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This article is written by Nishtha Garhwal, from Alliance School of Law, Bangalore. The article talks about whether the derivative claims can be arbitrated and many cases are being referred in order to understand the stand of the Court in this matter.

Introduction

In case of a breach of duty by a director, the company’s interests and benefits are harmed. In such a scenario, a derivative claim comes into the picture that allows a shareholder to bring an action on the company’s behalf as the director owes duties to the company. 

The claims whose nature is such that the shareholder gets the Right to Sue on behalf of the company not for protecting his personal or individual interests but the interests of the company are said to be derivative claims. In India, there exists no statutory provision that covers the derivative claims by shareholders. However, under the Companies Act, 2013, a chapter on the Prevention of Oppression and Mismanagement is some sort of provision that is available in this context. 

In the case of Rakesh Malhotra v. Rajinder Malhotra (2014), the Court took a stance against the arbitrability of oppression and mismanagement. A similar stance was taken by the Court in the case of Sporting Pastime India Ltd. v. Kasturi and Sons Ltd (2006) also. However, the stance of Courts remains unclear as far as the derivative action suits are concerned.

In the Indian context, at the outset, the oppression, mismanagement as well as class action claims are considered to vary from the typical derivative action suits. This is primarily because of two reasons. Firstly, the personal rights of the shareholders and not the corporate or economic rights are implicated by the derivative suits. And, secondly, because of this, in the lawsuits relating to oppression, mismanagement, and class actions, the applications on behalf of members are filed by the shareholder. However, this application is filed to seek personal reliefs in order to protect themselves whereas, in the case of derivative claims, the action remedies are sought on behalf of the company. Thus, if we consider the above point, the reasoning that is given in order to provide justification for the non-arbitrability of matters relating to oppression and mismanagement cannot always be applied to suits relating to a derivative action.

In the case of Rashmi Mehra v. Eac Trading Ltd. (2006), for the first time, it was held by the Bombay High Court that derivative action claims are arbitrable. In addition to this, the Court also said that this is what distinguishes the derivative claims from that of cases relating to oppression and mismanagement. 

Review of judgments

In the case of Onyx Musicabsolute.Com Pvt. Ltd. v. Yash Raj Films Pvt. Ltd. & Ors. (2008), the judgment that was delivered by the Bombay High Court changed the status quo. The Court dealt with an application relating to the Companies Act, 2013 in this case and the application was in the nature of derivative action. 

Section 9 of the Arbitration and Conciliation Act,1996 talks about interim relief measures that a court can grant before or during the process of arbitration, or at any time after the making of any arbitral award but before its enforcement. 

In the case of Onyx Musicabsolute.Com Pvt. Ltd. v. Yash Raj Films Pvt. Ltd. & Ors. (2008), the second defendant was formed as a joint venture by the plaintiff and defendant number 1. Both of them held 50% of the shares. After some time, a licensing agreement was entered into by the first and second defendants. Under the terms of the agreement, the mobile rights of the film that was produced by the first defendant would be licensed by the second defendant. Later, the first defendant licensed certain films to a third party in place of the second defendant. Consequently, due to the breach of the terms of the contract by the first defendant, disputes arose between the parties to the contract. 

Consequently, the proceedings of arbitration were initiated. While the proceedings were pending, the plaintiff requested an injunction under Section 9 in order to put a bar on the first defendant so that rights are not licensed to the third party. The Court gave two reasons to not enjoin the first defendant under Section 9. First, the licensing agreement was not between the first defendant and plaintiff, rather it was between the first and second defendant. This entitled the plaintiff from invoking the said clause. Second, the petition under Section 9 was in a derivative action form and thus, a private mode of dispute resolution is better suited than a public forum, for instance, arbitration. However, one interesting fact, in this case, is that the Court did not refer to the earlier judgment delivered by the same court on a similar matter in the case of Rashmi Mehra v. Eac Trading Ltd. (2000).

In the case of Rajiv Vyas v. Johnwin Manavalan Groge Mandavalan and Ors. (2010) and Welspun Enterprises Ltd. v. ARSS Infrastructure Projects Ltd. (2015), the Onyx case was distinguished. In the Rajiv Vyas case, the respondents entered into a shareholder’s agreement with the plaintiff in order to form an entity for their business. Approximately 33.3% of the shares were held by the petitioner. 

Arbitration proceedings were initiated by the petitioner when the respondent made an attempt to alienate certain of the company’s rights. Subsequently, in order to restrain the actions of the respondent against the company’s interests, the petitioner filed an application under Section 9 of the Act. Finally, the Court allowed the Section 9 application due to the fact that an arbitration clause was present in the shareholder’s agreement, and not just the company but also the petitioner was affected by the respondent’s conduct.

While giving the judgment for the Welspun Case, the Court referred to the Rajiv Vyas Case and not the Onyx Case, and thus, despite the fact that the petitioner requested partly to protect the personal rights of the shareholders and partly to protect the rights of the company, the Court allowed the application under Section 9. The justification that the Court gave was that in case, the shareholders enter into a shareholder’s agreement and if one shareholder commits any breach of the contract, the other shareholder who seeks to protect his personal, as well as the company’s rights, would be entitled to go for arbitration. However, the only condition here is that an arbitration clause must be contained in the shareholder’s agreement.

