Supreme Court confirms that company directors' powers must be exercised for a proper purpose

In an important decision which will impact upon corporate disputes, the Supreme Court has confirmed that the exercise of an apparently unfettered discretionary power given to directors under the articles of association of a company must only be exercised for a proper purpose: Eclairs Group Limited v JKX Oil & Gas Plc [2015] UKSC 71.

The decision is likely to be particularly relevant to battles for control of a company in circumstances where the directors may have allegiance to a particular shareholder group. In this context, the exercise of a discretionary power by directors is more commonly attacked on the basis that it does not best promote the success of the company (often a matter of subjective belief as to the business interests of the company). However, the present decision affirms the availability of another line of attack, based on the proper purpose of the power.

Gary Milner-Moore and Andrew Cooke, a partner and associate respectively in our dispute resolution team, consider the judgment below, and look at what this may mean for future battles for control.

Background

Eclairs Group Limited and Glengary Overseas Limited (together, the "Disenfranchised Shareholders") are shareholders in JKX Oil & Gas Plc, an English company listed on the London Stock Exchange.

JKX's articles of association, in common with the articles of many other listed companies, contains provisions broadly parallel to those which are contained in sections 791 to 828 of the Companies Act 2006. Under the Act, a public company is entitled to give notice to any person whom the company knows or has reasonable cause to believe to be interested in the shares of that company (or have been so interested within the previous three years). The company's notice may require the person to confirm that they are interested in the shares and to provide such other information as may reasonably be required within a reasonable time period.

It is an offence for the person not to provide the information requested by a notice within the time specified. In these circumstances, the company may also apply to the court for an order for restrictions on the person's shares, including that: (i) transfers of the shares are void; (ii) no voting rights are exercisable in respect of those shares. It is a further offence to attempt to evade the restrictions. The court has further powers, including to order the sale of the shares. A company must issue a notice if shareholders holding at least 10% of the shares in the company so require.

In the case of JKX, the articles went further than the Act, again as is common for listed companies. In particular, the articles provided that where a notice was issued to a person and that person failed to comply with the notice, or the response was known, or reasonably believed, to be false or materially incorrect, the directors could impose restrictions on the shares without the intervention of the court.

The Disenfranchised Shareholders

In early 2013, JKX was the subject of what Lord Sumption called an "alleged 'corporate raid'" by the Disenfranchised Shareholders, who together held 39% of its shares. JKX's directors therefore served notices seeking disclosure of information on the Disenfranchised Shareholders and persons connected with them.

Responses were provided by the recipients of the notices. The directors considered that they had reasonable grounds to believe that the responses were materially incorrect. Under JKX's articles, the directors therefore imposed restrictions preventing the transfer and voting of the Disenfranchised Shareholders' shares. The imposition of restrictions was announced on 3 June 2013, two days before the AGM, so that the Disenfranchised Shareholders were prevented from voting at the AGM.

Had the Disenfranchised Shareholders been permitted to vote at the AGM, their evidence was that, in addition to voting against the re-election of certain directors, they would have voted against certain proposed special resolutions, permitting the company to raise capital by the issue and allotment of shares. Because the Disenfranchised Shareholders between them held over 25% of the company, that would have been sufficient to block the special resolutions. With the Disenfranchised Shareholders' votes, the resolutions would have failed but without them, the resolutions were passed. The final results of the AGM, and the subsequent general meetings during the appeal process, were suspended pending the outcome of the case.

High Court and Court of Appeal

The Disenfranchised Shareholders challenged the restrictions that had been imposed on their shares. They did not suggest that the directors had acted other than in good faith and in accordance with what they believed to be the best interests of JKX. They also did not suggest that the power had been exceeded. Rather, the Disenfranchised Shareholders contended that in imposing the restrictions the directors had gone beyond the purpose for which the power in the articles was provided. In essence, the Disenfranchised Shareholders contended that the directors had abused their power; traditionally, in equity, a 'fraud on a power'.

In the High Court, Mann J held that the predominant purpose of the directors was to prevent the shares being voted at the AGM so as to seek to ensure that the resolutions would be passed. That was not a proper purpose of the power in the articles; that power was, Mann J held, conferred on the directors to seek to ensure that proper information was provided in response to notices. He therefore set aside the restrictions.

A majority of the Court of Appeal overturned Mann J's order. It held that the power in the articles was not subject to any material express or implied limitation as to the purposes for which it could be exercised. The Court of Appeal therefore held that the restrictions could be imposed by the directors for any purpose, including that which Mann J had identified as the predominant purpose. They did so for three main reasons. First, the directors did not unilaterally impose restrictions; they could only do so where persons failed to comply with a notice. Second, the very thing that the articles contemplated was restrictions for non-compliance, so that once the notices had not been complied with there was no further hurdle to overcome before restrictions could be imposed. Third, there was no express limitation on the power whether under the Act or in JKX's articles. The majority said that any other result would encourage deceitful attempts to gain control of a company.

