Derivative Suits: Protecting Minority Shareholders in Corporate Governance

Corporate governance in Saudi Arabia is crucial to ensure foreign investments are protected and minority shareholders' rights are respected. The new Companies Law has introduced some protections, but it fails to identify the concentrated ownership structure and provide sufficient safeguards for minority investors. Derivative suits under Saudi company law have several limitations, including ambiguity around costs and indemnity, which may discourage minority shareholders from taking action. Furthermore, the legal system in Saudi Arabia gives priority to majority shareholders' interests, leaving minority shareholders vulnerable. Overall, there is a need to strengthen corporate governance practices and provide better protections for minority investors.

Derivative Suit
protection of minority shareholders

Derivative Suit
Importance of protecting minority shareholders
In today’s world with the high focused media reports on the scandals prevailing in the corporate
world, links the financial crises to the negligible protection forwarded to the minority
shareholders. The studies linked to this topic of lesser protection to the minority shareholders
suggests that the majority shareholder have the tendency to expropriated minority shareholder,
and in so doing makes the maximum benefit out of it1.
In each and every company the rule which is followed is the majority rule, i.e. the control over
the firm’s operational activities by the majority shareholders or by the exercise of the managerial
powers by the majority shareholders. This compliance of the majority rule is not at all contrary
or in detriment to Law. But, still there lies the reason which seeks to protect the minority
shareholders. The most obvious and the straightforward reason is that when the above two
practices are followed by the majority shareholders then it sometimes become oppressive for the
minority shareholders. This mechanical rule which applies to the majority shareholders, if goes
unchecked becomes detrimental to the minority shareholders and hence making it contrary to
law, and which in near future will be the witness to the destruction of the company2. So, for the
effective maintenance of the business environment an enhanced method must be implemented
and thus executed for the rectification of the mistakes and in so doing the monitoring of it is
paced up. Again, for the protection of the minority shareholders, derivative suits are considered
to be the best approach for maintaining the corporate governance to get relief or remedy, against
any director on whom the benefit of the company is vested to assert their rights3. But, for the
1 (Birds, 2007)
2 (He, 2005)
3 (Isberg, 2007)
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minority shareholders, the derivative claims are allowed only when there is solvency in the
company and shares which are claimed have the substantial value.
The protection of minority shareholders is important because, the growth in the economy gets
stimulated by this and also the agency costs of the firm gets reduced which benefits the firm as a
whole, thereby resulting in the efficient management of the firm. Furthermore, the protection of
the minority shareholders helps in the cross listing which is listing stock with the foreign stock
exchange and also trading in the very nation where the company is incorporated4.
Derivative suit to help protect minority shareholders
The derivative action by the minority shareholder, dates back to Anglo-Saxon legal system,
where lawsuit is brought into action by the shareholder on company’s behalf, due to the damages
so borne by the actions of directors or any other people within the company or outside it 5. The
derivative suit challenges those damages and seeks judicial reparation5.
4 (French, 2007-2008)
5 (Puchniak, 2012)
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Current practice in USA and UK and other countries in regards to derivative suit
In the UK, the right to shareholders are not formulated by the legislations, so that they can be in
a position to decide on the company’ goals and objectives. But, the Shareholders Voting
Guidelines 19946 specifically provides, the information relating to important decisions of the
company must be passed on to the shareholders so that they can exercise their legal right when it
comes to voting. The companies Act also allows proxy voting to the shareholders and the
electronic form of appointing proxy by the shareholders are also granted by the legislation. These
concepts of proxy voting are a tool which can be used by Saudi Arabia for the protection of the
minority shareholders’ rights. The UK Companies Act 20067, also do not provide the definition
of share but, precedence as observed in Borland’s Trustee v Steel Brothers & Co Ltd 8 is used,
where share was defined as the liability and 2ndly the interests and also includes mutual
covenants
Company law specifically emphasizes on the fact that, if the directors’ handling results in abuse
or any kind of misconduct, they will be jointly or severely liable for compensating the company
as a whole or it shareholders, as the case may be. So, to bring an action for the liability against
