This is the eighth in our series of short articles in which we try to shed light on some of the more confusing aspects of the Companies Act 2006 (the "Act"). Earlier in the series, we looked at some of the practical issues which arise in connection with those directors' duties under the Act which tend to attract the most attention, including the duty to promote the success of the company and the duty to avoid conflicts. This article is intended to serve as a reminder of the importance of one of the less high-profile duties: the duty under section 171 only to exercise powers for the purposes for which they are conferred.
The duty under section 171 to act within powers encompasses two duties:
- a duty to act in accordance with the company's constitution
- a duty only to exercise powers for the purposes for which they are conferred.
There is very little to say as far as the obligation to act in accordance with the company's constitution is concerned. Experienced directors will no doubt be aware that they must comply with the company's articles, and generally the only stumbling-block in relation to ensuring compliance with the obligation will be the fact that the meaning of "constitution" is wider than one might expect (sections 17 and 257 of the Act provide a partial definition). For example, it appears to encompass board resolutions which are passed in accordance with the articles.
The duty only to exercise powers for the purposes for which they are conferred was, prior to the introduction of the Act, commonly known as the duty to exercise powers for a proper purpose. Section 171 does not seem to have changed the substance of the duty, but nor has it made it any easier to apply in practice. The chief problem is that it is not always clear for what purpose a particular power has been conferred.
The case law in which the duty was originally developed established that the duty applies to a wide variety of powers, including the power to issue shares, the power to recommend a dividend and the power to refuse to register transfers of shares. It will apply, in fact, to any powers conferred on the directors by the shareholders through the articles (for example, a power to appoint a new director), and to some, if not all, powers conferred on them by statute. Unfortunately, neither the case law nor the Act contains a general test to assist directors in determining the purpose for which a particular power has been granted to him. In practice, therefore, directors will not always find it easy to decide whether a proposed exercise of a power may constitute a breach of the duty.
The following scenarios illustrate the difficulty. The background to them both is the acquisition by Buyer Co of a 60% stake in Target Co, with the remaining 40% staying in the hands of several dozen existing small shareholders.
- Scenario 1
Target Co's affairs run smoothly for a while, but after a year or so differences of opinion as to the direction in which its business should be heading arise between Buyer Co and the minority shareholders. Buyer Co decides to exercise its powers under the articles to replace the existing board with a new set of directors, and those directors proceed to issue Buyer Co with shares which will take its holding above the 75% level, effectively giving it full control over Target Co. (The articles of Target Co disapply the statutory right of pre-emption.)
The newly-appointed directors might feel that they are perfectly entitled to dilute minority shareholders' stakes in this way, but the case law suggests that the main purpose for which directors are given the power to issue shares is in order to enable them to raise capital. A court may well look askance at an allotment which is designed purely to weaken the position of minority shareholders.
- Scenario 2
Target Co's board consists of some directors who were in place before the acquisition and a majority who were appointed subsequently by Buyer Co. In the years following the acquisition, Buyer Co's nominees on the board use their power under the articles to recommend a dividend consistently to recommend very low dividends, despite the fact that Target Co is extremely profitable. In doing so, they are acting in accordance with Buyer Co's wishes (Buyer Co wants Target Co to build up a war chest to fund possible future acquisitions (although there are no opportunities on the horizon)), but the minority shareholders are unhappy with this approach, and would prefer to enjoy a more immediate benefit from the company's success in the form of higher dividends. It is quite possible that a court would refuse to interfere in what it may see as the legitimate execution of the company's long-term strategy. There is, however, a risk that it might conclude that, in the absence of any immediate acquisition plans, the minority shareholders are entitled to participate more fully in the company's current success, and that the directors are not exercising their power to recommend dividends properly.
Tips for minimising the risk
Given that there is no clear test for ascertaining whether a proposed exercise is for a proper purpose, how should a director go about minimising the risk that he might be breaching section 171?
- The first step is to remember that the duty exists. Compared to some of the other statutory duties, the duty to exercise powers for the purposes for which they are conferred receives very little coverage, and some directors may, on occasion, simply forget to consider it.
- Directors should check the wording of the provision (whether in the articles or elsewhere) which grants them the power in question, and comply with any express restrictions on the purposes for which it is to be exercised.
- When considering whether a power is subject to any implied restrictions, directors should take into account the particular balance of power in their company between the shareholders and the board. If the shareholders have always given the board free rein, that might indicate that the range of purposes for which the directors may properly exercise a power is relatively wide.
- In some (but not all) cases, it may be helpful to obtain shareholder approval in advance of a planned exercise of a power.
- Directors should document their efforts to comply with the duty. The minutes of any board meetings should contain a full explanation of the reasons behind their decision to exercise the power in question in a particular way.