The capacity of a shareholder to sue for damage incurred by the company /security for costs when plaintiffs sue concurrently

The capacity of a shareholder to sue for damage incurred by the company /security for costs when plaintiffs sue concurrently

K & J Acquisitions Pty Ltd v Manauzzi [2009] NSWSC 279, Supreme Court of New South Wales, Kirby J, 17 April 2009

(a) Summary

This case was an interlocutory application by the defendants to dismiss the plaintiffs’ case for lack of a reasonable cause of action and to seek additional security for costs from the plaintiff. This decision was heard by Kirby J in the Supreme Court of New South Wales.

The background to this case was an action by the first plaintiff, K & J Acquisitions Pty Ltd (K&J), and its 45% shareholder and director, Kevin Carter (Carter), against K&J’s former auditors for breach of contract, negligence, misrepresentation and a breach of section 52 of the Trade Practices Act 1974 (Cth).

The key issue in this case was whether the plaintiffs had a reasonable cause of action. This required Kirby J to explore the ‘Prudential Principle’, from Prudential Assurance Co Ltd v Newman Industries Ltd (No 2).

This involved an assessment by Kirby J as to whether Carter had sufficient capacity to sue the defendants for damages due to a diminution of his share value, while relying on the same cause of action and facts as K&J. Kirby J also considered whether additional security for costs was required to be given in this case.

Kirby J found that, essentially, Carter had sufficient capacity to sue the defendants as Carter’s loss derived from damage incurred by him, independently of K&J, and as Carter pleaded his case in the alternative. In resolving the costs question, after citing several cases, Kirby J concluded that sufficient security for costs had already been provided by the plaintiff. Accordingly, Kirby J dismissed the defendants’ application as the defendants failed to make out their submissions.

(b) Facts

K&J ran a successful business building and installing office refurbishments. Its only two shareholders were Carter, who held a 44.5% shareholding and Colin Alexander (Alexander), who held a 55.5% shareholding. Carter and Alexander were the only two directors. Between 1998 and 2001, Alexander, using his position as manager of K&J’s finances and administration, made a number of unauthorised purchases of overseas securities and foreign currency exchanges.

Alexander’s actions cost K&J a total of $11,577,212.00. Carter only became aware of this by June 2001. After this point, K&J and Carter set about recouping this loss.

Of the total $11,577,212.00, the following funds were recovered:

  • $1,265,484.03, repaid by Alexander voluntarily;
  • $1,752,176.00, from Alexander through an earlier suit by K&J; and
  • $4,500,000.00 from Westpac, the company’s bank, through an action for failing to notice and stop the transactions.

K&J and Carter then brought an action against its auditors to recoup the remaining $4,059,557.97. The crux of K&J and Carter’s case was that the defendants failed to properly describe Alexander’s unauthorised activities in their reporting and to notify K&J and Carter.

The difference between K&J and Carter’s submissions was that, firstly, Carter did not sue the defendants for breach of contract and, secondly, Carter’s damages submission was that the defendants’ actions caused a loss to K&J, which then led to a reciprocal decrease in the value of Carter’s shares and dividends.

The defendants brought the action by an Amended Notice of Motion.

(c) Decision

The defendants made two submissions:

  • that Carter, a shareholder, did not have a reasonable cause of action, as member of a company cannot sue for loss or damage merely because that company suffered a loss; and
  • the plaintiffs had to provide additional security for costs, with individual amounts attributable to each plaintiff.

Kirby J rejected these submissions. Addressing the first submission, his Honour found that Carter had a reasonable cause of action as Carter’s action was within the limited capacity of a member of a company to sue for a diminution of share value known as the ‘Prudential Principle’. In resolving the defendants’ second submission, his Honour found, after a thorough analysis of the relevant principles that no further security for costs was required and that sufficient security for costs had already been provided.

(i) The Prudential Principle

The Prudential Principle is a doctrine accepted in Australian law that was established by the House of Lords in Prudential Assurance Co Ltd v Newman Industries Ltd (No 2). The principles set down in that case can be summarised as follows:

  • Where a company suffers loss caused by a breach of duty owed to it, only the company may sue in respect of that loss. The shareholder has no right to sue in his or her own capacity where the diminution of share value merely reflects the loss suffered by the company. This is the rule even when a company has declined or failed to make good on that loss.
  • If a shareholder suffers a loss due to a diminution of share value, the shareholder may sue if, firstly, the shareholder has a cause of action and, secondly, the company has no cause of action to sue to recover that loss.
  • A shareholder may sue where a company suffers a loss caused by breach of duty to it and the shareholder suffers a loss separate from that suffered by the company caused by a breach of duty independently owed to the shareholder. Neither the shareholder or the company, however, may sue to recover each other’s separate losses on behalf of the other.

Kirby J applied this principle to the case, finding that Carter came within the second and third limbs of the Prudential principle. Carter accepted that if the company were to succeed he would have no right to damages in respect of the same loss.  His claim was brought as an alternative to the company’s claim, should that claim fail and, according to the plaintiffs, the claim was made pursuant to an independent breach of duty to Carter (i.e. Carter’s submission was that the defendants, as K&J’s auditors, should have reported Alexander’s transactions to Carter).

Carter, a shareholder, was suing for loss due to a diminution of share value and was relying on the same cause of action as K&J. However, the claim arose independently and was pleaded in the alternative to be relied upon should the company’s claim fail. Therefore, the claim fell within the second limb of the Prudential principle according to Kirby J. Also, the plaintiffs claimed that an additional loss was suffered by Carter which was not shared by the company and which was claimed to have arisen from the defendants’ breach.  This claim was apparently pleaded late and was not made clear in the judgment.  Kirby J found, as a result of this, that Carter’s claim also fell within the third limb of the Prudential principle.

Accordingly, Kirby J concluded that Carter had a reasonable basis for a cause of action and the defendants’ strike-out application failed.

(ii) Costs

The defendants had already secured an undertaking for security for costs of $75,000 by bank guarantee, during prior litigation in 2008. In this application, the defendants sought an additional $75,000, estimating that their costs would total $150,000. By the time this action took place, K&J was no longer trading, had no significant assets and it was accepted that without support, K&J would be unable to pay all the costs of the defendants if ordered.

Kirby J reviewed the authorities regarding plaintiffs relying on interlocking arguments but did not reach any firm conclusion about these. His Honour did not form a clear view as to whether the cases of K&J and Carter were completely interlocked (in which case the possibility would be that Carter would be exposed to a costs order for the defendants’ costs).

He found that if Carter succeeded and the company failed, the defendants would only be entitled to the particular costs arising from the joinder of the company in the action, not the general costs. He found that the security lodged was more than adequate to cover that possibility.

He then found that, if both the company and Carter failed, the position is (if the litigation is considered to be completely interlocked) Carter would be exposed to an order for the defendants’ costs and security would not be appropriate.
His Honour concluded that the overlap between the two cases was substantial. In the case that both plaintiffs failed, it was likely that costs would be ordered against both and the defendant could look to either. If the costs order was to award a set proportion against the company, his Honour concluded that Carter would be able to make up the balance. He did not, therefore, award any further security for costs.

 

Co-authored by James Rankin.

Published by SAI Global on behalf of Centre for Corporate Law and Securities Regulation, Faculty of Law, the University of Melbourne with the support of the Australian Securities and Investments Commission, the Australian Securities Exchange and the leading law firms.