member of the company by other members or (less commonly) by the company itself on such terms as the court thinks fit. Any order for the purchase of shares by the company will have to pay careful regard to the interests of creditors and the implications of diminishing the company’s assets or increasing its indebtedness to fund the share purchase.
• Make orders against directors and third parties (if made respondents to the petition) where it is just to grant a remedy against them (including imposing an obligation to purchase the petitioner’s shares) having regard to their involvement in the conduct complained of.

In exercising its powers under section 996, the court is not constrained by the type of order sought by the petitioner (albeit the acceptability of the order to the petitioner will carry great weight) and will be guided not only by the need to provide redress to the petitioner, but also to regulate the affairs of the company in the future.

In Ferdinand v. Patel (2016), the court went so far as to order the winding up of the company (despite neither party having requested this) on the basis that this was the fairest way of doing justice between the two solicitor shareholders who could each pursue their respective practices through newly incorporated companies.

The unfairly prejudicial conduct (not to mention any ensuing litigation) will in the vast majority of cases have led to a breakdown in the relationship between the parties. Effective relief will therefore normally entail the making of an order providing for a clean break between the parties. The usual method of achieving this is to make a purchase order.

Purchase order

A purchase order normally requires the wrongdoing member(s) to purchase the minority shareholding of the petitioner. However, in exceptional circumstances an order may be made requiring the majority members of a company to sell their shares to the minority petitioner. Such circumstances may be found to exist where the conduct of the majority demonstrates that they are unfit to be involved in the affairs of the company (see Re Company No 00789 of 1987)).

Where a petitioner and the respondent have shareholdings of the same, or similar, size and cannot agree who should buy the other out, the court decides who should sell and who should buy having regard to the:

• Best interests of the company.
• Extent of the wrongdoing.
• Views of other stakeholders.

Valuation is normally determined on the basis of expert evidence adduced by the petitioner and respondent and the court has a broad discretion to do what is fair in determining the appropriate valuation methodology.

Minority discount

A further adjustment which may be extremely significant in terms of the purchase price (where a purchase order is made by the court) is whether a discount should be made to reflect a petitioner’s minority interest.

Until recently the circumstances in which a minority discount would be applied were relatively settled. In a normal trading company a discount was usually included absent exceptional circumstances.

This approach was doubted in the case of Re Blue Index Ltd (2014), where Robin Hollington QC (sitting as a deputy High Court judge) held that the default position should be no minority discount for all companies. To order otherwise would be to reward the oppressing majority and improperly treat the petitioner as if he was a willing seller. An exception to this would be if the shares in question were originally acquired at a discount.

This approach was considered in Re Autobody Ringway Limited (2018). The petitioner had been excluded from management in breach of an agreement that he would be involved. While HHJ Hodge held that his removal was justified, it was nevertheless unfairly prejudicial for the respondent to continue to run the company without offering to buy out the petitioner.

On the facts of the case, HHJ Hodge considered that a minority discount was appropriate because his removal had been justified and the petitioner had only paid a nominal amount for his shares, while the respondent had provided the business connections, experience and opportunities that allowed the formation of the company.

However, had the circumstances been different, and in particular had the removal of the petitioner not been justified, HHJ Hodge stated that he would have disallowed a minority discount. That the justifiability of the petitioner’s removal from management may serve as a ‘litmus test’ for the existence of a minority discount or not in cases of this nature has been further endorsed in subsequent case law.

Bars to relief

A respondent to an unfair prejudice petition may be able to rely on one or more of the following bars to relief by way of defence or in support of an application to strike out the petition:

• Refusal by the petitioner of a fair offer to purchase his shares.
• Express provision for an exit route in the company’s articles of association or in a shareholder agreement.
• Misconduct on the part of the petitioner.
• Delay in presenting the petition or acquiescence in the alleged unfairly prejudicial conduct.

This article is intended for general information only, applies to the law at the time of publication, is not specific to the facts of your case and is not intended to be a replacement for legal advice. It is recommended that specific professional advice is sought before relying on any of the information given. © Jonathan Lea Limited.