UK Subsidiary?

U.S. corporations with UK subsidiaries should be aware that company law in the UK is currently going through a process of significant review and change. There is compelling evidence that when the Company Law Reform Bill comes into force next year, the risks facing UK company directors will be at an all-time high. For the first time, the new legislation introduces a statutory basis for claims by shareholders against directors for negligence, default, breach of duty or breach of trust.

In this article, we look at the impact of the proposed changes in the context of a global shift toward greater accountability to shareholders, and the potential consequences for businesses having a presence in the UK.

The Current Regime in the UK

At present, UK companies are not required to act on the instructions of shareholders controlling less than 50% of the shares by value. The right to bring a claim in respect of directors' conduct vests in the company and not its shareholders. As a result, the odds are stacked against a minority shareholder who has suffered as a consequence of the actions of directors. An aggrieved minority shareholder is typically required to show 'unfair prejudice' or a 'fraud on the minority shareholders' and 'wrongdoer control' in order to bring a derivative action in the name of a company.

The new regime will potentially allow a broader range of claims to be brought. Perhaps inevitably, concerns have been expressed that the new legislation would make it too easy for disgruntled shareholders to pursue derivative claims. A number of procedural safeguards have been included in the new Bill to meet these concerns. The financial risk of bringing a claim lies with the plaintiff shareholder, whilst any financial benefit from the action belongs to the company for the benefit of all of its shareholders. Permission of the court will be required to proceed with a derivative action, and this must be refused where the claim would be contrary to the promotion of the success of the company, or the conduct complained of has been authorized or ratified by the company. In other cases the court has the discretion whether to grant permission.

The Regulatory Context

The latest reforms must be seen in the context of increasing duties placed on UK directors. Since last April, directors have been at risk of criminal sanctions if they fail to provide full information to auditors covering not just what they know, but what they ought to know. This follows the trend set by the U.S., most notably by the Sarbanes-Oxley Act (SOX).

As directors' responsibilities in-crease, so inevitably do their liabilities. More and more, directors are seen as fair targets if there is some financial scandal or poor corporate performance. The U.S. class actions against the directors of WorldCom, Enron and Global Crossing resulted in large settlements for their shareholders. Although a number of similar high profile claims in the UK (such as Equitable Life) have failed, most commentators expect the frequency of claims to increase. The last few years have seen the Financial Services Authority increasingly target individual officers and impose large fines on directors for regulatory breaches. These factors may lead potential directors to decide that the risks of the job are simply not worth taking on.

Group Litigation

Concerns were expressed in the UK Parliament that the new regime for derivative actions could encourage a litigation culture amongst aggrieved shareholders. At present, civil procedure in England and Wales does not permit class actions in the U.S. sense. Whereas in the U.S. a corporate defendant can be faced with potentially massive aggregate liability through a single set of proceedings, group actions in the UK require plaintiffs positively to 'opt in' to the group and the court to decide that this is the most cost effective way for the litigation to be managed.

The trend toward increased group litigation is reflected elsewhere in Europe. Last year, procedures were introduced in Germany that will make it easier for claims to be pursued by shareholders or other investors in securities cases. Forms of collective action are also permitted in Sweden, Holland and Spain. Several other European countries including France, Italy and Ireland are currently considering proposals that would allow individual claims to be aggregated. At the same time we are witnessing a greater willingness by shareholders in Europe to take legal action to protect their position ' for example Railtrack in the UK, Deutsche Telekom in Ger-many and EADS in France.

The procedures vary from jurisdiction to jurisdiction. Some are restricted to particular sectors or types of claim. All fall well short of the U.S. class action regime where class members are entitled to the fruits of the action unless they 'opt out' of the class.

Other aspects of U.S. procedure not replicated in Europe include the ability to advertise for plaintiffs, the funding of actions through contingency fees and punitive damages. The general rule also remains that the losing party pays the winner's costs, which acts as a significant deterrent to weak or speculative claims. However, the trend toward increased collective litigation should not be ignored, particularly as some of the large U.S. plaintiff law firms are actively investigating the European market.

The changes to company legislation are of course highly political. The media increasingly draw comparisons between the ways that national governments tackle a common problem. Consumer associations are increasing in power and profile. The last 5 years have seen a raft of new corporate governance legislation, led by SOX in the U.S. Governments face public criticism if their legal system does not provide a remedy for the victims of corporate misconduct. The political ramifications can be even greater where in contrast the laws of other countries do provide access to justice and compensation for their citizens affected by the same or similar events.

