Supreme Court: not enough for directors to use powers 'honestly' or 'in good faith'

Out-Law News | 04 Dec 2015 | 4:29 pm | 4 min. read

Directors of a publicly-listed gas exploration company were not entitled to impose voting restrictions on certain shareholders which had failed to comply with statutory disclosure notices, the UK's highest court has ruled.

The directors had been concerned that the company, JKX Oil and Gas (JKX), was the subject of a "corporate raid' by a group of minority shareholders, which the court heard had been attempting to exploit their stake in the company in order to obtain effective management and voting control. However, the Supreme Court ruled that this was not a 'proper purpose' allowing the board to restrict the shareholders' rights.

"The judgment highlights the importance of directors exercising their powers for a 'proper purpose', especially in the exercise of draconian powers, such as the power to unilaterally impose restrictions on voting rights," said commercial litigation expert Richard Twomey of Pinsent Masons, the law firm behind Out-Law.com. "In other words, it is not enough for directors to act honestly or in good faith. They must also act in the best interests of the company for the benefit of its members as a whole."

"The Supreme Court drew the limits of what might comprise a 'proper purpose' fairly widely - more widely than the judge at first instance had done. What the court did not consider proper was the situation it found in this case: where the power had been used by directors to influence the outcome of the AGM, essentially using directors' powers to transfer power from shareholders to the board," he said.

The so-called 'proper purpose' rule was introduced in 2006 by way of the 2006 Companies Act. It requires a director to "only exercise powers for the purposes for which they are conferred". The rule is substantially the same as the equitable rule applied by the courts to the exercise of discretionary powers by trustees, according to Lord Sumption in his leading Supreme Court judgment.

One of the most common applications of the proper purpose rule in company law is to prevent directors from using their powers to influence the outcome of a general meeting. However, this leads to difficulties where directors use their powers for multiple purposes, "all influential in different degrees but some proper and others not", Lord Sumption said.

The 2006 Companies Act gives public companies the right to issue a disclosure notice to any person that it knows or reasonably believes to be interested in its shares. The notice may require that person to disclose whether there is and the nature of such an interest, and whether the persons interested have formed an agreement to acquire interests in shares or the ability to exercise any rights conferred by holding those shares. Failure to comply with a disclosure notice may result in the court restricting the exercise of rights conferred by those shares.

In this case, JKX's board of directors had corresponding powers to issue a 'restriction notice' whenever a statutory disclosure notice had been issued and not complied with. These powers were set out in the company's articles of association. The board was entitled to exercise these powers unilaterally, without having to go to court as it would be required to do when exercising its statutory powers.

The High Court had previously established three 'proper purposes' for which these powers could be used: 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 for punitive reasons. These three purposes were all "directly related to the non-provision of information" required in response to the notice, but did not extend to influencing the outcome of the resolutions at a general meeting, Lord Sumption said.

"That may well be a consequence of a restriction notice," he said. "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."

Treating voting restrictions as "a free standing technique for frustrating the raiders' plans" for as long as the information was withheld would "[extend] the purpose of a restriction notice beyond its proper limits", the judge said.

"It treats failure to comply with a disclosure notice as no more than a 'gateway' or condition precedent to the directors' right to impose and maintain the restrictions for any purpose which they bona fide conceived to be in the interests of the company, including securing their preferred outcome at the AGM," he said.

"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 [the company's articles of association]. They are matters for the shareholders, not for the board," he said.

"It was significant in this case that JKX's articles had been amended to enable the board to impose restrictions directly, rather than requiring the company to apply to the court first, which is the starting point under the 2006 Companies Act," said commercial litigation expert Richard Twomey. "This enabled the board to move quickly in the days preceding the AGM."

"One other question that arose but was not decided is whether a decision taken for an improper purpose should be set aside if the board would nevertheless have reached the same decision if it had acted for a proper purpose. Although two judges agreed with that proposition, the remainder of the Supreme Court reserved judgment until the precise case came before them," he said.