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. 


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Mihir Naniwadekar

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