What could make a derivative claim arbitrable

There exist some elements that could lead to the arbitrability of a derivative claim. However, those elements come with certain challenges. An agreement to arbitrate must be entered in between the shareholders, or the shareholders and the third party against whom the claims of relief are made on the company’s behalf. The case of Onyx made it a sort of rigid rule in order to make derivative claims arbitrable, however, this does not seem to be that rigid a rule. If we consider the case of Rashmi Mehra, no arbitration clause was contained in the contract. 

arbitration

There existed some interconnected contracts and only one among them provided for an arbitration agreement. However, it was held by the Court that the backbone of the entire transaction is the arbitration clause that is contained in the contract, and under an ancillary agreement, arbitration could be initiated by a shareholder thereby bringing the derivative action claims before the tribunal.

It must be noted here that a similar kind of argument could be made in the Onyx case. As it is evident that the plaintiff was not a party to the licensing agreement between the first and second defendants. But it was mentioned under the licensing agreement that its validity would continue to exist till the joint venture agreement between the plaintiff, second and first defendants remained in full force as well as effect. 

The interconnectedness test that was laid in the Rashmi Mehra case if applied to the Onyx case, then through the joint venture agreement, even though the plaintiff who was not actually a party to the licensing agreement could have been held entitled to arbitrate on behalf of the company because the validity of the licensing agreement was completely dependent on the validity of the joint venture agreement. Thus, the joint venture agreement formed the backbone of the entire transaction.

The nature of a derivative claim is such that a shareholder acts on behalf of the company in order to secure its interests. Now, due to the fact that the derivative claim is brought on the company’s behalf, it binds the shareholder to the interests of the company to arbitrate. 

Perspective of United States of America on derivative claims 

In the United States of America, this principle was relied upon in the case of In re: Salmon Inc. Shareholders’ Derivative Litigation (1995) so as to allow the arbitrability of the derivative claims. The Court gave the reasoning for the same that in a derivative claim, the actual plaintiff is the company, and therefore, if there exists a pre-dispute arbitration agreement between the company and a third party, it would be inevitably binding the shareholders also to the arbitration. 

As per the Onyx case, the Court has the power of refusing to refer the dispute to the tribunal even if an arbitration clause exists in the agreement by stating that it is better suited to get adjugated by the public forum, by implying that if it goes for arbitration, it would affect the public policy. It is seen as a regressive rationale keeping in mind that it had been already established in America that a close and private company’s shareholders can also arbitrate derivative claims.

This contention that the arbitrability of derivative claims would affect the public policy was dismissed by a Court in New York in the case of Lane v. Abel-Bey (1980)The Court asserted that this should not be a case in a privately owned and closed corporation. This is a similar situation to that of the Onyx case as even there the plaintiff approached the Court on behalf of a privately owned and closed company. Thus, if a Court holds that derivative claims are not arbitrable on the pretext that it affects public policy, it would go against the consent of the parties to the contract. 

The judgment delivered by the Court in the Rajiv Vyas case, as well as the Welspun case, seems to be problematic. In both cases, it was held that the rights of the shareholder and the company are affected by the applications that were made under Section 9. The derivative claim was considered by the Court only in part and this was ample to allow its arbitration.

If we consider the Rajiv Vyas case as well as the Onyx case, in both cases an injunction was sought by the shareholder. In the Rajiv Vyas case, the Court distinguished itself from the Onyx case and held that if an injunction is not granted, it would cause irreparable injury to the company’s interests as well as the plaintiff’s interests as a shareholder. Thus, it is evident that in both cases, despite the fact that similar reliefs were claimed, however, two different conclusions were reached by the Court. 

The approach that was taken by the Court in the Rajiv Vyas case that the claimed reliefs were partly personal and partly derivative which makes them arbitrable, stood against the stand of the Court in the case of Sukanya Holdings Pvt. Ltd. v. Jayesh H. Pandya (2003). In this case, the Court said that the bifurcation of a cause of action cannot take place while the dispute is being referred to arbitration. In case, the Rajiv Vyas case is considered to be an exception to the Sukanya Holdings case, then even if there is a fully derivative claim, there exists no reason for the Court to not permit arbitration. There is no proper criterion to determine which of the reliefs claimed in the company’s name are derivative and which of them are personal. Thus, whenever the question of arbitrability of derivation claims arises before the judiciary, it must derive a test to determine this. 

Conclusion

Although the judgment that was delivered by the Court in the Onyx case seems to be flawed and problematic, it had been referred to by the courts in order to refuse arbitration of derivative claims. The courts in India have begun to adopt a general policy when it comes to arbitration and particularly, in favour of it. Thus, there exist no reasons for refusing the arbitrability of the derivative claims. 

The derivative claims rely completely on judicial determinations as there exists no provision for the same under the Companies Act, 2013. Thus, at different times, the courts have used different approaches and interpretations to determine the arbitrability of the derivative claims. However, now it’s high time that a uniform approach is adopted by the Indian judiciary as far as the arbitrability of the derivative claims is concerned that is also consistent with the international standards.

References


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