Although the Supreme Court decided that the proper purpose rule applied to an article provision which imposed restrictions, there was no unanimity on the appropriate test that should be applied in identifying whether or not directors acted for a proper purpose within the powers conferred on them, particularly where multiple purposes were involved
Part 22 of the Companies Act 2006 (“CA 2006”) is concerned with information about interests in a company’s shares. The purpose of Part 22 CA 2006 is to seek information about a person’s ‘interest’ in the company’s shares, whether past or present: Re TR Technology Investment Trust plc  BCLC 256. Sections 793-797 CA 2006 allow a company to issue a statutory disclosure notice requiring information about persons interested in a company’s shares. Part 22 CA 2006 also empower the court to restrict the exercise of rights in shares where there is non-compliance in providing the requisite information. JKX Oil & Gas plc had a provision under its articles of association in the form of Article 42 (“Article 42”), which empowered the board of directors (instead of the court under Part 22 CA 2006) to impose such restrictions where a statutory disclosure notice had not been complied with. Article 42 provided that the board was entitled to treat a response to a disclosure notice as non-compliant where it knew or had reasonable cause to believe that the information provided was false or materially incorrect.
JKX’s directors believed that the company had become the target of a corporate raid (an attempt to exploit a minority shareholding in a company to obtain effective management or voting control without paying what other shareholders would regard as a proper price) by two minority shareholders, Eclairs and Glengary. JKX issued disclosure notices requesting information from Eclairs and Glengary about the number of shares held, their beneficial ownership, and any agreements or arrangements between the persons interested in them. Subsequently at a board meeting, JKX’s directors considered that there were agreements or arrangements between the addressees of the disclosure notices which had not been disclosed in the responses. The board resolved to exercise powers under Article 42 by issuing restriction notices in relation to the shares held by Eclairs and Glengary. This had the effect of suspending their right to vote at general meetings and restricting the right of transfer of shares.
The restriction notices were challenged by Eclairs and Glengary who relied on the proper purpose rule under s.171(b) CA 2006, which provides that a director must only exercise powers for the purposes for which they were conferred. At first instance, Mann J held that the board’s decision was invalid. The power conferred by Article 42 could be exercised only 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 arrangement or agreement between Eclairs and Glengary, the board’s purpose was to influence the fate of the resolutions at the AGM. The Court of Appeal, however, allowed the appeal by a majority. It held 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, and because the application of the rule was inappropriate in the course of a battle for control. Eclairs and Glengary appealed to the Supreme Court.
The Supreme Court allowed the appeal. It held that the proper purposes rule applied to the exercise of power by directors under Article 42, and that the directors of JKX had acted for improper purposes. Although the main judgment was given by Lord Sumption (with whom Lord Hodge agreed), the other Law Lords had some reservations on some aspects of the proper purpose rule identified by Lord Sumption, and preferred to defer their views and opinions for another subsequent case on this issue.
Origins of the Proper Purposes Rule
The early origins of the proper purposes rule had its roots in equity and its application to trustees with discretionary powers given under a trust. A trustee was not permitted to use the powers which the trust conferred upon him at law except for the legitimate purposes of the trust. The trustee was required to act bona fide and in the best interests of the trust: Balls v Strutt (1841) 1 Hare 146. In equity, the doctrine was known as “fraud on the power”, and the Chancery Courts attached consequences of fraud to acts which were honest and unexceptional at common law, but unconscionable under equitable principles. Equity would intervene and set aside dispositions under powers conferred by trust deeds if, although within the language conferring the power, they were outside the purpose for which they were conferred: Lane v Page (1754) Amb 233; Aleyn v Belchier (1758) 1 Eden 132. Equity did not require the proof of any fraud to intervene in cases dealing with proper purposes: Vatcher v Paull  AC 372.
Modern View of the Proper Purpose Rule
The fiduciary duty of directors to ensure that they exercise their powers for proper purposes has been codified under s.171(b) CA 2006, which requires that a company director must “only exercise powers for the purposes for which they were conferred”. This section is based on certain common law rules and equitable principles as they apply to directors and have effect in place of those rules and principles as regards duties owed to a company by a director: s.170(3) CA 2006. Further, this duty is to be interpreted and applied in the same way as the common law rules or equitable principles, and regard shall be had to the corresponding rules and equitable principles in interpreting and applying the general duties: s.170(4) CA 2006.
