Directors’ powers: The ‘proper purpose’ rule

11th February 2016

The ‘proper purpose’ rule

Section 171 of the Companies Act 2006 provides that directors may only exercise powers for the purposes for which they are conferred. That is widely known as the ‘proper purpose’ rule.

In Eclairs Group v JKX Oil & Gas [1], the directors of JKX Oil & Gas (the Company) suspected that two of its shareholders were acting in concert and planning a corporate raid. The Company had provisions in its articles which allowed directors to request information from any person interested in its shares via a disclosure notice, and to impose restrictions or suspend shareholders’ rights if such notices were not complied with. The Company issued disclosure notices to the shareholders in question, but the shareholders denied any agreement between them. The directors believed that the shareholders had failed to disclose their corporate arrangement and so the Company suspended the shareholders’ rights to vote and restricted their rights of transfer. The shareholders issued court proceedings, claiming that the directors had exercised their powers for an improper purpose. The shareholders argued that the only proper purpose for which the directors’ powers could be exercised was to extract information, but that the directors’ actual purpose in this case had been to stymie the shareholders’ rights at the Company’s forthcoming AGM.

A shield not a sword

The case went all the way to the Supreme Court, which ultimately found unanimously for the shareholders. The court noted that directors are fiduciaries and the proper purpose rule is an equitable principle which controls the exercise of their powers to shield shareholders from abuse.

Whilst there was no question that the articles did confer upon the directors the powers to suspend and limit shareholders’ rights in the event of non-compliance with a disclosure notice, the purposes of those powers were:

• to induce shareholders to comply with notices;
• to protect the Company from having to make decisions in the absence of relevant information; and
• to enable punitive sanctions to be imposed where a shareholder failed or refused to respond, on the basis that a shareholder in those circumstances should not be entitled to the benefit of its shares.

None of those purposes extended to influencing business done at an AGM. Whilst that might be a consequence of the valid exercise of the directors’ duties, directors could not properly use their powers as a defensive weapon for the direct purpose of restraining a suspected corporate raider.

Legal and practical points

It is clear from this case that:

• the exercise of directors’ powers will always be subject to the proper purpose rule;
• to determine this, the court will need to ascertain the true reason behind directors’ decisions; and
• the test is, necessarily, subjective.

However it is not entirely clear what the legal position is where members of a board have multiple purposes, some of which are proper and some of which are not. Here the Supreme Court was divided. Lords Sumption and Hodge, in the minority, considered that a ‘but for’ test of causation should be applied. Namely, one should ask whether the improper purpose really motivated the decision, i.e. ‘but for’ the improper purpose, would the directors still have exercised their powers? If not, then the decision should be set aside because any concurrent proper purposes were, effectively, irrelevant. As the majority did not adopt this approach, nor any alternative, this ‘but for’ test is not legally binding on lower courts, but it is likely to be influential.

So what does this mean for directors?

• The first hurdle which directors must overcome if they are to ensure that their decisions will stand is always to ensure that any action taken is strictly in accordance with, and within the scope of, any constitutional powers.
• If the nature or size of the business has changed since the company’s articles were adopted, it may be wise to have them reviewed to ensure that purposes for which powers may be exercised are properly understood and that the articles and powers remain relevant and sufficient.
• The purposes for which powers are given are not usually expressed. To determine this, therefore, directors should consider the mischief against which the provision is designed to protect, and the business context.
• When exercising powers, directors may wish to keep a contemporaneous note of the reason(s) behind their decision making process so that, if needed, evidence of proper purpose(s) can be adduced.

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[1] Eclairs Group Ltd and Glengary Overseas Ltd v JKX Oil & Gas plc [2015] UKSC 71