Directors must exercise their powers for proper purposes - or else

Posted: 12/04/2016

In December 2015, the Supreme Court handed down a significant judgment on the nature and effect of the “proper purpose” rule in company law and when the presence of an improper purpose will invalidate a decision of directors ((1) Eclairs Group Ltd (2) Glengary Overseas Ltd v JKX Oil & Gas Plc). In doing so, it overturned the previous decision of the Court of Appeal and restored the decision at first instance. The judgment is interesting for its analysis of how the “proper purpose” provisions interact with other provisions of the Companies Act 2006 (the Act) which are intended to protect companies from external, rather than internal, interference/manipulation. 

Covert acquisition and disclosure notices

The dispute concerned an alleged “corporate raid” ie in this context “an attempt to exploit [disenfranchise] a minority shareholding in a company to obtain effective management or voting control without paying what other shareholders would regard as a proper price” (paragraph 1). 

Section 793 of the Act provides public companies with a tool to resist covert acquisition of control by corporate raiders. It enables public companies to issue notices to persons whom they know or reasonably believe to be interested in the company’s shares, requiring those persons to disclose information regarding both their interests and any agreements in place relating to the acquisition of interests in shares or the exercise of any rights conferred by the shares. Where a disclosure notice is not complied with, the company can apply to the court for an order making the shares subject to restrictions. In this case, the respondent (the company) had a provision in its articles of association empowering the board to impose such restrictions directly (Article 42). Nowadays, this is a common provision to find in a company’s articles. 

The appellants were two significant minority shareholders in the company. In 2013, a dispute arose between the company and the appellants because the appellants opposed the board’s proposals to issue additional shares in the capital of the company and disapply pre-emption rights, and sought to remove the current chief executive and commercial director from the board. Around this time, the directors of the company perceived that it had become the target of a raid by the appellants and consequently issued disclosure notices to the appellant and certain other parties under Article 42, requiring disclosure of information regarding interests in its shares and any arrangements in place in relation to them. 

Although the appellants provided answers to the disclosure notices, the board believed that the notices had not been properly complied with and that the answers received failed to disclose agreements or arrangements between the addressees that the board believed were in existence. The board therefore resolved to use the Article 42 power to place restrictions on the appellants’ shares preventing them from voting on the various resolutions to be considered at a forthcoming AGM. The appellants commenced proceedings challenging the restrictions.

Proper or improper purpose?

The Act contains safeguards intended to protect a company from internal interference or manipulation by its officers for their own ends. Under section 171(a), a director of a company must act in accordance with the company's constitution. Section 171(1)(b) provides that a director may only exercise the powers for the purposes for which they are conferred. The appellants argued that the board’s use of Article 42 to prevent them from voting at the AGM was a breach of the proper purpose doctrine.

The appellants succeeded at first instance, although it was found by the trial judge that certain individuals behind the appellants had a reputation as corporate raiders. However, the decision was reversed in the Court of Appeal, which found that the proper purpose doctrine had no application in the operation of section 793 or Article 42. The dispute then went to the Supreme Court, which disagreed with the Court of Appeal. Finding that the proper purpose doctrine did indeed apply in this context, the Supreme Court went on to consider whether, in placing restrictions on the appellants’ shares, the directors had acted in breach of the proper purpose rule under section 171(b) of the Act which provides that a director of a company must only exercise powers “for the purposes for which they are conferred”.

The appellants argued that the Article 42 power could be exercised only to provide an incentive to remedy the default or a sanction for failing to do so, but, on this occasion, the board had in fact exercised the power for the purpose of influencing the outcome of the resolutions at the AGM. The Supreme Court agreed. In doing so, it noted that the directors may have had multiple purposes in using the Article 42 power, some proper and some improper. The company might have focused instead on an argument that the same decision would have been reached having regard to the other purposes even without reference to the improper purpose of defeating the raiders. However, that was not the company’s case and the first instance judge did not allow the company to take the point later on when attention had been drawn to its possible relevance (and the company had not appealed against that refusal). 

Accordingly, the Supreme Court held that (1) the proper purpose rule applied to Article 42 (over-ruling the decision of the Court of Appeal) and (2) the directors of the company had indeed acted for an improper purpose. The appeal was therefore allowed. 

Analysis

In his leading judgment, Lord Sumption reflected on the history of the proper purpose doctrine in equity and noted that it is concerned with abuse of power, where acts are done within the scope of the power but for an improper reason. The rule is commonly applied to prevent the use of directors’ powers for the purpose of influencing the outcome of a general meeting. Such use of directors’ powers, as in this case, is not only an abuse of power for a collateral purpose, but also offends against the constitutional separation of powers between the different interest groups in a company. For example, it would permit directors’ powers to be used in a manner that would allow the board to influence decisions which company law and the company’s constitution had reserved to the members. 

The separation of such powers is fundamental to the operation of a company and lies at the heart of this decision. However, it is easy to have some sympathy with the company, given that the board appeared to believe genuinely that it was acting in the company’s best interests, and given the Supreme Court’s finding that the board had reasonable cause to believe that the company was the subject of a corporate raid and “that the answers to the disclosure notices had been false" (paragraph 25). The lesson for directors is to evaluate and record all their motives honestly before exercising a power. They may also be prudent to consider taking early legal advice before doing so. 

This article was published in Commercial Litigation Journal in April 2016.

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