The proper purpose rule is not concerned with excess of power by doing an act which is beyond the scope of the instrument creating it as a matter of construction or implication. It is concerned with an abuse of power by directors – by doing acts which are within the scope of authority but carried out for an improper reason. The exercise of directors’ powers are limited to the purpose for which they were conferred. For example, an abuse of directors’ powers would apply where the directors attempted to influence the outcome of a general meeting. This would be an abuse of power for a collateral purpose. It would also offend the constitutional distribution of powers between the different organs of the company, because it involves the use of the board’s powers to control or influence a decision, which the company’s constitution assigns to the general body of shareholders: Fraser v Whalley (1864) 2 H & M 10; Anglo-Universal Bank v Baragnon (1881) 45 LJ 362; Hogg v Cramphorn Ltd  1 Ch 254.
According to Lord Sumption, although a company’s articles of association are part of the contract of association, to which successive shareholders accede on becoming members of the company, a term limiting the exercise of powers conferred on directors to their proper purpose may sometimes be implied on the ordinary principles of law governing the implication of terms. However, this was not the basis of the proper purpose rule. The rule was not a term of the contract and did not necessarily depend on any limitation on the scope of the power as a matter of construction. The proper purpose rule was a principle by which equity controlled the exercise of the fiduciary powers in respects which were not or not necessarily determined by the instrument. Ascertaining the purpose of a power where the instrument was silent depended upon an inference from the mischief of the provision conferring it, which was itself deducted from its express terms, from an analysis of their effect and from the court’s understanding of the business context.
The purpose of a power conferred by a company’s articles was rarely expressed in the instrument itself – but it was obvious from its context and effect why a power had been conferred.
On the facts, Lord Sumption was of the view that the purpose of Article 42 was threefold:
- To induce the 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.
- The restrictions had a punitive effect – they were 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 persisted, on the footing that a person interested in shares who had not complied with obligations attaching to that status should not be entitled to the benefits attaching to the shares.
These three purposes were all directly related to the non-provision of information requisitioned by the disclosure notice. The imposition of the restrictions under Article 42 was a serious interference with the financial and constitutional rights which existed for the benefit of the shareholder and the company.
According to Lord Sumption, the rule that the fiduciary powers of directors may be exercised only for the purposes for which they were conferred was one of the main means by which equity enforced the proper conduct of directors. It was also fundamental to the constitutional distinction between the respective domains of the board and the shareholders. These considerations were particularly important when the company was in play between the competing groups seeking to control or influence its affairs.
Lords Neuberger, Mance and Clarke agreed that the appeals should be allowed, but declined to express a concluded view on some of the issues raised by Lord Sumption. Lord Mance believed that the restriction notices were issued for the principal purpose of improving the prospects of passing at the forthcoming AGM two special resolutions to authorise market purchases and to disapply the pre-emption rights.
On the interpretation of s.171(b) CA 2006, Lord Mance was of the view that the purpose had to be a legitimate one for it to be a proper purpose. However, further clarity was required as to the scope of the duty under s.171(b) CA 2006.
Tests for Determining “Proper Purpose”
Although their Lordships were in agreement on the nature and context of the proper purpose rule and its application to Article 42, there was neither consensus nor agreement on the test that should be applied in identifying whether or not the powers exercised by the directors were for proper purposes. A majority of their Lordships preferred to defer a decision as to the test to be applied until a subsequent case in this area.
The issue is further compounded by the fact that there may be multiple purposes which directors have in mind in exercising their powers under s.171(b) CA 2006 – some may be for proper purposes while others may be improper. The issues for consideration have been: which purpose should prevail; and what should be the test?
Set out below are various tests that may be associated with the proper purpose rule and its application to directors in company law.