the directors, the company itself or any shareholder on its behalf can lodge an action, subject to
the fact that the directors’ action of misconduct harmed all the shareholders and also the
company. Each and every shareholder can also bring a liability action against the director’ action
6 (Federal Register, 1994)
7 (UK Government, 2006)
8 (Borland's Trustee v Steel Brothers and Co. Ltd., 1901)
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or misconduct if such actions relates to specific damage for individual shareholders, but this
action can only have brought if the company still possess the right of litigation9.
The rights belonging to shareholders varies from country to country and is dependent solely on
some factors which includes political and economic structures of the company. It is important to
protect the rights of the shareholders, by the using the regulations or by the use of the judicial
process or by the maintenance of the corporate governance within the company itself, since this
practice of corporate governance ensure the foreign investments where the directors are under
obligation to consider the rights of the investors with other clients and employees and obviously
the minority shareholders10.
In the US, which is quite contrary to UK, the shareholders are allowed by legislation to annually
participate in discussion regarding company’ agenda if the shareholder holds a minimum of 1%
of the total number of shares. The listed companies in US have the option of cumulative voting
and is compulsory for some States, while it is only an option for the others11. Furthermore,
majority investors ought to not the slightest bit exploit their status to control or direct
authoritative choices to serve their interests, particularly when such choices are troublesome to
the premiums and rights of the minority investors as well as of the organization overall.
9 (Goo, 2008)
10 (N., 2013)
11 (Investors, n.d.)
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Practice of derivative suit under Saudi company law
New Companies Law failed to identify the Saudi ownership structure in stock exchange and has
also failed to protection to minority shareholders12. But, the law introduced new tools, for
protections for minority shareholders, but as a whole the law failed to provide protection to the
minority shareholders, since it basically failed to identify concentrated ownership, thereby
restricting minority shareholders to sue the management of the company on its behalf when the
serious disagreement heightens and in so doing the wrong doers who deserves prosecution is not
achieved and thereby prejudicing the justice being delivered.
The Company Law do not address the problem which arises with the costs when it is actually
connected with derivative actions. So, to determine the costs of the lawsuit and which party will
be responsible for the payment is ambiguous. The case of Smith v Croft 13is followed by the
Courts in Saudi Arabia when it comes to indemnity. But, it is also true that minority
shareholders will not lay their claim and will never risk when it comes to an uncertain outcome.
So, it is important to include wider approach when it comes to minority shareholders, since their
action can be a boon for the company in related ways.
The legal system in Saudi Arabia, gives the option to the shareholder in minority to place
against the majority shareholder, the complaint14. But, the complaint so made cannot be to the
Board of directors based on the fact of assumption about the future occurrence of any unethical
or illegal behavior which is likely to happen. So, it is clear that minority shareholder can only
complain after the occurrence and not in suspicion of it. The minority shareholder is also
12 (Ministry of Commerce and Industrial (MOCI) , 2016)
13 (Smith v Croft, 1986)
14 (Ansary, 2008)
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restricted to seek review after the completions of the actions which is on the contrary with the
majority shareholder15. When there is the situation which report for the abuse of power, then also
majority shareholder is in the forefront and they have the right to held the directors liable or
accountable for any misconduct on their part. In general circumstances, the Court often take the
side of the majority shareholder, so that they do not have to intervene in the internal affairs of the
company. Even the majority shareholders incorporate their own terms and conditions in the
shareholder agreement, subject to the fulfillment of conditions that the terms and conditions so
included is not in conflict with the company’s original vision. So, it is apparently obvious that
the legal system in Saudi Arabia do not actually take the side and in so doing do not provide
adequate protection in securing the rights and the interests of the minority shareholders14.
Again, the company law in Saudi Arabia, do not provide the definition of the word share, but the
Saudi Arabia Capital Market 16provides a definition for it and held share to be an investment
indicating ownership in the company.
15 (Naciri, 2008)
16 (Board of Capital Market Authority, 2006)
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