A derivative claim is a legal action brought by a shareholder on behalf of a company to address wrongdoing committed against the company, typically by its directors. The claim arises where the company itself has suffered harm, for example, through negligence, breach of duty, default, or fraud, but those in control refuse to authorise proceedings.
Derivative claims play a key role in corporate governance. They provide a mechanism for minority shareholders to hold directors accountable where the board is conflicted or compromised. At the same time, they are deliberately difficult to pursue. Strict procedural safeguards, cost risks and judicial scrutiny mean they are relatively rare in practice.
This guide explains what derivative claims are, when they apply, how the court permission process works, and the practical considerations shareholders should weigh before proceeding.
Summary
- Derivative Claim Definitions
- When can a Shareholder bring a Derivative Claim?
- Examples of Situations where Derivative Action may be Triggered
- The Two-Stage Court Permission Process
- Practical Challenges for Shareholders
- Alternatives to Derivative Claims
- Derivative Claims Case Law
- Practical Advice for Shareholders
What is a Derivative Claim?
A derivative claim under Part 11 of the Companies Act 2006 (‘CA 2006’) allows a shareholder to ‘step into the shoes’ of the company to pursue a course of action that belongs to the company. It typically arises where directors have committed negligence, default or failure to perform obligations, breach of statutory or fiduciary duty, or breach of trust.
The defining features are:
- The wrongdoing is done to the company, not to the shareholder personally.
- The claim is brought in the company’s name.
- Any damages or remedy awarded are paid to the company, not the shareholder.
This distinguishes a derivative claim from a direct (personal) action, where a shareholder sues to recover compensation for personal loss suffered in their own capacity – for example, breach of a shareholders’ agreement or infringement of rights attached to shares. A derivative claim enforces the company’s rights where it has suffered the loss.
Statutory v Common Law Origins
The starting point in common law was the rule in Foss v Harbottle (1843), which established the proper claimant principle: where a wrong is done to a company, the company itself is the only proper claimant.
While this reflected the company’s separate legal personality, it created difficulties where the alleged wrongdoers controlled the company. In such cases, they could prevent the company from bringing proceedings against themselves. To prevent injustice, the courts developed narrow exceptions permitting shareholders to sue where:
- There was a fraud on the minority; and
- The wrongdoers were in control of the company.
These common law exceptions were, however, criticised for being narrow, technical, and uncertain, making derivative actions difficult to pursue successfully.
Part 11 of the CA 2006 replaced the common law derivative action with a statutory framework. The new regime removed the strict fraud requirement and broadened the types of misconduct covered. It also introduced a structured court permission process. While the statutory framework is more flexible, it remains tightly controlled. Judicial oversight ensures that derivative claims are permitted only where genuinely justified.
When Can a Shareholder Bring a Derivative Claim?
Under Part 11 of the CA 2006, a shareholder may bring a derivative claim in respect of an actual or proposed act or omission by a director involving:
- Negligence
- Default or failure to perform obligations
- Breach of duty (including breach of the duty to promote the success of the company under S.172)
- Breach of trust
Importantly, the shareholder does not need to have suffered personal loss. The focus is entirely on harm done to the company.
Who Can Bring the Claim?
Any shareholder may bring a derivative claim regardless of the size of their shareholding, provided that:
- They are a current member of the company; and
- They were a member at the time of the alleged wrongdoing (or acquired their shares by operation of law, e.g. through inheritance).
However, bringing the claim is only the first step. The shareholder must obtain the court’s permission to continue the action.
Examples of Conduct that may Trigger a Claim
Derivative claims commonly arise in closely held or family-run companies where governance standards have broken down. Typical scenarios include:
1. Misuse of Company Funds
- Transferring company funds into personal accounts
- Paying excessive salaries, bonuses, or ‘loans’ to directors without proper approval
- Selling company property to themselves or connected parties at below-market value
- Declaring unlawful dividends
2. Conflicts of Interest
- Accepting improper benefits from third parties
- Diverting corporate opportunities for personal gain instead of offering them to the company
- Entering into related-party transactions without full disclosure or approval
3. Breach of the Duty to Act in the Company’s Best Interests
- Recklessly approving high-risk transactions without proper due diligence
- Engaging in wrongful trading
- Ignoring fiduciary duties
- Misleading shareholders
The Two-Stage Court Permission Process
Derivative claims are subject to a strict two-stage permission process designed to filter out weak, tactical or unmeritorious claims.