Protecting Directors

Looking forward, large multi-national companies may well question the benefits of trading in highly regulated environments where the potential exposure of their directors is particularly severe. We have already seen how European companies trading or investing in the U.S. have been exposed to class actions and enforcement action by the Securities and Exchange Commission. In 2004, there were 29 U.S. class actions brought against non-U.S. issuers and their directors. In the recent Shell case, the U.S. class action brought against the company and its directors for breach of U.S .securities laws included all Shell investors within its class, regardless of whether they were based in the U.S. That claim settled in August 2005 by payment of $9.2 million in lawyers' fees and an agreement to make changes to Shell's corporate governance. Other non-U.S. issuers which have faced enforcement action by the SEC for breaches of the SOX legislation include Vivendi Universal, Royal Ahold, Deutsche Bank and Parmalat. Ultimately, this has led to some UK companies de-listing from U.S. stock exchanges and de-registering from the SEC. Examples include Premier Farnell plc and ITV plc. However, de-registration is by no means straightforward.

Companies trading in Europe (including U.S. subsidiaries) also have to consider the impact of the regulatory regimes in countries where they operate. There are a number of steps which UK registered companies can take to protect their directors under the new regime:

• First, under the Companies (Audit, Investigations and Community Enterprise) Act 2004, UK companies may now indemnify their directors against defence costs and damages arising out of claims by third parties. The DTI has said that 'third parties' should include shareholders.
• Second, companies would be well advised to take steps to protect their directors, through directors' and officers' (D&O) insurance cover. Such cover may be broader in scope than the protection available through indemnities from the company.

On balance, the new UK legislation is unlikely to prompt a significant move toward U.S.-style shareholder class actions against directors in England and Wales. However, the Bill should be seen in the context of an evolving regulatory landscape. Directors of UK-registered companies will increasingly have to understand and monitor the risks faced by them (and the companies they represent) from regulators, investors and third parties, through proceedings both in the UK and elsewhere.

Richard Matthews ([email protected]) heads the Product Liability practice of international law firm Eversheds LLP, where he advises on a wide range of multi-party actions and has acted in some of the largest product recalls in the UK. Matthews is a member of the Defense Research Institute. He is currently chairing a Product Liability comparative survey of member firms of the World Law Group and is a member of a Task Force of the International Bar Association considering the international harmonization of class action procedures. The author gratefully acknowledges the assistance of his associate, Chris Taylor, in the preparation of this article.

U.S. corporations with UK subsidiaries should be aware that company law in the UK is currently going through a process of significant review and change. There is compelling evidence that when the Company Law Reform Bill comes into force next year, the risks facing UK company directors will be at an all-time high. For the first time, the new legislation introduces a statutory basis for claims by shareholders against directors for negligence, default, breach of duty or breach of trust.

In this article, we look at the impact of the proposed changes in the context of a global shift toward greater accountability to shareholders, and the potential consequences for businesses having a presence in the UK.

The Current Regime in the UK

At present, UK companies are not required to act on the instructions of shareholders controlling less than 50% of the shares by value. The right to bring a claim in respect of directors' conduct vests in the company and not its shareholders. As a result, the odds are stacked against a minority shareholder who has suffered as a consequence of the actions of directors. An aggrieved minority shareholder is typically required to show 'unfair prejudice' or a 'fraud on the minority shareholders' and 'wrongdoer control' in order to bring a derivative action in the name of a company.

The new regime will potentially allow a broader range of claims to be brought. Perhaps inevitably, concerns have been expressed that the new legislation would make it too easy for disgruntled shareholders to pursue derivative claims. A number of procedural safeguards have been included in the new Bill to meet these concerns. The financial risk of bringing a claim lies with the plaintiff shareholder, whilst any financial benefit from the action belongs to the company for the benefit of all of its shareholders. Permission of the court will be required to proceed with a derivative action, and this must be refused where the claim would be contrary to the promotion of the success of the company, or the conduct complained of has been authorized or ratified by the company. In other cases the court has the discretion whether to grant permission.

The Regulatory Context

The latest reforms must be seen in the context of increasing duties placed on UK directors. Since last April, directors have been at risk of criminal sanctions if they fail to provide full information to auditors covering not just what they know, but what they ought to know. This follows the trend set by the U.S., most notably by the Sarbanes-Oxley Act (SOX).

As directors' responsibilities in-crease, so inevitably do their liabilities. More and more, directors are seen as fair targets if there is some financial scandal or poor corporate performance. The U.S. class actions against the directors of WorldCom, Enron and Global Crossing resulted in large settlements for their shareholders. Although a number of similar high profile claims in the UK (such as Equitable Life) have failed, most commentators expect the frequency of claims to increase. The last few years have seen the Financial Services Authority increasingly target individual officers and impose large fines on directors for regulatory breaches. These factors may lead potential directors to decide that the risks of the job are simply not worth taking on.

