Supreme Court: Corporate Raids and the Proper Purpose Rule

17 01 2016

Eclairs Group Ltd and Glengary Overseas Ltd v JKX Oil & Gas plc [2015] UKSC 71 (2 December 2015)

In a judgment which may at first blush appear to be unremarkable, Lord Neuberger, Lord Mance, Lord Clarke, Lord Sumption and Lord Hodge held that the proper purpose rule applied to the exercise of the power conferred on the board – allowing it to issue a “restriction notice” whenever a statutory disclosure notice had been issued and had not been complied with – under article 42 of JKX’s articles of association and that the company’s directors acted for an improper purpose. Notably, section 793 of the Companies Act 2006 provides a public company the power to issue a statutory disclosure notice to any person whom it knows or reasonably believes to be interested in its shares. According to the Supreme Court, in circumstances where a company’s board of directors was entitled under the company’s articles of association to issue a disclosure notice against a shareholder and where the board was further entitled – in the event that they knew or had reasonable cause to believe that the statements given in response were incorrect – to restrict the shareholder’s right to attend or vote at any general meeting of the company, any such restriction would be invalid if the board’s purpose in making the restriction had been to prevent the shareholder voting at the meeting.

Lord Sumption gave the main judgment and Lord Hodge agreed with him. Lord Mance and Lord Neuberger agreed that the appeals should be allowed, but they preferred to not to express a view on aspects of the reasoning. Moreover, Lord Clarke agreed, but expressed a preference to defer a final conclusion on those aspects until they arise for decision and have been fully argued. Prior to this decision, the case had been reported in the Court of Appeal as [2014] Bus LR 835 and in the High Court as [2014] Bus LR 18. JKX Oil & Gas Plc, an English company listed on the London Stock Exchange, was the parent company of a group involved the development and exploitation of oil and gas reserves, primarily in Russia and the Ukraine. From that perspective, Lord Sumption used the opportunity to apply his unrivalled expertise on both company law and Russia to the present case. The exercise of a discretionary power by directors tends to be challenged on the ground that it does not promote the success of the company, a subjective question as regards the company’s business interests. However, in that regard, by providing an alternative ground of challenge under the proper purpose rule, this judgment adds to the learning on battles for control of a company where the directors have allegiance to a particular shareholder group. Lord Sumption and Lord Hodge proposed refining the law in respect of the requirements for causation as regards directors’ actions in circumstances where the board had multiple purposes, some of which were improper and some of which were not.

Overview

In introducing the appeal, Lord Sumption observed that Mann J termed the expression corporate raid as “pejorative”. But in spite of its negative connotations, his Lordship used it because it was convenient. The directors of JKX thought in 2013 that the company had been made the target of a corporate raid by Eclairs and Glengary, two companies incorporated in the British Virgin Islands. The raid involved an attempt to exploit a minority shareholding in the company with a view to obtaining effective management or voting control without paying what other shareholders would regard as a proper price.

As noted, a public company trying to resist the covert acquisition of control by raiders can issue a statutory disclosure notice calling for information about persons interested in its shares. Statutory provisions empower the court to restrict the exercise of rights attaching to shares if those interested in them fail to comply with a disclosure notice. Yet, as in this case, the articles of a public company usually empower the board to impose such restrictions. The issues thrown up by this appeal were important for companies whose articles adopted powers of this type. In summary, the appeal raised turned on:

  • The proper purposes for which the board may 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?

Lord Sumption observed that article 42 of the articles of association differed from sections 794-800 of the Companies Act 2006 by vesting the power to impose restrictions in the board rather than the court. The said article also contained a definition section spelling out the circumstances in which the board is entitled to treat a response to the notice as non-compliant. Instances of non-compliance empowered the board to restrict the exercise of rights attaching to shares and it was entitled to consider a response to a disclosure notice as non-compliant where it knew or had reasonable cause to believe that materially incorrect or false information had been provided.