Supreme Court

The Supreme Court unanimously allowed the Disenfranchised Shareholders' appeal, restoring the order of Mann J and holding that the exercise of the power in JKX's articles was subject to the proper purpose test in section 171(b) of the Act. If the only purpose which actually affected the directors' decision was an improper one, Lord Sumption stated that it was difficult to envisage any basis on which the decision could be sustained.

That said, the Supreme Court did not agree with all of Mann J's reasoning. The Supreme Court held that the purpose of the power in the articles was broader than that identified by Mann J. The power could be used to induce compliance with a notice but could also be used to coerce the recipient of the notice to provide the required information, protect the company (and other shareholders) from making decisions without the benefit of the required information and provide a sanction for non-compliance.

However, the Supreme Court did not consider that the directors had acted for any of those purposes. Rather, the Supreme Court held that the directors had acted for the purposes of influencing the outcome of the AGM. As might be expected, the separation of powers within a company between the directors and the shareholders requires the directors not to interfere in the exercise of the shareholders' constitutional right to vote. That principle has been established in the cases since at least the 1860s – as Lord Sumption said, "to prevent the use of the board's powers to control or influence a decision which the company's constitution assigns to the general body of shareholders." Lord Sumption noted that the purpose of a power is rarely expressed in the articles of a company but that the court had nevertheless applied the proper purpose test in previous cases. Application of that rule was further supported by the nature of the directors' power, a serious interference with shareholders' property rights. This was not a question of interpreting the articles so as to find an implied limitation on the exercise of the power; rather, that limitation applies to the exercise by directors of any power they have been given in that capacity as a result of section 171(b).

The Supreme Court then considered the appropriate remedy, though that point had not been the subject of full argument before the court. The issue was whether the restrictions imposed by the directors should be set aside if the evidence was nevertheless clear that, had they acted for a proper purpose, they would still have imposed the same restrictions. The majority of the Supreme Court (Lords Mance, Clarke and Neuberger) held that this issue did not arise so expressed caution at indicating any firm views. The minority of the Supreme Court (Lords Sumption and Hodge) that did express a view held that the restrictions should not be set aside if, but for the improper purpose, the directors would in any event have imposed the restrictions.

Comment

In one sense, the decision of the Supreme Court is unremarkable – the directors of a company are fiduciaries and fiduciaries are generally required to exercise all of the powers given to them in that capacity for a proper purpose. Indeed, that requirement, as stressed by the Supreme Court, is enshrined in the Act at section 171(b): "a director of a company must…only exercise powers for the purposes for which they are conferred."

Though the Supreme Court reaffirmed orthodoxy, for corporate advisers and directors, the decision may present some difficulties. Those difficulties correspond with opportunities for activist shareholders:

• Section 171(a) of the Act provides that a director must "act in accordance with the company's constitution." JKX's articles did not contain any express limitation on the purpose for which the power to restrict the transfer and voting of shares could be exercised. The directors' submission that they had acted in accordance with JKX's articles had some force – they had acted in accordance with the articles' literally read, express terms. Overlaying a proper purpose test onto all exercises by directors of their constitutional powers adds potential uncertainty.
• It also means that the interpretation of a company's articles further diverges from the interpretation of other sorts of contract (though even in other contracts, there is some support for the proposition that unfettered contractual rights can be subjected to good faith and proper purpose considerations: see for example Redwood Master Fund Ltd v TD Bank Europe Ltd [2006] 1 BCLC 149).
• A company's articles may first have been adopted many years ago and may have been amended regularly by a 75% majority of the shareholders from time to time. Identifying the purpose for which provisions incorporated in the original articles or by amendment may be exercised by directors is inherently (and conceptually) difficult.
• Indeed, the company may have developed from a small enterprise into a global, listed business. In those circumstances, the purpose for which it was envisaged that directors might exercise a power may no longer be applicable. It is questionable whether the shareholders' intended purpose is relevant at all; the test is whether the directors acted for a "proper purpose" and the proper purpose may not necessarily accord with what the shareholders intended.
• Further, identifying the purpose for which a power is actually being exercised is difficult. That requires investigation of the directors' states of mind. Board resolutions may not be unanimous. Each director may have a different purpose. Some directors may have more than one purpose. The Supreme Court referred to analysis of the directors' predominant intention, but that could require detailed factual investigation, disclosure and evidence. There remains an issue as to how far the shareholders are able to look behind any purpose recorded in the board minutes at any non-recorded purpose. These all raise questions of fact for determination by a trial judge. In JKX, four of the seven directors were found to have acted on the power "to get an advantage…for [their] own sake, not linked to the extraction of information" and "did not have in mind the protection of the company pending the provision of the information", but it is not clear what other purposes are and are not proper.

As to those difficulties, directors and corporate advisers will await further guidance in an appropriate case. Until then, the proper purpose test is (as Lord Sumption noted) "particularly important when [a] company is in play between competing groups seeking to control or influence its affairs."