The Legal Costs Principle: When you cannot use company money in litigation

Posted on: August 5th, 2021

It is a well-established principle that a company’s money should not be spent on disputes between shareholders – this is the ‘legal costs principle’. This principle is triggered if the dispute is between shareholders and does not involve the company itself. Breaching this principle goes against established company law as has been reaffirmed by the courts in a recent case.    

In the case of Koza Ltd and Hamdi Ipek -v- Koza Altin Isletmeleri AS (Koza), the court awarded an injunction restraining Koza’s sole director, from using Koza Ltd money to use its funds to pay legal costs in the case which was a shareholder dispute.

The decision upholds the ‘legal costs principle’ in company disputes, that company funds should not be spent on disputes between shareholders. Koza does not establish new law, but it does reaffirm some important aspects of company law, which all directors should be aware of and which we have covered below.

A company is a separate legal entity to that of its shareholders

The reason for this distinction is that a company has a separate legal identity to that of its shareholders. Applying this principle, Koza highlights that a shareholder cannot simply treat a company as its own and use that company’s resources to fund its own litigation. The courts are often likely to take punitive steps to prevent this.

As a company cannot make decisions on its own on how to use these finances and resources, its decisions are made by directors.

Acting in the company’s best interest

Directors have a duty under the Companies Act to act in the best interest of the company. Koza acts as a stark warning for directors to exercise caution when deciding if the company should use its resources for litigation. If they decide to use the company to fund the litigation and this does not benefit the company, causing the company to pay for it is likely to amount to a breach of the director’s duty. It does not matter if the director is also a shareholder.

Before taking a decision to fund litigation, a company’s directors should ensure they understand what interest the company has in the litigation and how a successful outcome would benefit the company, not themselves. If the directors choose to proceed, there will always be a heavy onus on the company to show the necessity of doing so.

The decision in the case of Koza is a timely reminder, it upholds the well-recognised principle that a party to a shareholder dispute should not use, or be permitted to use, the company’s funds to finance their own legal costs. The foundation of this principle comes from well establish company law. Furthermore, if ultimately the company ends up paying the costs of one party of a shareholder dispute, this effectively causes the other party to incur their costs.

Ian Dawes, Head of Litigation at Coffin Mew comments, “As Companies emerge from the pandemic we are seeing an increasing number of shareholder disputes and we expect this to continue. It is important that shareholders understand that they cannot use company money to fund these disputes. If they do, they could be in breach of their duties to the company and could, in some cases, face significant personal financial penalties.”

If you need any assistance or advice with a potential or ongoing shareholder dispute, please do not hesitate to contact us.