JKX’s share price plummeted to low levels and the company’s troubles led its directors to believe that two British Virgin Islands’ companies, Eclairs and Glengary, had made it the target of a corporate raid. Eclairs, which beneficially owns 47 million shares amounting to 27.55% of the issued share capital of JKX, is controlled by trusts related to a prominent Ukrainian businessman Igor Kolomoisky and his associate Gennadiy Bogolyubov. Alexander Zhukov controls Glengary, which beneficially owns 19 million shares amounting to 11.45% of the issued share capital of JKX, and his right-hand man Ratskevych also has a small holding. Mann J found that both Kolomoisky and Bogolyubov were well-known corporate raiders. However, Zhukov was less reputed as a raider and JKX’s directors were of the view that he had past business dealings with Kolomisky.

Between 2010-2012, JKX’s efforts to raise capital were hampered because of political turmoil and upheaval in Ukraine. Numerous proposals made for raising capital by issuing and allotting new shares failed because Kolomoisky opposed them. Eclairs had a blocking minority and the proposals would have required shareholders’ special resolutions. In 2013, Eclairs invited JKX to convene an extraordinary general meeting to consider ordinary resolutions for the removal of the chief executive and the commercial director from the board and to appoint three new directors.

The move was thought to be the work of Kolomoisky and Zhukov; the new directors were their associates and the Ukrainian press reported that Kolomoisky was trying to take control of JKX’s principal subsidiary in Ukraine. JKX responded to the request by issuing five disclosure notices – requesting details of the number of shares held, their beneficial ownership and any agreements or arrangements between the various persons interested in them – addressed to Eclairs, Bogolyubov, Glengarry, Zhukov and Ratskevych who responded promptly admitting the existence of interests in JKX shares, but denied that they were party to any agreement or arrangement among themselves. The responses revealed that Ratskevych, a director of Eclairs, also held 5% of the shares in Glengarry. Further disclosure notices were subsequently issued.

The chief executive was re-elected at the 2013 AGM and directors’ remuneration report was approved. Moreover, three resolutions empowering the board to allot shares for cash, disapply statutory pre-emption rights upon the allotment of shares and make market purchases of the company’s shares were part of the day’s business. Eclairs subsequently published an open letter to shareholders and an advertisement in the Financial Times inviting shareholders to oppose these developments. The resolutions to authorise market purchases and to disapply pre-emption rights were certain to fail because a special resolution was required but the other resolutions only required an ordinary resolution, which would be hard to get through because of opposition from two powerbrokers in the company who together controlled 39% of its shareholding.

The responses to the disclosure notices were considered inadequate because the directors believed that the addressees involved in were agreements or arrangements that they had not disclosed. The directors resolved to issue restriction notices under powers conferred on the board as regards the 47 million shares in which Eclairs was interested and the 19 million shares in which Glengary was interested. The effect of the restriction notices was to suspend the right to vote at general meetings attaching to these shares and to restrict the right of transfer. The restriction notices were challenged in separate proceedings in the Chancery Division and the grounds were rejected but one of them made it to the Supreme Court, namely that the board acted for a collateral, and therefore improper, purpose. Undertakings given by JKX on the day meant that the votes attaching to the 47 million and 19 million shares were cast on the resolutions without prejudice to their validity.

Proceedings Below

Under the proper purpose rule in section 171(b) of the Companies Act 2006 a director must “only exercise powers for the purposes for which they are conferred” and when the restriction notices were challenged Mann J held that the board’s decision was invalid because the power in 42 power was only exercisable to provide an incentive to remedy the default or a sanction for failing to do so. Although the board had reasonable cause to believe that there was an agreement or arrangement between the addressees, its real purpose was to influence the fate of the resolutions at the AGM. Mann J found that four of the six directors (who apparently gave evidence out of a total of seven) were concerned only with the effect of the restriction notices on the outcome of the general meeting. They acted for an improper purpose.

Holding that 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 on the exercise of their rights, the Court of Appeal allowed the appeal by a majority. Longmore and Sir Robin Jacob and Briggs LJJ (dissenting) held that the application of the rule was inappropriate in the course of a battle for control.

