In Eclairs Group Limited v JKX Oil & Gas plc and Glengary Overseas Ltd v JKX Oil & Gas plc [2015], the Supreme Court allowed an appeal from a majority decision of the Court of Appeal and held that when directors exercise a power conferred by the Company’s articles of association to suspend the voting rights of shareholders who fail to comply with a notice under section 793 of the Companies Act 2006, the directors must exercise that power for a proper purpose. The proper purpose rule is stated in section 171(b) of the Companies Act 2006, which provides that a director must only exercise powers for the purposes for which they are conferred.

Background

The proceedings arose in the context of an alleged 'corporate raid'. Section 793 of the Companies Act 2006 is one of the tools available to a public company seeking to resist the covert acquisition of control by 'corporate raiders' and allows a public company to serve a statutory notice on a person calling for information about that person's interests in the company’s shares. There are statutory provisions empowering the court to restrict the exercise of rights attaching to shares if the recipient fails to comply with a section 793 notice. Restrictions include the suspension of voting and transfer rights. The articles of association of public companies commonly include equivalent provisions empowering the board to impose such restrictions in these circumstances.

JKX Oil & Gas plc, a listed company, is involved in the exploitation of oil and gas reserves in the Ukraine and Russia. In 2013, the share price of JKX had fallen to historically low levels and the directors believed that JKX was the target of a raid by Eclairs and Glengary, both shareholders of JKX, the aim of which was to make changes to the board. Eclairs wrote to JKX calling upon it to convene an extraordinary general meeting to consider ordinary resolutions for the removal of the chief executive and the commercial director and the appointment of three new directors. JKX responded by serving section 793 notices on Eclairs and Glengary (together holding 39% of JKX's issued share capital) and JKX convened an AGM. The board believed that the objective of the raiders was to depress the value of the shares so as to enable them to buy shares more cheaply and take control of the company's Ukrainian subsidiary and that the removal of the two directors and their replacement by inexperienced associates of the raiders was part of that plan.

The board of JKX considered that the responses to the section 793 notices were inadequate and exercised the power of the directors in article 42 of JKX's articles of association by issuing restriction notices to suspend the voting and transfer rights attached to the shares held by Eclairs and Glengary.  Article 42 provided that the board could exercise these rights where the board knows or has reasonable cause to believe that the information provided is false or materially incorrect.

Eclairs and Glengary applied to the court challenging the restriction notices on the basis that the board acted for a collateral, and therefore improper, purpose. Eclairs and Glengary argued that the only proper purpose for which the power could be exercised was to extract the information required by the section 793 notices. They alleged that the real purpose of the board, however, had been to ensure that the special and ordinary resolutions (including to re-elect the chief executive and to allot new shares with a view to raising capital) to be proposed at the forthcoming AGM would be passed and would not be blocked or made more difficult to pass by Eclairs and Glengary.

JKX's case was that once the raiders had failed to provide the information, the power to issue a restriction notice could properly be exercised for the purpose of defeating their attempt to influence or control the company's affairs, provided that the board of JKX had acted in good faith in the company's interests.

The central questions for the courts were what are the proper purposes for which the board may enforce provisions in the articles of association to restrict the exercise of rights attaching to shares and in what circumstances can the restrictions be challenged on the ground that they were imposed for a collateral purpose?

High Court Decision

The High Court (Mann J) found on the evidence that the directors had reasonable cause to believe that the responses to the section 793 notices were inadequate. However, in issuing the restriction notices the directors had not acted for a proper purpose, because they issued the restriction notices to prevent the shareholders in question from blocking, or making it harder to pass, resolutions at the AGM. The only purpose for which the power to impose restrictions was conferred by article 42 was to "provide a sanction or an incentive to remedy the default". The primary purpose of the board in issuing the restriction notices was to influence or determine the fate of the resolutions before the AGM. The restriction notices were therefore invalid.

The bona fides of the directors, and the genuineness of their desire to benefit the company as a whole, was not challenged and in the judge's view could not be challenged.

