South Africa: Spin The "Harbottle"

Does the Cellular Calls case present new possibilities for aggrieved shareholders?

A decision of the Witwatersrand Local Division in an action brought by a certain Mr Kalinko against the directors of Cellular Calls (Pty) Ltd and a cellular telephone service provider has caused some consternation in company law circles, inasmuch as it seems to turn the well-known rule laid down in Foss v Harbottle on its head.

That rule has two essential principles:

1. Where a wrong is done to a company (including any wrong perpetrated by the directors of the company), it is the company itself that must assert its rights of recourse against the wrongdoers, and not individual shareholders. If the company fails to do so, then in certain circumstances an individual shareholder may assert those rights.
   
2. The conduct of the business of a company is based on the concept of rule by the majority - in other words the affairs of the company are decided by the wishes of the majority of shareholders. Accordingly, where the conduct is lawful and can be later ratified and made binding by a simple majority vote in general meeting of members, an individual member cannot maintain an action in respect of that conduct.

The effect of the rule is therefore that if a wrong is done to a company, it is the company itself that must act, and if the company fails to do so, then an individual shareholder in certain circumstances may institute an action on behalf of the company, but not where the conduct can be condoned or ratified by a simple majority of members.

With this in mind, we turn to consider a summary of the facts in the Cellular Calls case.

Mr Kalinko was a 51% shareholder in the company. In terms of the shareholders agreement, he was entitled to appoint, remove or replace one director on the board. He was employed as CEO of the company from inception of the company in December 1996 through to December 1998. The company had a retailer's agreement with a cellphone service provider in terms of which the company sold cellular telephones and related equipment to customers, who would use the network services provided by the service provider.

From December 1998, the defendant directors were responsible for the management of the company. Mr Kalinko contended that, at that time, the value of his 51% shareholding in the company was some R15 million.

Cellular Calls was liquidated in January 2000. Mr Kalinko proved a claim against the insolvent estate in respect of a loan of some R500 000.00 made to the company, but received no liquidation dividend inter alia by reason of prior subordination of members' loan accounts.

Mr Kalinko brought certain claims against the defendant directors and the service provider. The claim of relevance is the claim against the directors for the payment of damages in the amount of R15 million arising out of an alleged breach of their fiduciary duty to the shareholders of the company and the consequent dimunition in the value of Mr Kalinko's shares.

The wrongful conduct alleged was the failure by the directors to maintain the contract with the service provider on a proper footing (alternatively the failure to enter into a similar agreement with a new service provider once the first contract was cancelled), unlawfully raising an unauthorised claim in the books of the company in favour of the service provider for an amount of more than R12 million, the continued trading in insolvent circumstances for more than seven months prior to final liquidation, the failure to appoint "competent and able staff to manage and direct the day-to-day running of its affairs", the failure to take any or adequate stock levels for the same seven month period, operating without sufficient stock during that period, the failure to keep adequate financial records for the same period, and the failure to take any or adequate steps to ensure that a unilateral amendment of the retailer agreement by the service provider did not occur (by which the company was compelled to pay a subsidy on contract phones, thereby resulting in a liability of some R5 million to the service provider for stock on hand).

The court has not at this stage been called upon to determine the liability of the directors for the conduct complained of. What the court was required to consider was an exception raised by the directors to Mr Kalinko's claim, based on the Foss v Harbottle rule.

In summary, the directors contended that it is the company, not Mr Kalinko, that might have a claim against them (if such claim exists at all), and as such it was for the company to advance that claim. The loss allegedly suffered by Mr Kalinko "is at best merely a reflection of the loss suffered by Cellular Calls". The directors contended that they owed Mr Kalinko as shareholder no fiduciary duty and their conduct (even if proved to be unlawful) would accordingly not be unlawful vis a vis Mr Kalinko.

Counsel for the defendant directors apparently recognised the exception to the rule applied in English and American law, which allows an aggrieved minority shareholder to bring a "derivative action" against wrongdoers in control of the company, on the basis that such minority shareholders represent the company in obtaining redress, the company being otherwise unable to do so because it is controlled by the very people against whom it seeks relief. However, it was apparently argued that because Mr Kalinko was the majority shareholder, no right to a derivative action arose.

The court stated that the Foss v Harbottle rule is not absolute. Where no risk of double recovery exists and the shareholder has suffered damages through a dimunition in value to his shares, "the continued application of the rule …would amount to an unwarranted and technical obstruction to the course of justice". The court determined that whilst a shareholder may not have a direct proprietary interest in the business of a company, there is most certainly a financial interest in it.

It was argued for the directors that the exception should be upheld on the basis that the derivative action lies in the hands of a minority shareholder only, whereas the Plaintiff was a majority shareholder and was therefore in control of the company.

For the purposes of deciding the exception, the court referred to "control" as defined in the shareholders' agreement, and found there on the facts that Mr Kalinko was in a minority situation at director's level, at which level he would not have been able to control the company in his capacity as majority shareholder. The court held that the argument that Mr Kalinko could have controlled the board through the exercise of his majority rights in a Section 220 removal of directors and re-composition of the board could not prevail in the face of the subsequent liquidation of the company. The exercise of such rights would have lapsed, and it would be futile at exception stage to deny a plaintiff rights of action simply because he failed to act previously in a different manner. The court recognised that such failure might affect the quantum of his loss, but held that, at exception stage, the question was not relevant.

It is reported in the financial press that the Defendant directors will be appealing against this judgement. If that is so, then it seems that a higher court may have the last word. In the meanwhile, the position remains that, having regard to the particular facts, a court has not been prepared to allow an "unwarranted" and "technical" mechanism such as the rule in Foss v Harbottle obstruct an aggrieved shareholder from seeking damages against directors for alleged breach of their fiduciary duties traditionally owed to the company.

Mr Kalinko is not out of the woods yet. He may yet face a "double jeopardy" problem if the liquidator decides to institute a claim against the directors. It also remains for him to prove the alleged unlawful conduct on the part of the directors and the extent of his loss. The importance of this judgment is that, despite his majority shareholding in the company, Mr Kalinko has been given the opportunity to do so. The judgement must give all directors and their insurers pause for thought.