Group Litigation

Concerns were expressed in the UK Parliament that the new regime for derivative actions could encourage a litigation culture amongst aggrieved shareholders. At present, civil procedure in England and Wales does not permit class actions in the U.S. sense. Whereas in the U.S. a corporate defendant can be faced with potentially massive aggregate liability through a single set of proceedings, group actions in the UK require plaintiffs positively to 'opt in' to the group and the court to decide that this is the most cost effective way for the litigation to be managed.

The trend toward increased group litigation is reflected elsewhere in Europe. Last year, procedures were introduced in Germany that will make it easier for claims to be pursued by shareholders or other investors in securities cases. Forms of collective action are also permitted in Sweden, Holland and Spain. Several other European countries including France, Italy and Ireland are currently considering proposals that would allow individual claims to be aggregated. At the same time we are witnessing a greater willingness by shareholders in Europe to take legal action to protect their position ' for example Railtrack in the UK, Deutsche Telekom in Ger-many and EADS in France.

The procedures vary from jurisdiction to jurisdiction. Some are restricted to particular sectors or types of claim. All fall well short of the U.S. class action regime where class members are entitled to the fruits of the action unless they 'opt out' of the class.

Other aspects of U.S. procedure not replicated in Europe include the ability to advertise for plaintiffs, the funding of actions through contingency fees and punitive damages. The general rule also remains that the losing party pays the winner's costs, which acts as a significant deterrent to weak or speculative claims. However, the trend toward increased collective litigation should not be ignored, particularly as some of the large U.S. plaintiff law firms are actively investigating the European market.

The changes to company legislation are of course highly political. The media increasingly draw comparisons between the ways that national governments tackle a common problem. Consumer associations are increasing in power and profile. The last 5 years have seen a raft of new corporate governance legislation, led by SOX in the U.S. Governments face public criticism if their legal system does not provide a remedy for the victims of corporate misconduct. The political ramifications can be even greater where in contrast the laws of other countries do provide access to justice and compensation for their citizens affected by the same or similar events.

Protecting Directors

Looking forward, large multi-national companies may well question the benefits of trading in highly regulated environments where the potential exposure of their directors is particularly severe. We have already seen how European companies trading or investing in the U.S. have been exposed to class actions and enforcement action by the Securities and Exchange Commission. In 2004, there were 29 U.S. class actions brought against non-U.S. issuers and their directors. In the recent Shell case, the U.S. class action brought against the company and its directors for breach of U.S .securities laws included all Shell investors within its class, regardless of whether they were based in the U.S. That claim settled in August 2005 by payment of $9.2 million in lawyers' fees and an agreement to make changes to Shell's corporate governance. Other non-U.S. issuers which have faced enforcement action by the SEC for breaches of the SOX legislation include Vivendi Universal, Royal Ahold, Deutsche Bank and Parmalat. Ultimately, this has led to some UK companies de-listing from U.S. stock exchanges and de-registering from the SEC. Examples include Premier Farnell plc and ITV plc. However, de-registration is by no means straightforward.

Companies trading in Europe (including U.S. subsidiaries) also have to consider the impact of the regulatory regimes in countries where they operate. There are a number of steps which UK registered companies can take to protect their directors under the new regime:

• First, under the Companies (Audit, Investigations and Community Enterprise) Act 2004, UK companies may now indemnify their directors against defence costs and damages arising out of claims by third parties. The DTI has said that 'third parties' should include shareholders.
• Second, companies would be well advised to take steps to protect their directors, through directors' and officers' (D&O) insurance cover. Such cover may be broader in scope than the protection available through indemnities from the company.

On balance, the new UK legislation is unlikely to prompt a significant move toward U.S.-style shareholder class actions against directors in England and Wales. However, the Bill should be seen in the context of an evolving regulatory landscape. Directors of UK-registered companies will increasingly have to understand and monitor the risks faced by them (and the companies they represent) from regulators, investors and third parties, through proceedings both in the UK and elsewhere.

Richard Matthews ([email protected]) heads the Product Liability practice of international law firm Eversheds LLP, where he advises on a wide range of multi-party actions and has acted in some of the largest product recalls in the UK. Matthews is a member of the Defense Research Institute. He is currently chairing a Product Liability comparative survey of member firms of the World Law Group and is a member of a Task Force of the International Bar Association considering the international harmonization of class action procedures. The author gratefully acknowledges the assistance of his associate, Chris Taylor, in the preparation of this article.