Separate Legal Personality and the Challenges Facing Shareholders Who Claim Damages from Directors

Separate legal personality and the challenges facing shareholders who claim damages from directors Image: Adobe Stock

Separate legal personality and the challenges facing shareholders who claim damages from directors 

Common law and statutory remedies under which a shareholder can possibly claim for such losses against the director within a business.

Separate Legal Personality and the Challenges Facing Shareholders Who Claim Damages from Directors

Separate legal personality and the challenges facing shareholders who claim damages from directors Image: Adobe Stock

The concept of separate legal personality is one of the most pivotal and fundamental concepts in company law, and results in shareholders finding it legally challenging to claim damages directly from the directors of the company (as opposed to the company itself) when they have suffered losses as shareholders as a result of the actions of the directors.

This paper will discuss the various common law and statutory remedies under which a shareholder can possibly claim for such losses against the director, the common law principles that are founded on the concept of separate legal personality that make it legally challenging for shareholders to succeed in such claims, and recent case law on the subject. 

SEPARATE LEGAL PERSONALITY

The concept of separate legal personality arises from the concept of a legal person (as opposed to a human person) having ‘its own legal personality to acquire rights and incur obligations that are distinct from those of the directors and shareholders of the company’[1]. That it is one of the most pivotal and fundamental concepts in company law is supported by academics, including R. Cassim who states that ‘[t]he Foundation of company law rests on the concept that a company has a separate legal personality’[2] and “at the heart of company law is the concept of a company as a separate legal person’.[3]

The concept was established in the case of Salomon v Salomon & Co Ltd[4], and is entrenched in s 19(1)(b) of the Companies Act[5] (‘the Act’) and in s 8(4) of the Constitution of the Republic of South Africa.[6]

The pertinent aspects of separate legal personality for this paper are:

  • that the company has limited liability, which means the debts and liabilities of the company belong only to the company. It follows that directors are not liable for the company’s debts (unless the company is a personal liability company), as confirmed in s 19(2) which states that a person is not, solely by reason of being an incorporator, shareholder or director of a company, liable for any liabilities or obligations of the company except to the extent that the Act or the company’s memorandum of incorporation provides otherwise[7];
  • the company owns its own property and assets, and they are not owned by its shareholders; and 
  • the company can sue or be sued in its own name.[8]

This concept of limited liability is at the heart of company law because it allows business people to invest in companies knowing that their risks are limited,[9] and allows people to hold the position of a director of a company knowing that their risks in doing so are limited. As such, it encourages the growth of commerce, which generates wealth and employment, and underpins the way in which commercial enterprise functions. It follows that the legal protection of the concept of separate legal personality and the consequent concept of limited liability is important.[10]

COMMON LAW PRINCIPLES THAT ARE KEY CHALLENGES TO SHAREHOLDERS’ CLAIMS

Some of the key challenges facing shareholders trying to claim damages against directors are the common law principles discussed below, all of which are a direct consequence of, and rely on the existence of, companies having separate legal personality. 

(a) Directors Duties are Not Ordinarily Owed to Shareholders

As mentioned in the introduction, directors’ fiduciary duties are owed to the company and not to its members because the company is distinct from its members, having its own separate legal personality. This was confirmed in De Bruyn v Steinhoff International Holdings N.V.[11] (“De Bruyn”).  The court in De Bruyn also noted that this rule is a consequence of the rule that arose in Foss v Harbottle[12] which stated that where a wrong is done to the company, the proper plaintiff is the company itself.[13]

It is however possible that the directors may be held to owe duties to the shareholders, but these must arise from a special factual relationship between the director and the shareholder. Examples of such relationships which have been recognised in other cases are where ‘directors have persuaded outside shareholders to sell their shares in the company to the directors’, in ‘family companies were shareholders reposed trust and confidence in a family member and sort advice on information’, and ‘where directors had made representations to shareholders to secure options undertaking to sell the shares of the shareholders and so assuming a position of agency and being accountable to the shareholders’.[14]

So to succeed in a claim for damages against a director on the basis that the director breached a duty that caused the shareholder a loss, a shareholder must prove the shareholder had a special factual relationship with the director in terms of which this duty was owed to the shareholder.

