Derivative Action in Australia, when a Shareholder Can Sue on the Company's Behalf

When a company has a solid legal claim, the decision to sue normally belongs to the board. The directors weigh the costs, the risks and the disruption, and their judgment usually stands. But what happens when the claim is against one of the directors themselves, or when the people in control simply will not act? The company's rights can sit unenforced while everyone waits for someone else to move.

That gap is what the statutory derivative action is designed to fill. It is a mechanism in Part 2F.1A of the Corporations Act 2001 (Cth) (the Act) that lets a shareholder or eligible officer ask a court for leave to bring proceedings in the company's name, or take over proceedings the company has let drift. If leave is granted, the company becomes the plaintiff and any remedy belongs to the company, not the applicant. This article explains how the scheme actually operates: who the players are, what triggers it, what the court must be satisfied of, and where it tends to go wrong for small and medium businesses.

Who Does What in a Derivative Action

Four actors matter, and each has a distinct role:

The company: the nominal plaintiff. The claim and any recovery belong to it, and under s 236(2) of the Act proceedings brought on its behalf must be brought in its name.
The applicant: a member, former member or person entitled to be registered as a member of the company or a related body corporate, or an officer or former officer of the company. These are the only people who can apply under s 236(1). They supply the energy and, in practice, much of the funding.
The board: the usual decision-maker on whether the company litigates. The application exists because the board either will not pursue the claim, is conflicted about it, or has let it lapse.
The court: the gatekeeper. It decides whether leave is granted, and once it is, it keeps supervising the case rather than stepping away.

The underlying tension is easy to see. The applicant wants the company's rights enforced. The board, or the majority behind it, may have good reasons or bad reasons for not suing. The court's job is to decide whose view prevails, but it does so by applying the statutory tests in s 237, not by deferring to either side.

The Trigger: A Company That Will Not Sue

A derivative action is not a general licence for shareholders to litigate on the company's behalf whenever they disagree with a decision. It only engages when the company has a cause of action and it is probable that the company will not itself bring the proceedings, or properly take responsibility for them. That is the first limb of s 237(2)(a), and it is the reason the regime exists.

The situations where it typically arises in private companies include:

alleged breaches of directors' duties under ss 180 to 183 of the Act, covering care and diligence, good faith and proper purpose, and the proper use of position and information;
related-party transactions at an undervalue, or entered into without proper approval;
misappropriation of company assets or opportunities by insiders; and
board inertia, where the directors who should be suing are the ones who would be sued.

Two structural points are worth noting. First, the old general law derivative action is gone: s 236(3) of the Act abolishes the right of a person at general law to bring or intervene in proceedings on behalf of a company. The statutory regime in Part 2F.1A is now the only route. Second, the regime applies to companies registered under the Act. Incorporated associations and other structures have their own rules, so the Part 2F.1A pathway will not be available to them in the same form.

Who Can Apply, and the Notice That Must Come First

Eligibility is set out in s 236(1). An application for leave can be made by a member, a former member, or a person entitled to be registered as a member of the company or a related body corporate, or by an officer or former officer of the company. That covers minority shareholders in a family company, a former director who has been pushed out, and current directors who are outvoted, among others. The applicant must also be acting with leave granted under s 237, which is what the application seeks.

Before the application can succeed, the applicant must usually give the company written notice. Under s 237(2)(e)(i), the notice must be given at least 14 days before the application is made, and it must state the intention to apply for leave and the reasons for applying. The court can dispense with the requirement under s 237(2)(e)(ii) where it is appropriate to grant leave even though notice was not given, but dispensation is a matter for the court, not a fallback the applicant can simply rely on.

The notice step is not a formality. It must happen before the application is filed, because the section is drafted that way, and courts treat the timing as a genuine precondition. The letter also does practical work: it gives the board a final chance to act on the claim, it gives the company an opportunity to take its own advice, and it demonstrates that the applicant is approaching the matter in an orderly way. All of that feeds into the tests below.

The Tests the Court Must Be Satisfied Of

The centrepiece of the regime is s 237(2). The court must grant the application if it is satisfied of five things:

That the company is unlikely to act: it is probable that the company will not itself bring the proceedings, or properly take responsibility for them or for the steps in them.
That the applicant is acting in good faith: the applicant genuinely seeks to advance the company's interests rather than a personal agenda. This is assessed subjectively. In Swansson v Pratt [2002] NSWSC 583, the court refused leave where the applicant's real grievance was a property dispute arising from her divorce, and the claim against a director risked double recovery of assets already dealt with in the family settlement.
That leave is in the company's best interests: an objective assessment of whether the likely benefit of the proceedings outweighs their cost, risk and distraction to the business.
That there is a serious question to be tried: where the application is for leave to bring proceedings, the underlying claim must be arguable and supported by evidence, not a bare allegation.
That the notice requirement is satisfied, or dispensed with: the 14-day written notice discussed above, or a court order dispensing with it.

There is also a rebuttable presumption that cuts against applicants. Under s 237(3), if the proposed proceedings are by or against the company in relation to a third party, and the company has decided not to bring, not to defend, or to discontinue, settle or compromise the proceedings, then a presumption arises that granting leave is not in the company's best interests. The presumption only applies where every director who participated in that decision acted in good faith for a proper purpose, had no material personal interest in the decision, informed themselves about the subject matter, and rationally believed the decision was in the company's best interests. Those elements mirror the statutory business judgment rule in s 180(2) of the Act. The practical effect is that an independent, informed board decision not to sue a third party is a serious obstacle, and the applicant carries the burden of rebutting the presumption.

