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Rebecca_Davis_phThe Supreme Court recently handed down its judgment in the case of Eclairs Group Ltd v JKX Oil & Gas Plc [2015] UKSC 71 (read our Case Preview here). The decision concerns the application of the proper purpose rule to restriction notices imposed by the defendant on the claimant companies’ shares. The claimants sought to overturn the Court of Appeal’s previous decision that the proper purpose rule had no significance to service of the notice and that the notices (and the resultant restrictions on the claimants’ shares) had therefore been validly imposed.

Background

The case concerned a so-called “corporate raid” on the defendant company, whereby it was alleged that two of its minority shareholders, Eclairs and Glengary (who together held a combined stake of 39% in the company), had entered into an arrangement to combine their shareholdings to obtain voting control. It was assumed that the purpose of such control would be to then orchestrate a “raid” on the company by using such voting power to purchase its shares for a value below their market price.

In response to suspicious behaviour by Eclairs and Glengary, including an attempt to remove the existing chief executive of the company and to prevent its other efforts to raise capital, JKX issued five disclosure notices on the shareholders under Companies Act 2006, s 793. This section provides that a public company may issue a disclosure notice on any person that it knows, or reasonably believes, to be interested in its shares, requesting information including the number of shares held, the beneficial ownership of such shares, and of any agreements or arrangements between the persons interested in them. Under Companies Act 2006, s 794, if a person on whom such a notice has been served fails to comply with the notice, the company may apply for a court order imposing restrictions on the shares, including on transfer of the shares, exercise of voting rights and on rights to receive payments of capital or income.

This provision was also mirrored in article 42 of JKX’s articles of association, which provided further that such restrictions could be imposed directly by notice of the board (rather than by court order). The article also provided that the company would be treated as not having received the required information if its directors knew or had reasonable cause to believe that the information provided in response to the notices was false or materially incorrect.

Although both Eclairs and Glengary responded to the notices, admitting the existence of interests in JKX shares, they denied any arrangements or agreements between themselves. Suspecting that there were in fact such arrangements in place, the board held that the responses were inadequate and issued restriction notices on the two shareholders. Crucially, the restriction notices also prevented the two shareholders from voting to block resolutions which were to be proposed at JKX’s ensuing AGM, including to re-appoint the chief executive Dr Davies, to authorise new share allotments and disapply pre-emption rights, and to authorise the company to make market purchases of its shares.

In response to the notices, Eclairs and Glengary contested the restrictions, arguing that the board had imposed them for an improper purpose, contrary to Companies Act 2006, s 171(b) (that a director must only exercise powers for the purpose for which they are conferred). They argued that the restrictions were imposed in order to prevent their voting on the forthcoming shareholder resolutions.

In the High Court, Mr Justice Mann found in favour of the claimants. He ruled that while the directors had had reason to believe the responses to the disclosure notices had been inaccurate, this had not in fact motivated their decision to impose the restrictions, which had rather been unduly influenced by the ulterior motive of preventing the “raiders” from blocking the resolutions at the ensuing AGM. Although imposing the restrictions could be considered to be in the best interests of the company and its other shareholders, it was outside the proper purpose and scope of article 42, which was  to elicit the correct information relating to the disclosure notices. Mann J therefore held that the restrictions had been imposed for an improper purpose and should accordingly be set aside.

On appeal, the Court of Appeal overturned this decision. By a majority of two to one (Briggs LJ dissenting) it held that the proper purpose doctrine had no significance to the application of article 42. The article depended solely on whether the directors considered that the disclosure notices had been properly complied with. Since the shareholders had the power to avoid the restrictions by complying with the notice, issue of the notices where they did not comply would be valid whatever ulterior motives were involved. It would not be a “unilateral” decision by the board, but rather one conditioned by the shareholders’ own acts. The Court of Appeal was disinclined to apply the proper purpose doctrine in such a context, where it could have the effect of undermining the statutory regime, as such notices were most likely to be served at points of conflict, where a range of changing and conflicting motives could be involved.