The Supreme Court

The court found it uncontroversial that company directors are fiduciaries and are thus generally obliged to exercise all of the powers bestowed upon them in that capacity for a proper purpose. Yet the finer points made by the justices and their indulgence in Commonwealth jurisprudence will no doubt be doubly interesting to those who study company law and the court.

(i) Lord Sumption

Embarking on a detailed analysis of the proper purpose rule, in a judgment perhaps endorsing orthodoxy, his Lordship said that the rule corresponded to the well-known equitable rule applicable to the exercise of discretionary powers by trustees. He noted that in Balls v Strutt (1841) 1 Hare 146, Sir James Wigram V-C underlined the principle that “that a trustee shall not be permitted to use the powers which the trust may confer upon him at law, except for the legitimate purposes of the trust.” Lord Sumption held at para 14 et seq that proper purpose rule is concerned with abuse of power: a company director must not, subjectively, act for an improper reason. He noted that the rule originated in the inappropriately named equitable doctrine of “fraud on a power”.

In the Privy Council case of Vatcher v Paull [1915] AC 372, Lord Parker of Waddington opined that the principle has nothing to do with fraud and held that “it merely means that the power has been exercised for a purpose, or with an intention, beyond the scope of or not justified by the instrument creating the power.” Centrally, the present case was not concerned with excess of power by doing an act beyond the scope of the instrument creating it as a matter of construction or implication. Instead, it was concerned with abuse of power, by doing acts falling within its scope but done for an improper reason and Lord Sumption quoted Viscount Finlay’s remarks in Hindle v John Cotton Ltd (1919) 56 Sc LR 625, 630, that “where the question is one of abuse of powers the state of mind of those who acted, and the motive on which they acted, are all important.”

Lord Sumption said that even though a company director differs from an express trustee in having no title to the company’s assets, he is surely a fiduciary and has always been treated as a trustee but the exercise of his powers is limited to the purpose for which they were conferred. He found that to prevent the use of the directors’ powers for the purpose of influencing events at a general meeting is one of the commonest applications of this norm of company law. To manipulate the outcome of a general meeting not only constitutes an abuse of a power for a collateral purpose but also offends the constitutional distribution of powers between the different organs of the company – the underlying reason being that such a strategy involves using the board’s powers to control or influence a decision that is assigned to the general body of shareholders by the company’s constitution.

The court analysed influential case law from the High Court of Australia such as Mills v Mills (1938) 60 CLR 150 and Whitehouse v Carlton House Pty (1987) 162 CLR 285. In Mills, Dixon J pointed out the difficulties linked with too rigorous an application of the public law test to the decisions of directors. He opined that applying the general equitable principle to the acts of directors managing a company’s affairs “cannot be as nice as it is in the case of a trustee exercising a special power of appointment” and the court held that where the main purpose of the directors’ resolution (to increase the share base in this case) is to benefit the company it matters not that it incidentally also benefits a director. Lord Sumption approved of the “right” judicial approach in these cases and found it to be “consistent with the rationale of the proper purpose rule” which chimed with the position taken by the courts of equity about the exercise of powers of appointment by trustees in cases such as Birley v Birley (1858) 25 Beav 299, Pryor v Pryor (1864) 2 De G J & S 205, Roadchef (Employee Benefits Trustees) Ltd v Hill [2014] EWHC 109 (Ch). Lord Sumption, with whom Lord Hodge concurred, went on to hold that where the directors have multiple concurrent 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.

After looking at nineteenth century case law, such as Fraser v Whalley (1864) 2 H & M 10 and some other cases, he noted that in more recent times Buckley J held in Hogg v Cramphorn Ltd [1967] 1 Ch 254 that the directors’ powers to issue shares could not properly be exercised for the purpose of defeating an unwelcome takeover bid, even if the board was genuinely convinced that the continuance of its own stewardship was in the company’s interest. So the company’s interest was an additional and not an alternative test for the propriety of a board resolution. Lord Sumption found at para 24 that in Howard Smith Ltd v Ampol Petroleum Ltd [1974] AC 821 Lord Wilberforce held that but for their desire to convert the majority shareholders into a minority, the directors would not have sought to raise capital by means of a share issue, nor at that point of time.

