Directors: Proper Purpose Test

This explored the principle that directors can only exercise powers for the purposes for which they are conferred,[i] i.e. the “proper purpose test” (section 171 (b)).

Background

In 2013, the directors of JKX Oil & Gas Plc (“JKX”), an English company listed on the LSE with oil and gas concessions in the Ukraine believed that it had become the target of a “corporate raid” by two minority shareholders, which together owned around 40% of the company’s share capital: Eclairs (controlled by trusts associated with Igor Kolomoisky and by Gennadiy Bogolyubov) and Glengary (controlled by Alexander Zhukov and Mr Ratskevyich). They opposed the board’s proposals to issue additional capital and disapply pre-emption rights, and wanted to remove the Company’s chief executive and commercial director from office.

The board of JKX fought back by convening an AGM, and issuing statutory disclosure notices under Part 22 of the Act. Ahead of the meeting the directors wrote to Eclairs and Glengary under article 42 of JKX’s articles, (based on section 793 of the Companies Act 2006). Article 42 allowed the board to seek disclosure from shareholders of any voting arrangements affecting shares in the company, and to issue “restriction notices” suspending shares from voting if the board considered there were reasonable grounds for believing the replies to be inaccurate.

The board requested information from each about the number of shares held, their beneficial ownership, and any agreements or arrangements between the persons interested in them. The shareholders’ replies to these notices denied any such arrangement. The board regarded this as unsatisfactory, and under JKX’s Articles of Association imposed restrictions over the shares of Eclairs and Glengary. This suspended their right to vote at general meetings and restricted their right to transfer the shares.

Eclairs and Glengary then issued proceedings, claiming that their suspensions and disenfranchisement were unlawful.

Earlier Decisions

At the original trial, Eclairs and Glengary won. They successfully argued that the JKX directors had acted improperly and broke the proper purposes principle by acting predominantly for the improper collateral purpose of preventing the shareholders from voting at the AGM. Mann J found

• it was irrelevant that the directors had honestly believed themselves to be acting in the Company’s best interests.
• as a fact, that the JKX board in removing the votes of Eclair and Glengary intended to influence the outcome of the forthcoming AGM.

The Court of Appeal (Briggs L.J. dissenting) however, decided that the proper purposes principle had no application in the context of restriction notices under section 793 or (by extension) article 42. This finding was reversed by the Supreme Court.

Supreme Court

All five of Supreme Court judges agreed that

• the proper purposes rule applied to the exercise of the power under article 42.
• the directors of JKX had acted for an improper purpose
• the disenfranchisement was invalid

The Supreme Court’s judgment reaffirms the fundamental importance of the proper purposes rule in company law, being the principal means by which equity enforces directors’ proper conduct and is crucial to the distinction between boards and shareholders.

However, three of the Supreme Court judges declined to give an opinion regarding the proper purpose test in less clear cut cases. For example where directors have mixed, or more than one purpose there was no decision on whether the statutory duty incorporates a principal, or primary purpose test, and whether or not a “but for” test in granting relief should equally apply. All agreed that would be a new development in company law.

Action Points

1. The case gives valuable guidance on when the presence of an improper purpose is sufficient to invalidate a decision by the directors.
2. It is common to assume that the court won’t interfere with directors’ decisions within the range of decisions which directors could make, acting reasonably. This case however, emphasises that directors must, in reaching their decision, not subjectively act for an improper purpose
3. It confirms that in exercising their powers, directors must consistently act in the best interests of the company.
4. This will lead to a debate where there may be mixed reasons for directors making a decision, some proper and some questionable.
5. For practical governance, the judgment underlines that directors should keep a clear record of the decision-making processes in case this is subject to judicial scrutiny.

Paul Sykes is a Director in our Disputes Management department. For further information regarding directors contact Paul.Sykes@lf-dt.com