If Leave Is Granted: The Company's Case, Under Court Supervision

Once leave is granted, the proceedings are conducted in the company's name, and any remedy belongs to the company. The applicant prosecutes the claim on the company's behalf, but never owns it. The court keeps a supervisory hand in, in several ways:

No settlement without leave: under s 240, proceedings brought with leave cannot be discontinued, compromised or settled without the court's further leave. The applicant cannot quietly trade away the company's claim.
Ongoing directions: under s 241, the court can make any orders or give any directions it considers appropriate, including interim orders, requiring mediation, directing the company or an officer to do or not do an act, and appointing an independent person to investigate and report on the company's financial affairs, the facts giving rise to the cause of action, or the costs incurred.
Ratification is weighed, not decisive: under s 239, if the members ratify or approve the impugned conduct, that does not prevent the application or force its refusal. But the court can take the ratification into account when deciding what orders to make, having regard to how well informed the members were and whether they were acting for proper purposes.
Costs flexibility: under s 242, the court may at any time make any orders it considers appropriate about the costs of the applicant, the company and any other party, and an order may require indemnification for costs.

Costs: Who Pays When It Goes Wrong

The costs position is the part of the scheme that surprises applicants most. Under s 242 the court has a broad discretion to make costs orders in relation to both the leave application and the proceedings, including ordering the company to indemnify the applicant. But that is a discretionary outcome, not an entitlement.

The default position is that costs follow the event. An unsuccessful leave application can leave the applicant paying not only their own lawyers but the company's costs and the costs of any respondents. In Swansson v Pratt itself, the applicant's request for a costs order under s 242 failed along with the application. For a small company, that exposure is real money, and it is worth budgeting for before the application is filed.

Practical steps that improve the position include keeping the evidence targeted and contemporaneous, running the claim at a scale proportionate to the business, and being able to show the court that the case will be managed efficiently if leave is granted. A dispute worth $50,000 in a micro-company should not be run like a million-dollar case, and courts notice when it is.

Where Derivative Actions Go Wrong: Common Pitfalls

Several patterns recur when derivative actions fail, and they are worth knowing before you commit:

The notice trap: filing the application before the 14-day notice has run, or giving notice after filing, and expecting the court to overlook it. The statutory precondition is not satisfied, and dispensation is discretionary. The notice letter should go out, with reasons, at least 14 days before anything is filed.
A personal agenda showing through: good faith is a subjective test, but the court forms its view from the applicant's conduct, communications and history. The applicant in Swansson v Pratt was undone by the fact that her real dispute was personal. Measured, company-focused correspondence avoids giving the court that impression.
Underestimating a considered board decision: where the claim is against a third party and the directors made an informed, disinterested decision not to pursue it, the s 237(3) presumption applies. The applicant must then show why that decision should be overridden, which is a heavy burden.
Majority ratification: a well-informed vote of members approving the impugned conduct will be weighed against the application under s 239, even though it does not automatically defeat it.
Liquidators and insolvency: in Chahwan v Euphoric Pty Ltd [2008] NSWCA 52, a shareholder sought leave to sue in the name of a company in liquidation after the liquidator declined to be involved, and leave was refused at first instance with the appeal dismissed. A liquidator's decision not to pursue a claim is a significant factor, and the court applies the same tests rather than treating leave as automatic.
Cost exposure in small companies: the applicant typically funds the application and the case. If the application fails, the costs order can be worse than the dispute was worth.

Alternatives Worth Trying First

A derivative action is powerful but heavy. Before applying, it is worth mapping the alternatives, both because they may resolve the problem faster and because trying them first strengthens the good faith and best interests limbs of any later application:

The oppression remedy: Part 2F.1 of the Act gives a member a personal remedy where the company's affairs are being conducted in a way that is oppressive or unfairly prejudicial to their interests. Orders can include requiring the company or another member to buy out the applicant's shares. The key difference from a derivative action is that the remedy is for the member personally, not for the company.
Information and inspection rights: members have rights to inspect company books under s 247A of the Act, subject to the court's leave where the member is not a director. Those rights can clarify the facts before any litigation decision is made.
Internal governance: a properly constituted board or members' meeting, with conflicts managed and independent advice taken, can produce a genuine decision about the claim, including a decision to sue that makes a derivative action unnecessary.
Negotiated outcomes: repayment, return of assets, a change in conduct, or a structured buy-out of a shareholder under the company's constitution or a shareholders agreement can close the matter without court involvement.

Where a Lawyer Comes In

The derivative action scheme is procedural, and the procedure has teeth. A lawyer's role runs from before the notice letter to after judgment:

assessing whether the company has a viable claim and whether the statutory tests can be met;
drafting the notice letter so that it satisfies s 237(2)(e)(i) and reads as a genuine demand in the company's interests;
preparing the leave application, including the affidavit, draft pleadings and written submissions addressing each limb of s 237(2);
advising on costs strategy, including whether and when to seek an indemnity order under s 242;
managing the court's supervision after leave is granted, including any application to settle under s 240.

The point to engage a lawyer is before the 14-day notice goes out, not after the application has been filed. The decisions that determine the outcome of a leave application, the wording of the notice and the framing of the evidence, are all made in the weeks before filing.

The Preconditions Are Unforgiving: Get Advice Early

If there is one misstep that costs applicants most, it is treating the leave application as a formality. The court must be affirmatively satisfied of every limb of s 237(2), the 14-day notice deadline is fixed by the statute, and a whiff of personal motive can sink the good faith limb no matter how strong the underlying claim looks. The cases that fail, like Swansson v Pratt, usually fail on the applicant's own conduct before the application is ever filed.

The practical takeaway is to have the groundwork checked early. A preliminary review of the claim, the evidence and the notice requirements is a modest cost compared with a refused application, an adverse costs order and a dispute that has become personal. If the tests can be met, a derivative action can recover real value for the company. If they cannot, that early advice saves the company from paying for litigation it should never have started.