Pointing out that the rule is not a term of the contract of association (of which the articles are of course a part) and does not necessarily depend on any limitation on the scope of the power as a matter of construction, Lord Sumption rejected JKX’s unwieldy arguments about efficacy and held:

30. … 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 examining the architecture of article 42, Lord Sumption generally approved of Mann J’s treatment of it but refined the analysis by discerning that article 42 shares three intertwined purposes (and all of them directly related to the non-provision of the details demanded by a disclosure notice). It induces the shareholder to comply with a disclosure notice. It intends to protect the company and its shareholders against having to make decisions about their respective interests in ignorance of relevant information. And the restrictions envisaged by it have a punitive purpose, i.e. where requested information is not supplied, sanctions are imposed on account of the addressee’s failure to comply with a disclosure notice (with the consequence a person interested in shares is disentitled from the rights attaching to them). Roundly rejecting the argument that unless the addressee of a disclosure notice put his “cards on the table” the directors were free to treat the restrictions as a free-standing technique for frustrating the raiders’ plans, Lord Sumption said:

33. … 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.

His Lordship considered, at para 35 et seq, the applicability of the proper purpose rule and he found that it applies to article 42. He made two preliminary observations. First, that the restrictions imposed pursuant to article 42 amount to a serious interference with financial and constitutional rights which exist for the benefit of the shareholder and not the company. Given that the interference caused by a restriction notice to a listed company such as JKX impacted the proper operation of the market in its shares (in which there is a significant public interest), Lord Sumption expected “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.” Second, his Lordship held that 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. “These considerations are particularly important when the company is in play between competing groups seeking to control or influence its affairs,” said Lord Sumption at para 37. For him, a battle for control of the company is probably the context where the proper purpose rule has the most valuable part to play.

Lord Sumption considered that the proper purpose rule applied and remained highly sceptical of the approach adopted by the majority in the Court of Appeal, which he found “as contrary to principle”. He considered an examination of the directors’ state of mind to be important in a rapidly fluctuating situation like a takeover bid or an attempted raid and found that court proceedings initiated a day before the AGM had sufficiently safeguarded the parties’ interests. His Lordship was happy with the way things had been procedurally handled in this case and was confident that the Chancery Division’s learned judges would respond diligently if they were called upon to fast-track proceedings pursuant to the tight deadlines under the City Code on Takeovers and Mergers.

He rejected, at para 39, the argument – one the Court of Appeal had accepted – that the power to impose restrictions under article 42 was not a “unilateral” power because the addressees of the disclosure notices had only to answer the questions fully and truthfully to bring the restrictions to an end. He went on to hold that the limitation of the power to its proper purpose derived from its fiduciary character. If its exercise would otherwise be an abuse, it could not be an answer to say that the person against whom it was directed had only himself to blame. Moreover, that proposition assumed that that person was the only one whose interests were adversely affected. But that was not right: other shareholders who agreed with that person would be deprived of his support.

(ii) The Other Justices

Lord Hodge concurred with Lord Sumption’s denouement that in circumstances where the directors have multiple concurrent 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 Neuberger, Lord Mance and Lord Clarke concurred that the appeals should be allowed, but their Lordships declined to express a concluded view on the application of a “but for” test to the proper purpose rule. Lord Mance agreed with Lord Sumption’s reasoning in allowing the appeal. In a brief judgment, his Lordship shed some light on the proper purpose rule as it was raised in the context of this appeal. First of all, the eminent jurist was keen to have submissions on the scope of the duty under section 171(b). Moreover, regardless of the scope, he did not fully concur with Lord Sumption’s para 24 interpretation about what Lord Wilberforce had meant in Howard Smith and he explained:

53. … In these circumstances, although I have 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, I am not persuaded that we can or should safely undertake what all parties consider would be “a new development” of company law, without having heard argument.