Stage One – Establishing a Prima Facie Case
The first stage is an initial screening process. The shareholder files a claim form and supporting evidence outlining the alleged wrongdoing. At this point, the court considers only the applicant’s evidence; the company and the alleged wrongdoers are not yet involved.
The shareholder must establish a prima facie case, meaning there is sufficient evidence to justify further consideration of the claim. If the court concludes that no prima facie case exists, it must dismiss the application, often without a hearing. If the threshold is met, the matter proceeds to Stage Two.
Stage Two – Full Permission Hearing
If the claim passes the initial filter, the court conducts a full permission hearing. The company is usually represented and may oppose the application.
Under section 263 of the CA 2006, the court must refuse permission if:
- A director acting in accordance with the duty to promote the success of the company (s.172) would not seek to continue the claim; or
- The act or omission is authorised or ratified by the company.
If these mandatory bars do not apply, the court has discretion and considers factors such as:
- Whether the shareholder is acting in good faith
- The importance a director acting under s.172 would attach to the claim
- Whether the company has decided not to pursue the action
- Whether the shareholder has an alternative personal remedy
The central question for the court is always whether continuing the claim would promote the company’s interests. If permission is refused, the claim ends.
Judicial Discretion in Practice
The courts apply an objective test: would a reasonable director complying with the duty under s.172 CA 2006 pursue the claim?
Relevant considerations include:
- The potential benefit to the company
- Whether an independent and reasonable board would litigate
- The likely costs and impact on company resources
- The strength and prospects of the claim
- Whether the conduct has been, or could be, ratified by independent shareholders
The court undertakes its own evaluation of these factors, focusing strictly on the company’s interests rather than the claimant’s perspective.
The availability of alternative remedies is also significant. If the shareholder’s grievance is essentially personal, and another procedure (such as unfair prejudice claim under S.994 of CA 2006) would more appropriately address it, permission is likely to be refused.
Overall, derivative claims are permitted only where litigation is genuinely justified from the company’s standpoint, which explains why courts approach them with caution.
Practical Challenges for Shareholders
Because of the strict filtering process and the associated cost risks, derivative claims remain relatively rare in practice. Derivative claims present significant legal, financial and practical challenges.
Legal costs and financial risk
These claims are expensive and high-risk. Legal fees can be substantial, and if the claim fails, the shareholder may be unable to recover their own costs and may be ordered to pay the company’s legal expenses.
Even if successful, any damages or compensation awarded are paid to the company, not to the claimant personally. This reduces financial incentive and increases personal exposure.
Difficulty accessing evidence
To obtain permission to continue a claim, the shareholder must produce evidence. However, the necessary internal documentation is typically controlled by the directors accused of wrongdoing. This may include board minutes, financial records and correspondence.
Inspection rights are usually limited by the articles of association. Where wrongdoers control the board, there is a risk that documents are withheld or obscured.
This evidential imbalance is one of the most significant practical barriers.
Risk of retaliation
Derivative claims can fundamentally disrupt corporate relationships and lead to retaliation, particularly in smaller or closely held companies. Directors may marginalise the claimant, remove them from management roles, or attempt to dilute their shareholding. Such disputes can also cause reputational harm within tight professional networks.
As a result, even if legally justified, the commercial and relational consequences must be carefully weighed.
Funding Options
Given the risks involved, shareholders often explore alternative funding arrangements to reduce exposure:
- Third-party litigation funding allows specialist funders to cover legal fees and expenses in exchange for a percentage of any recovery, often between 20% and 40%.
- Conditional fee agreements (‘no win, no fee’) enable solicitors to charge a success fee only if the claim succeeds, thereby limiting upfront costs.
- Indemnity orders, in which courts may order the company to indemnify the claimant’s reasonable costs, particularly where permission is granted.
Each option has strategic implications and should be assessed early.