Supreme Court decision

The Supreme Court upheld the appeal and dismissed the restrictions. It held that the proper purpose doctrine did apply to article 42 and that the directors had acted for an improper purpose in issuing the restrictions, as they had been motivated primarily by seeking to influence the outcome of the proposed shareholder resolutions, rather than to obtain the information sought by the prior disclosure notices. In reaching this decision, Lord Sumption, giving the judgment, noted that:

  • The proper purpose rule is concerned with the abuse of power by doing acts which are within the scope of the power, but for an improper reason or motive. An assessment of whether the power has been exercised properly is therefore necessarily subjective and dependent of the state of mind of the persons exercising the power.
  • To determine whether a power has been properly exercised, it is necessary to assess the “primary” or “dominant” purpose motivating the use of the power.  As there are likely to be multiple causes “some proper and some improper”, the relevant test should be that of causation – i.e. “but for” the relevant motive, the power would not have been exercised.  In cases where both improper and proper motives are combined, if the power would have been exercised regardless of the improper motive, it will remain valid despite the existence of some improper considerations.
  • In determining purpose, it was not necessary that the purpose of an instrument should be expressly stated – rather purpose would usually be implied from a mixture of the express terms of the instrument, an analysis of their effect and from the court’s understanding of the business context. In this context, the purpose of article 42 was threefold: (i) to induce the shareholder to comply with the disclosure notice; (ii) to protect the company and its shareholders from having to make decisions relating to the company without relevant information; and (iii) to impose punitive sanctions on the shareholders for failing to comply with the notice, for as long as such failure continued.  Seeking to influence the outcome of resolutions to be proposed at a general meeting did not therefore fall within the proper purpose of the powers conferred under the company’s articles.
  • Contrary to the finding of the Court of Appeal, it was precisely in situations where there were conflicting factors and where the affairs of a company were contested that the proper purpose rule should apply and would have “the most valuable part to play”. In such circumstances, this was a primary tool for ensuring the directors did act within their powers and of recognising the difference between their powers and those of a company’s shareholders. It was important to make this distinction; whereas the directors were bound by fiduciary duties to the company, the shareholders were entitled to exercise their rights according to their own interests regardless of whether this was for beneficial or malevolent purpose.
  • The Supreme Court also dismissed the Court of Appeal’s argument that the shareholders could avoid imposition of the restrictions merely by fully complying with the disclosure notice. As it was ultimately the decision of the board as to whether it considered the information provided was sufficient, there would always be room for the directors to “erroneously conclude that the answers are defective”. There was no reason for this to prevent application of the proper purpose rule, which was in any case a fiduciary duty existing independently of any actions of the shareholders.

On the facts, the court therefore held that the proper purpose rule did apply and that, given that the majority of the board had imposed the notices primarily for the purpose of frustrating the shareholders’ attempts to block the resolutions, they had acted improperly and the restriction notices should be set aside.

Obiter, Lord Mance (while otherwise agreeing with Lord Sumption), contested the application of a “but for” test to determining dominant or primary purpose, arguing that the primary test should still be what was the “principal or primary purpose”. He considered that without hearing further evidence on this point (and for example also considering the threshold for application of such a test) the court should refrain from stating a decided view on this point.

Comment

The case has significance in particular to corporate lawyers as a reminder of the importance of directors’ fiduciary duties of loyalty to the company, which the judgment re-affirms may apply even in situations seemingly merely of contractual interpretation (as here, in applying powers under a company’s articles).  It is also a reminder that the actions of directors are necessarily more circumscribed than those of shareholders, and that their decisions must therefore be taken more carefully, with appropriate recording of the intended purpose in the relevant board minutes.

As indicated in Lord Mance’s obiter judgment, while the evidence from the JKX board pointed towards a fairly straightforward causation, the case also perhaps raises more difficulties than it solves in relation to determining proper purpose in more complex scenarios, where the directors do not have a unified or evident purpose.  As the Supreme Court declined to comment decisively on the correct test, and also emphasised the importance of assessing the subjective intentions of each director, there will be room for debate on the matter, which may have to wait until a further test case to be conclusively determined.