Drawing an analogy with the public law test and the approach taken by May LJ in Smith v North East Derbyshire Primary Care Trust [2006] 1 WLR 3315, (quoted by Lord Neuberger in R (FDA) v Secretary of State for Work and Pensions [2012] EWCA Civ 332), Lord Mance also pointed out that thought needed to be given the standard to which the directors would have to show that they would have reached the same decision, even if they had not had the illegitimate purpose in mind. His Lordship asked whether probability would suffice or would the tests be whether their decision would inevitably have been the same?

Comment

Clearly, Lord Sumption’s elevation to the Supreme Court was founded on delivering exacting chancery judgments such as the present one. However, despite his Lordship’s prowess in such matters his tenure as a justice of the Supreme Court has been marred by views that aim to justify gender inequity in the law courts. Moreover, he is also seen as somewhat of a pariah when it comes to the subject of human rights. More judges like him can only please the likes of David Cameron whose crusade against human rights law has made the UK, the home of Magna Carta and Mill, a global laughing stock. (See, for example, my own critique of a dissenting Lord Sumption overpaying respect to the executive in Tigere v Secretary of State for Business, Innovation and Skills [2015] UKSC 57, a recent case where the majority of the court repudiated the principle that settlement rights must underpin access to student loans.)

On the other hand, in the context of the instant case, Lord Sumption flexed his powerful mental muscles to restate the weight and relevance of the proper purpose rule in company law and the Supreme Court took the opportunity to impart valuable guidance on the circumstances in which the presence of an improper purpose will be sufficient to spoil and impair the efficiency of a decision.

Yet, as seen by the approach espoused by the majority of the justices, the riddles and challenges of this genre of law cannot be solved by a single judgment of the Supreme Court. To identify the purpose for which a power is actually being exercised is not always easy and requires an examination of the state of mind of the directors each one of whom may have a different purpose. Indeed, some among them will have more than one purpose and issues are thrown up as to the ability of shareholder activists to prod official decision-making as regards any non-recorded purpose. In the present case, four out of seven directors acted to their personal advantage not connected to the extraction of information and were not inclined to protect the company pending the provision of the information.

Outside the dull world of corporate law, on the larger social question of gender and the law, Lord Sumption does not want gender equality in UK judiciary to be prioritised or rushed. Instead, he fears that initiatives favouring women could be off-putting for talented male candidates because (or so he claims) female lawyers are less willing to accept long hours. Charlotte Proudman, the barrister who made huge headlines last year for fighting sexist objectification on Linkedin by a senior male colleague, hit back at his dubious (arguably sinister) views by arguing that only quotas can challenge male privilege. For her, Sumption encapsulates the law’s sexism and only quotas can challenge the existing situation. She also excoriated him for the fact that his father got him a pupillage using influence: “string-pulling” by his father as he himself admits. And from that angle, he is clearly a “raider” in the Supreme Court who has been elevated to the rank of a justice on the basis of “pale, male and stale” privilege rather than decades of hard labour on the benches like other judges who have toiled to uphold the rule of law.

Unsurprisingly, the court’s deputy president Lady Hale could only agree with Proudman about the extent of male domination in the legal profession. The Supreme Court’s only female judge, who is an international role model and who unlike Lord Sumption is generally considered someone who speaks for the downtrodden, remonstrated that the court should be “ashamed” if radical improvements to its diversity in the next round of judicial appointments are not made. Of course, I totally agree with her Ladyship!


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20 02 2016
Loss of Habitual Residence: Legal Limbo and the Modern Law | United Kingdom Immigration Law Blog

[…] there. I must say that for once – see my earlier reservations about his judicial methods here and here – even I must agree with Lord Sumption. Though he did not say it, his critique of Lord Wilson’s […]

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