When a director of a corporation acts in bad faith, the law provides some avenues for relief for other directors. One option available to other directors of the corporation is to commence a derivative action. The Ontario Superior Court of Justice recently decided the case of Luo v 9477322 Canada Inc, in which one corporate director was successfully granted leave to commence a derivative action.
What is a derivative action?
A derivative action is a claim brought by a shareholder on behalf of a company, rather than by the company itself. It is meant to protect the interests of the company’s shareholders by preventing harmful activities from going unchecked.
A derivative action may be commenced when there are reasonable grounds to believe that the corporation has been harmed, or that its business has been adversely affected by improper acts or omissions of directors, officers, or employees. For example, suppose a shareholder suspects that the directors of a corporation are committing fraud, and that shareholder wishes to commence a lawsuit without separately suing the individuals. In that case, they could instead file a complaint as a representative of the company’s shareholders and ask for compensation from the company itself.
In order for a shareholder to receive permission to bring a derivative action before the court, there must be evidence to show that the potential applicant is acting in good faith with the interests of the corporation in mind.
Two Directors went behind another’s back for their own profit
In Luo v. 9477322 Canada Inc., there were three directors in the numbered company hereinafter referred to as 947. In 2017, two of the directors, Luo and Weng, incorporated another numbered company, 258, for the purpose of purchasing a property for a project in Oakville. 258 entered into an Agreement of Purchase and Sale in June 2017, and in July 2017, the directors advanced a $500,000 loan from 947 to pay 258’s purchase deposit. By November 2017, the property transaction fell through.
Weng and Li, two directors of 947 negotiated, without Luo, to arrange for the return of the majority of the deposit funds to 258. In lieu of returning the funds to 947, Weng and Li added themselves as directors of 258 and distributed the returned funds between themselves and other partners of 947. They did not share any of these funds, which they described as “profits,” with Luo.
In December 2019, Luo started a derivative action against 258, along with others who had been excluded and counsel of 947. In January 2020, Weng and Li, as majority directors of 947, passed a resolution that Luo had commenced the action without the corporation’s authority. Weng and Li directed counsel for 947 to discontinue the action.
The majority of Directors were not acting in good faith
Weng and Li submitted to the court that Luo had not been acting in good faith, or in the interests of 947, in bringing this action. The Court found that it was in fact Weng and Li who were not acting in good faith or in the interests of 947. The Court explained its reasoning as follows:
“I find that, by diverting the funds away from 947, and by adding themselves as Directors to 258, and thereby deliberately excluding Luo from involvement in the distributions of the returned funds, Weng and Li preferred their own interests to those of 947. They did not act in the interests of 947, nor in good faith with respect to their obligations as Directors to act in the best interests of 947.”
There was a conflict between Weng and Li’s obligations as directors of 947, their personal interests and those of 258. The only director who could bring a derivative action, therefore, was Luo.
Court permitted derivative action
Ultimately, the Court found that there was a prima facie case against Weng and Li for torts including “breach of trust, breach of fiduciary duty, fraud, oppression, conversion, theft, misappropriation of funds, and deceit.” Additionally, Weng and Li had tried to block Luo from continuing the action against them. For these reasons, the Court determined that Luo was acting in good faith by attempting to advance the derivative claim on behalf of 947.
Furthermore, the Court determined that the derivative action was also in the interest of 947, therefore Luo was granted leave to continue with the action.
Court limits potential applicants to the derivative action
Weng and Li’s counsel argued that the other applicants did not require leave due to Luo having already obtained leave for the derivative relief under the Canada Business Corporations Act. The Court agreed that it was “neither necessary nor proportionate to grant leave to Applicants other than Luo to prosecute the derivative action.”
Luo asked the Court to order Weng and Li to transfer the returned funds from 258 back to 947, however Weng and Li claimed that the limitation period had already passed. The Court left this issue to be decided in the derivative action.
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