(b) The Reflective Loss Rule

Due to its separate legal personality, a company can itself suffer losses. The common law principle of reflective loss arose from that premise, and states that ‘losses suffered by shareholders are reflective only of the losses suffered by the company and should, therefore, be recovered by the company itself’.[15]

As such, where shareholders have suffered losses as shareholders of the company as a result of the actions of the directors, the company will likely have suffered losses too and have a right of action in respect of that loss. In terms of this principle of reflective loss, the ‘shareholder has not suffered a loss which is regarded as being separate and distinct from the company’s loss’[16], and instead the shareholder’s loss is a reflection of the loss suffered by the company. As a consequence of that, the shareholder does not have an independent claim for damages. 

This principle was restated in Prudential Assurance Co Ltd v Newman Industries Ltd (No2),[17] and referred to in the decisions of Hlumisa Investment Holdings (RF) Limited and Another v Kirkinis and Others[18] (“Hlumisa”) and De Bruyn,[19] and will prevent many shareholders’ claims against directors from succeeding.

ALSO READ: What to Look For When Starting a Small Business in South Africa (thesouthafrican.com)

POSSIBLE SHAREHOLDER REMEDIES

The following common law and statutory remedies could possibly be utilised for a shareholder to claim damages directly from the directors of the company (as opposed to the company itself) when they have suffered losses as shareholders as a result of the directors actions.

(a) Section 20(6) -A Shareholder’s Claim Against Any Person

S 20(6) records that ‘each shareholder of the company has a claim for damages against any person who intentionally, fraudulently or due to gross negligence causes the company to do anything inconsistent with this Act, or a limitation restriction or qualification contemplated in this section, unless that action has been ratified by the shareholders in terms of subsection (2).’[20]

In De Bruyn, shareholders tried to rely on s 20(6) to claim against directors for damages suffered by them due to a dramatic drop in the value of shares in the company caused by misstatements made by its directors (the making of which amounted to a breach of various sections of the Act) becoming public. The court held that ‘the correct interpretation of s 20(6) is that it imposes liability on persons who cause loss to the company’[21] (in other words, not loss to the shareholders), and that s 20(6) ‘requires those who have caused the company to act ultra vires or unlawfully to make good to the company by way of damages the loss they have caused to the company’[22] (in other words, not make good to the shareholders).  The court, on application of the common law principles discussed above, held that ‘a shareholder cannot sue for the diminution in value of his or her shares where that loss is simply a reflection of the loss suffered by the company’.[23] It held that the shareholders’ losses were not distinct from that of the company and as such the shareholders had no claim under s 20(6).[24]

(b) Piercing the Corporate Veil- Section 20(9) and the Common Law

The common law provides the remedy of piercing the corporate veil where there has been a misuse or abuse of the separate legal personality by a person. In such instances the personal liability is attributed to the person guilty of the abuse. In effect, the courts treat the liabilities of the company as those of its shareholders or directors. [25]

S 20(9) of the Act is the first company law statutory provision which permits a court to disregard the separate legal personality of a company in instances of ‘an unconscionable abuse of the juristic personality of the company as a separate entity’.[26] This section gives the court a wide discretion to make orders it considers appropriate where it does wish to pierce the corporate veil. S 20(9) has not abolished the common law remedy, which remains available where the requirements of s 20(9) are not met.

Courts treat the common law remedy as an exceptional procedure[27] but s 20(9) may give courts a wider discretion to apply the remedy than under common law.[28] However, the Appellate Division asserted that courts ‘should not lightly disregard a company’s separate personality, but they should strive to give effect and uphold it’ and academics suggest courts should, when applying s 20(9), apply the balancing act of preserving the company’s separate legal personality against those policy consideration in favour of piercing the veil.[29] So while this remedy may be available to shareholders to claim damages from directors, it will not be applied by our courts lightly.

(c) Section 161 – Application to Protect Rights of Securities Holders

Under this section (which is a new remedy that was incorporated into the Act), a holder of issued securities may apply to court for an order to protect their personal rights, which can include an order to rectify any harm done to them. 

The harm may have been done to the securities holder by ‘any of the directors of the company to the extent that they are or may be held liable in terms of section 77 (which deals with the liability of directors and prescribed officers)’.[30]

However, it is unclear if this section can be used by a shareholder to claim damages against a director for losses suffered by the shareholder arising from the director’s actions. The same barriers arising from the common law principles discussed above, and that prevented the claim under s 20(6) and/or 218(2) (discussed below) from succeeding in the De Bruyn case may arise in respect of a claim under this s 161 against a director.