Court of Appeal Decision

On appeal, the Court of Appeal, by a majority (Longmore LJ and Sir Robin Jacob; Briggs LJ dissenting), allowed JKX's appeal and held that the exercise by the board of the right to suspend voting rights was valid. This was because, firstly, the proper purpose rule did not apply to article 42 because the shareholders only had to answer the questions more fully in order to avoid the imposition of restrictions – 'why should the law protect him when all he had to do was tell the truth?'. Secondly, the restrictions on voting and other rights was the very thing that article 42 was designed to permit if the directors reasonably considered that the disclosure notices had not been complied with. Therefore, once the board had reached that conclusion, there was no further limitation on their power to issue a restriction notice. Thirdly, no limitation on the proper purpose of a restriction notice was expressed, either in the Companies Act 2006 or in article 42. Such a purpose could not be implied because, in the nature of things, the statutory disclosure procedure was most likely to be operated at a time of controversy in the company's affairs and because the application of the rule was inappropriate in the course of a battle for control.

The result of applying the proper purpose rule would be to emasculate the statutory scheme and the corresponding provisions of article 42.  Any other view "would only be an encouragement to deceitful conduct and not something which English company law should countenance".

Supreme Court Decision

The Supreme Court unanimously allowed the appeals by Eclairs and Glengary and restored the decision of the High Court, holding that the proper purpose rule applied to the exercise of the power under article 42 and that the directors of JKX acted for an improper purpose.

Proper Purpose Rule

The proper purpose rule is the principal means by which equity enforces directors' proper conduct, and is fundamental to the constitutional distinction between board and shareholder. A battle for control of the company is probably the context where the proper purpose rule has the most valuable part to play.

The proper purpose rule is concerned with abuse of power by doing acts which are within the scope of the instrument creating it but done for an improper reason: a company director must not, subjectively, exercise fiduciary powers for an improper reason. 

Article 42

The power to restrict the rights attaching to shares under article 42 is ancillary to the statutory power to call for information under section 793. Article 42 has three closely related purposes:

  • to induce a shareholder to comply with a disclosure notice;
  • to protect the company and its shareholders against having to make decisions about their respective interests in ignorance of relevant information; and
  • as a punitive sanction for a failure to comply with a disclosure notice.

Seeking to influence the outcome of shareholders' resolutions is no part of those proper purposes.  Mann J found that four of the six directors were concerned only with the effect of the restriction notices on the outcome of the general meeting.

It was irrelevant whether Eclairs and Glengary could have averted the imposition of restrictions on their rights as shareholders by giving different answers to the questions and it was not sufficient for the directors to have acted honestly to promote the success of a company for the benefit of its members as a whole.

The imposition of restrictions under article 42 is a serious interference with financial and constitutional rights which exist for the benefit of the shareholder and not the company. In the case of listed companies such as JKX, a restriction notice is also an interference with the proper operation of the market in its shares, in which there is not only a private but a significant public interest. One would expect such a draconian power to be circumscribed by something more than the directors' duty to act in the company's interest as they may in good faith perceive it.

Where there are multiple purposes

What if there are multiple purposes, all influential in different degrees, some proper and some not.  How should the primary or dominant purpose be identified?  In his judgment, Lord Sumption (with whom Lord Hodge agreed) said that one option is to identify the "weightiest" purpose; the one about which the directors felt most strongly.  The other is that it is the purpose which caused the decision to be made.  In most, but not all, cases, the two tests will lead to the same result but the first test may be difficult to justify practically, as it would involve an enquiry into the directors' motivations and feelings.

