The Proper Purpose Rule

Eclairs Group v. JKX Oil [2015] UKSC 71 is an important illustration of the power of the Courts to interfere in decisions taken by the Board of a company (even when those decisions are taken in good faith by the Directors). JKX Oil [“JKX”] is a company listed on the London Stock Exchange. Eclairs and Glengary, both incorporated in the British Virgin Islands, owned substantial minority shareholdings in JKX, sufficient to block special resolutions: 27.55% and 11.45% respectively. Eclairs was owned beneficially by Ukrainian politician-businessmen, Mr. Kolomoisky and Mr. Bogulyubov, both having acquired the reputation of ‘raiders’. Glengary was owned by a Mr. Zhukov.Relations between JKX and Eclairs/Glengary do not appear to have been particularly cosy: by 2013, the directors of JKX perceived that they were the target of a raid by the two minority shareholders. From 2010 to 2012, JKX (which was going through a financially challenging time) attempted to raise capital, but these attempts fell through in view of the blocking minority with the raider group. In March 2013, Eclairs and Gregory wrote to JKX, calling for an extraordinary general meeting to consider resolutions for removal of the existing CEO of JKX, Mr. Dixon, from the Board.  An AGM was convened for June 2013. The agenda included the re-election of Dr Davies, the approval of the directors’ remuneration report and resolutions empowering the board to allot shares for cash.JKX issued disclosure notices to Eclairs and Glengary (as permissible under UK law), calling upon Glengary to provide information about their shareholding, their beneficial ownership and any agreements or arrangements between the various persons interested in them. Prompt responses gave information about the shareholding, but denied that the addressees were party to any agreement or arrangement among themselves. Article 42 of the Articles of JKX empowered the Board to issue restriction notices (restricting the exercise of voting rights) in respect of specified shares, in case the Board had reasonable cause to believe that information in response to disclosure notices was incomplete. Believing Eclairs and Glengary to have provided incomplete information, the Board issued restriction notices in respect of the shareholding of Eclairs and Gregory. The effect was that Eclairs and Gregory could no longer use their blocking minority at the AGM.The validity of the exercise of powers by the Board in issuing restriction notices was challenged by Gregory and Eclairs. They contended that although the Board was empowered to issue the restriction notices, the Board had issued the notices for an improper purpose (of ensuring that the blocking minority could not be used). Based on the evidence led at first instance, the trial Judge came to the finding of fact that the Board exercised its powers to prevent the Gregory/Eclairs from being able to block resolutions at the AGM, and that the Board acted in good faith and believed that this was for the interests of the company as a whole. On the basis of these findings, the trial Judge held that the powers were not exercised for proper purposes (as the only proper purpose was to ensure that the information sought in the disclosure notices was provided, not to prevent blocking minorities from exercising their rights). The Court of Appeal by majority reversed these conclusions. They held that restrictions on voting rights was the very thing that article 42 was designed to permit. Once the board had reached that conclusion that disclosure notices had not been complied with, there was no further limitation on their power to issue restriction notices. Eclairs/Gregory appealed to the Supreme Court.JKX argued that in determining for what purposes powers could be used for, regard must be had to principles of contractual interpretation and implication of terms: “Where the purpose of a power was not expressed by the instrument creating it, there was no limitation on its exercise save such as could be implied on the principles which would justify the implication of a term.” They further contended that such a term could only be implied on grounds of necessity. The Supreme Court rejected this argument, holding, “… a term limiting the exercise of powers conferred on the directors to their proper purpose may sometimes be implied on the ordinary principles of the law of contract governing the implication of terms. But that is not the basis of the proper purpose rule. The rule is not a term of the contract and does not necessarily depend on any limitation on the scope of the power as a matter of construction. The proper purpose rule is a principle by which equity controls the exercise of a fiduciary’s powers in respects which are not, or not necessarily, determined by the instrument. Ascertaining the purpose of a power where the instrument is silent depends on an inference from the mischief of the provision conferring it, which is itself deduced from its express terms, from an analysis of their effect, and from the court’s understanding of the business context…” In other words, when considering the application of the proper purposes rule, the Court must look at the express terms, analyse the effect and context of those terms to infer the mischief which those terms sought to avoid, and from this, restrict the exercise of power to curtail only the relevant mischief. The elegance of this analysis commends itself: however, determining the ‘mischief’ may not necessarily be reducible to this test. In construing legislation, a Court may often have specific material before it to appreciate the ‘mischief’ sought to be avoided. This process must necessarily be harder in the context of instruments such as trust deeds or articles. For instance, let us consider Article 42 itself: it seems perfectly reasonable to conclude that Article 42 sought to prevent the mischief of not giving complete information in respect of disclosure notices. But it this really any more reasonable than saying on the other hand that Article 42 sought to prevent very mischief which Eclairs/Glengary were (in the eyes of the Board) up to. Why should the mischief be limited only to incomplete responses to disclosure notices? Why should the mischief not extend to cover even the purpose which lay behind the issue of the disclosure notices also? Lord Sumption deals with such questions thus: “…In my view article 42 has