Alternatives to Derivative Claims
Derivative claims are not always the best route. In many cases, alternative remedies are more practical.
Unfair prejudice petition (S.994 CA 2006)
This is the most common alternative, and it applies where the company’s affairs are conducted in a way that unfairly prejudices a shareholder, such as exclusion from management or diversion of benefits. Typical remedies include a share buy-out, providing direct personal relief.
Courts are often reluctant to permit derivative claims where unfair prejudice offers a more appropriate remedy.
Personal Actions
Shareholders may bring personal claims where there is a breach of a shareholder agreement, the articles of association, or rights attaching to shares.
These claims seek compensation for personal loss rather than company loss.
Alternative Dispute Resolution (ADR)
Litigation is not always necessary. Options include mediation or arbitration, which can resolve disputes confidentially and cost-effectively.
Internal Remedies
Internal remedies, such as removing directors or passing shareholder resolutions, may address misconduct without litigation.
Winding-Up Petition on Just and Equitable Grounds
This may be available as a last resort where trust between shareholders has irretrievably broken down.
Notable Case Law
The law on derivative claims has evolved from restrictive common law principles to a structured statutory regime under the CA 2006. The following leading cases illustrate this shift.
Foss v Harbottle established the ‘proper plaintiff rule’: where a wrong is done to a company, the company itself is the proper claimant, not individual shareholders. Courts will not interfere in matters that a majority can ratify. Limited exceptions developed, particularly where alleged wrongdoers controlled the company and prevented it from suing.
In Franbar Holdings Ltd v Patel, the High Court refused permission to proceed with a derivative claim. Applying the ‘hypothetical director’ test, the court held that a director promoting the company’s success might not pursue the claim given the costs, disruption, and limited prospects. The availability of an unfair prejudice petition under s.994 was also a significant factor.
By contrast, the case of Kiani v Cooper demonstrates when permission may be granted. In that 50/50 shareholder dispute, strong prima facie evidence showed that a director had misappropriated company funds. The court concluded that a director acting to promote the company’s success would seek recovery for a clear breach of fiduciary duty.
These cases show that courts closely balance:
- Strength of evidence
- Commercial practicality
- Availability of alternative remedies
- Overall benefit to the company
Derivative claims are permitted only where litigation is objectively justified.
Practical Tips for Shareholders Considering a Derivative Claim
If you are considering a derivative claim, you should take a strategic and commercially informed approach.
- Seek early specialist legal advice
It is important to assess the claim’s merits, the strength of the evidence, and strategic options before issuing proceedings. - Gather and preserve evidence promptly
Assemble all relevant documentation, including board minutes, financial records, shareholder resolutions and email correspondence before access becomes restricted. - Understand the cost risks
These claims are expensive and procedurally complex, meaning that a clear funding strategy is essential from the outset. - Assess boardroom dynamics and commercial realities
Consider how the claim may affect governance, working relationships and voting power. - Consider alternative remedies
Evaluate whether unfair prejudice or another route is more appropriate - Review insurance arrangements
Directors’ and Officers’ insurance (D&O) may influence the company’s recovery prospects and the strategy you pursue.
Here to Help
A derivative claim allows a shareholder to bring proceedings on behalf of the company where directors have breached their duties and the company itself will not act. It is an exception to the general rule that the company is the proper claimant and is tightly controlled under the CA 2006.
It is important to remember that a derivative claim is about protecting the company’s interests, not pursuing a personal grievance. Any compensation awarded goes to the company, not the shareholder bringing the claim. The court will focus on whether the action genuinely benefits the company and whether another remedy, such as an unfair prejudice petition, would be more suitable.
Because these claims are legally complex, potentially expensive, and can strain boardroom relationships, they should not be entered into lightly. If you are considering this route, getting specialist legal advice early on can help you understand the risks, costs and alternatives, and decide whether it is the right step for you and the business.If you want to make or fight a derivative claim or are currently involved in a director dispute or shareholder dispute, our experienced team here at Witan Solicitors can help you assess your options and plan the best next steps. Simply contact our experienced team on 0300 303 2071 or email us to set up a consultation.