(d) Section 163 – Relief from Oppressive or Prejudicial Conduct

S 163 of the Act offers a remedy in addition to its equivalent common law remedy, and extends the remedy offered under the repealed Companies Act 61 of 1973. In brief, shareholders may apply to court for relief under s 163(1) from acts or omissions that are oppressive or unfairly prejudicial to, or that unfairly disregard the interests of, the shareholder.[31]

Interestingly, the act or omission complained of need not be unlawful, and the section empowers the court to take account of the applicant’s interests together with wide equitable considerations.[32] The inclusion of an unfair disregard of interests did not form part of the Companies Act 61 of 1973, and significantly broadens the scope of this remedy.  

S 163(2) grants the court the power to make any interim or final order it considers fit, and records a non-exhaustive list of such possible orders, one of which is an order to pay compensation to an aggrieved person, subject to any other law entitling that person to compensation.[33]

While it is conceivable that a court could grant on order under s 163 against a director to pay compensation to an applicant shareholder as damages for losses suffered by that shareholder arising from the directors actions, the same barriers arising from the common law principles discussed above may cause an application under this section to fail.

The case of Gent and Another v Du Plessis[34] is an example of a recent case in which the remedy under s 163 was denied to a shareholder. The shareholder in this case sought to invoke the provisions of s 163 against a person in her capacity as the majority shareholder and director of the company on the grounds that she had acted in an unfairly prejudicial and oppressive manner towards the shareholder.[35] The court however found that the applicant had not established the requirements for s 163 to be invoked, as he failed to demonstrate that her conduct towards him was oppressive or unfairly prejudicial, or that his interests had been unfairly disregarded, and he had relied on grounds that fell outside the ambit of s 163.[36]

(e) Section 218(2) Civil Actions

S 218(2) records that any person who contravenes any provision of this Act is liable to any other person for any loss or damage suffered by that person as a result of that contravention.[37] This section appears to offer a remedy for shareholders to claim damages directly from directors who have contravened the Act and in so doing caused the shareholder loss or damage. However, recent case law shows how narrowly our courts are applying this section, making it challenging for shareholders to succeed in claims against directors.

In De Bruyn[38] the shareholders brought a claim under section 218(2) against the directors for damages suffered by them due to the directors’ misstatements. The court said that although the plain language of section 218(2) ‘has led certain courts to interpret the provision literally and in the widest terms’[39] it should not be applied in a literal way, and that in applying this section one needs to answer the questions of what obligation arises from the contravention of the Act that gives rise to liability, and to whom the obligation is owed.[40] The court confirmed that although this section confers a right of action for loss or damage arising from contraventions of the Act, ‘what the right consists of, who enjoys the right, and against whom the right may be exercised are all issues to be resolved by reference to the substantive provision of the Companies Act’.[41]

The court referenced the case of Hlumisa, saying it provided a strong endorsement to interpret section 218(2) in line with the common law and the limitations it places on liability.[42]

Following from that, and on the basis that the court had ‘already found that the common law does not hold directors liable to shareholders who suffer the loss of value of their shares, even if … that loss was caused by a breach of the directors of the standards required of them in section 76(3)’, the court held that ‘section 218(2) cannot be read to render directors liable to shareholders for breach of their duties under section 76(3) when the common law, incorporated by reference in section 77(2)(a), recognises no such liability’.[43]

(f) Common Law Delictual Claim

Shareholders can also launch a common law delictual claim to try and claim damages against directors. The shareholders tried this in De Bruyn, claiming that the directors owed them a duty of care at common law which they had breached by making the misstatements.  The court confirmed that for such a delictual claim to succeed, it needed to be shown that there was wrongful conduct against the shareholders by the directors, and to whom the directors owed the duty of care.[44] The court held that the directors’ duties were owed to the company and not the shareholders, and no special factual relationship between the shareholders and the directors had been shown which could have created a duty owed by the directors to the shareholders.[45] As such, the court held that there was no wrongful conduct by the directors as against the shareholders, and their common law claim in delict failed. [46]

CONCLUSION

This paper has shown that a company’s separate legal personality results in shareholders finding it legally challenging to claim damages against directors for losses they suffered as shareholders of the company as a result of actions of the directors. The common law and statutory remedies of piercing the corporate veil could assist shareholders to succeed in such a claim, but to succeed using the other statutory remedies discussed above, the shareholders will need to prove an exception to the rule that directors owe their fiduciary duties to the company and not to the shareholders, and that the shareholders’ loss is not merely a reflection of the company’s loss.

Written by Abigail Reynolds (Corporate & Commercial Law Specialist)

This article originally published by Reynolds Attorneys

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