Causation – the "but for" test

Lord Sumption approached the problem from a causation standpoint, citing Australian authority and the leading modern case of Howard Smith v Ampol Petroleum Ltd [1974] (also a case of multiple concurrent purposes) and considered that where the directors have multiple purposes, the relevant purpose or purposes are those without which the decision would not have been made. If that purpose or those purposes are improper, the decision is ineffective.  Lord Sumption approved the formulation of the High Court of Australia in a 1987 case that a decision of the board would be invalidated if the impermissible purpose was causative in the sense that, but for its presence, the power would not have been exercised.  This "but for" test was to be preferred over the conventional approach of establishing the purpose about which the directors felt most strongly – the "weightiest" purpose, in respect of which Lord Sumption mentioned the practical difficulties of an enquiry into the relative intensity of the directors' feelings about the various considerations that influenced them.

One has to focus on the improper purpose and ask whether the decision would have been made if the directors had not been moved by it. If the answer is that without the improper purpose(s) the decision impugned would never have been made, then it would be irrational to allow the decision to stand simply because the directors had other, proper considerations in mind as well.  Correspondingly, if there were proper reasons for exercising the power and it would still have been exercised for those reasons even in the absence of improper ones, it is difficult to see why justice should require the decision to be set aside.

Lord Sumption posed the question, suppose that the directors had decided to issue the restriction notices as a sanction for the non-provision of the information and to protect the company from the consequences of its non-disclosure pending its provision. Suppose that they also made the decision in order to secure the passing of the resolutions, but would have done the same thing even if that had never entered their minds. On that hypothesis, it would be difficult to regard the impact on the resolutions as a primary consideration. The lack of information would have been a sufficient justification of the restrictions and the impact on resolutions would have been irrelevant; no more than a welcome incidental consequence.  On the other hand, if the only consideration which actually influenced the decision was an improper one, it is difficult to envisage any basis on which their decision could stand.   

However, the other members of the Supreme Court, whilst agreeing that the appeal should be allowed, declined to express a concluded view on Lord Sumption's  "but for" test without the point being fully argued.  Lord Mance raised the question of the evidential standard which would apply in showing that the directors would have reached the same decision even if they had not had the illegitimate purpose in mind.  Would probability be enough or would the test be whether their decision would inevitably have been the same? Also, Lord Manse did not agree that the evidential problems inherent in establishing the principal or primary purpose referred to by Lord Sumption were any less in relation to a test based on "but for" causation.  If anything the principal or primary purpose would be likely to be easier to identify, since it was likely to be reflected in directors' exchanges before and/or at the time of the decisions.  Although Lord Mance had sympathy with Lord Sumption's view that "but for" causation offers a single simple test which it might be possible or even preferable to substitute for references to the principal or primary purpose, he was not persuaded that the court should undertake "a new development" of company law without having heard argument. 

Result

The appeal was unanimously allowed.  However, as mentioned above, Lord Neuberger, Lord Mance and Lord Clarke declined to express a concluded view on the application of a "but for" test to the proper purpose rule.  They also wanted further clarification on the meaning of "only" in section 171(b) of the Companies Act 2006 (a director must only exercise powers for the purposes for which they are conferred) in the context of a directors' power used for mixed purposes, some good and some bad.

Comment

When directors exercise a right conferred by, for example, the articles of association, the proper purpose rule applies and when there are multiple purposes the principal or primary purpose must be established, so that the principal or primary purpose can be identified as a legitimate purpose. The decision means that a close analysis is required of the purpose for which a power of a board exists; whether the power is being exercised for that purpose will, where there are multiple purposes, depend on identifying the principal or primary purpose for which it was exercised.  It is not enough for a board to assume that because the pre-conditions for the exercise of a power have apparently been met, the board can therefore also use that power for a convenient collateral purpose.  In the context of this case, the board of JKX was interfering with the basic right of shareholders to control a company. The case particularly illustrates the need for caution when a board exercises disenfranchisement rights, which is always going to be particularly important in the context of a battle for control or a takeover situation.

Also, note that it was accepted that the directors exercised the power in good faith to promote the success of the company in accordance with their statutory duties, but this was not sufficient to validate the restrictions.

The Supreme Court did not agree on the test which should be applied to establish the purpose for which the directors have exercised a power and hence establish whether that is a proper purpose. Whether the "but for" test is the correct approach was left for another day.