three closely related purposes. The first is to induce the shareholder to comply with a disclosure notice… Secondly, the article is intended to protect the company and its shareholders against having to make decisions about their respective interests in ignorance of relevant information… Thirdly, the restrictions have a punitive purpose. They are imposed as sanctions on account of the failure or refusal of the addressee of a disclosure notice to provide the information for as long as it persists, on the footing that a person interested in shares who has not complied with obligations attaching to that status should not be entitled to the benefits attaching to the shares. That is the natural inference from the range and character of restrictions envisaged in article 42(3), which affect not only the right to participate in the company’s affairs by voting at general meetings, but the right to receive dividends. These three purposes are all directly related to the non-provision of information requisitioned by a disclosure notice. None of them extends to influencing the outcome of resolutions at a general meeting. That may well be a consequence of a restriction notice. But it is no part of its proper purpose. It is not itself a legitimate weapon of defence against a corporate raider, which the board is at liberty to take up independently of its interest in getting the information… However difficult it may be to draw in practice, there is in principle a clear line between protecting the company and its shareholders against the consequences of non-provision of the information, and seeking to manipulate the fate of particular shareholders’ resolutions or to alter the balance of forces at the company’s general meetings. The latter are no part of the purpose of article 42. They are matters for the shareholders, not for the board…”On this basis, the appeal was allowed. In his judgment, Lord Sumption also reflected on the role of the proper purposes rule in the context of battles between groups of shareholders. He concludes, “… The rule that the fiduciary powers of directors may be exercised only for the purposes for which they were conferred is one of the main means by which equity enforces the proper conduct of directors. It is also fundamental to the constitutional distinction between the respective domains of the board and the shareholders. These considerations are particularly important when the company is in play between competing groups seeking to control or influence its affairs. The majority of the Court of Appeal were right to identify this as the background against which disclosure notices are commonly issued. But they drew the opposite conclusion from the one which I would draw. They seem to have thought it unrealistic, indeed undesirable, against that background to expect directors to distinguish between the proper purpose of enforcing the disclosure notice and the improper purpose of defeating the ambitions of one group of shareholders. I find this surprising. The decision to impose restrictions under article 42 requires the directors to recognise the difference between the purpose of a decision and its incidental consequence. That certainly calls for care on their part and possibly for legal advice. But there is nothing particularly special in this context about a decision to issue a restriction notice under a provision such as article 42. The directors’ task is no more difficult than it was in the many cases like Howard Smith Ltd v Ampol Petroleum Ltd in which other fiduciary powers, such as the power to issue shares, have been held improperly exercised because in the face of pressures arising from a battle for control the directors succumbed to the temptation to use their powers to favour their allies. I would agree with the majority of the Court of Appeal that in that situation the board would naturally wish to have the predators disenfranchised. That is precisely why it is important to confine them to the more limited purpose for which their powers exist. Of all the situations in which directors may be called upon to exercise fiduciary powers with incidental implications for the balance of forces among shareholders, a battle for control of the company is probably the one in which the proper purpose rule has the most valuable part to play…”Lord Sumption also discussed in some detail the evolution of the proper purposes rule, and his analysis of how the rule would operate when a power is exercised for multiple purposes (some proper and some improper) is also extremely interesting. On this latter question, ultimately, the majority decided to keep the issue open. In India, the higher judiciary does not seem to have had the occasion to consider the scope of the proper purposes rule in depth. In Dale & Carrington v. Prathapan (2005) 1 SCC 212, the Court held, “…Courts in the Commonwealth countries including England and Australia have emphasized that the duty of the Directors does not stop at “to act bonafide” requirement. They have evolved a doctrine called the ‘proper purpose doctrine’ regarding the duties of company directors. In Hogg v. Cramphorn, explicit recognition was given to the proper purpose test over and above the traditional bona fide test…In the present case we are concerned with the propriety of issue of additional share capital by the Managing Director in his own favour. The facts of the case do not pose any difficulty particularly for the reason that the Managing Director has neither placed on record anything to justify issue of further share capital nor it has been shown that proper procedure was followed in allotting the additional share capital. Conclusion is inevitable that neither the allotment of additional shares in favour of Ramanujam was bonafide nor it was in the interest of the company nor a proper and legal procedure was followed to make the allotment. The motive for the allotment was malafide, the only motive being to gain control of the company. Therefore, in our view, the entire allotment of shares to Ramanujam has to be set aside…” It seems that the decision turned ultimately on the lack of bona fides, rather than strictly turning on the application of the proper purposes rule based on an analysis of the relevant document to determine the purpose for which powers were granted [also see Sangramsingh Gaekwad AIR 2005 SC 809. 

Source: Corporate

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