According to the Supreme Court, the test to be applied for determining whether the directors acted for proper purposes was subjective: the state of mind of those who acted, and the motive on which they acted were all important aspects for consideration: Hindle v John Cotton Ltd (1919) 56 ScLR 625.
The “Trusteeship” Test
A test which has previously been applied by the Chancery Courts has been to consider directors’ duties as similar or analogous to those of a trustee. The courts have adapted this trusteeship principle to apply to directors in the company law sphere, particularly in respect of the exercise of discretionary powers by trustees under the trust instrument and its analogy with directors’ powers under the proper purpose rule. This would have some support particularly when considered against the background and origins of the proper purpose rule. However, in Mills v Mills (supra), Dixon J stated that the application of trusteeship principles to directors was not the same or analogous to those that applied to a trustee of a trust instrument.
Bona Fide Test
Under this test, the courts are reluctant to be involved in management issues as directors are best placed to decide what is in the best interests of the company as a whole. The courts prefer not to “second-guess” directors’ decisions. However, where powers are usurped for improper purposes the courts have intervened to prevent power manipulation by the board. A test that has previously applied in identifying what are the proper purposes for which the directors’ powers are exercised has been to consider whether the directors acted honestly and bona fide when exercising the power. In Harlowe's Nominees Pty. Ltd. v. Woodside (Lakes Entrance) Oil Co. N.L. (1968) 121 C.L.R. 483, an issue of shares was made to a large oil company in order to secure the financial stability of the company. This was upheld as being within the power conferred on directors, although it had the effect of defeating the attempt of the claimant to secure control by buying up the company's shares. The Australian High Court stated that the ultimate question must always be whether in truth the power which was exercised by the directors was made honestly in the interests of the company: “Directors in whom are vested the right and the duty of deciding where the company's interests lie and how they are to be served may be concerned with a wide range of practical considerations, and their judgment, if exercised in good faith and not for irrelevant purposes, is not open to review in the courts”.
However, subsequent cases have shown that honesty and bona fide aspects in the decision making process are not sufficient to demonstrate that directors exercised their powers for proper purposes. In Hutton v West Cork Railway Company (1883) 23 ChD 654, Bowen LJ stated that bona fides could not be the sole test “otherwise you might have a lunatic conducting the affairs of a company, and paying away its money with both hands in a matter perfectly bona fide yet perfectly irrational”. See too Howard Smith Ltd v Ampol Petroleum Ltd  AC 821.
Public Law Test
One test that could be used to identify proper purposes is to adapt the public law principles for company law. Accordingly, a decision which has been materially influenced by a legally irrelevant consideration should generally be set aside, even if legally relevant considerations were more significant: R (FDA) v Secretary of State for Work and Pensions  1 WLR 444; and Smith v North East Derbyshire Primary Care Trust  1 WLR 3315. Although such public law test has not been applied in the context of directors’ duties, there was a suggestion by Dixon J in Mills v Mills (1938) 60 CLR 150 that the public law test may be applied in the context of company law.
Directors’ decisions may generally be set aside only if the primary or dominant purpose for which it was made was improper. This is because the courts of equity are concerned to uphold the integrity of the decision making process, but also to limit its intervention in the conduct of the company’s affairs to cases in which an injustice has resulted from the directors having taken irrelevant considerations into account.
The court will compare the relative significance of different considerations which influenced the directors in arriving at their decision. However, in determining what is the “primary” or “dominant” purpose and how this is identified, the court may consider what was the “weightiest” purpose – one about which the directors felt most strongly. According to Lord Sumption, this test would be difficult to justify because it would involve a forensic inquiry into the relative intensity of the directors’ feelings about the various considerations that influenced them.
Further, the test is also met with a fundamental point of principle. Under s.171(b) CA 2006, the directors must exercise their powers “only” for the purposes for which they were conferred. The duty is broken if they allow themselves to be influenced by any improper purpose.
“Moving Cause” Test
The issue for determination here is which considerations led the directors to act as they did (ie. The “moving cause”)? In this regard, the court may have regard to the “moving cause” of the decision: Hindle v John Cotton; Mills v Mills, supra. However, this test may not assist where the board was concurrently moved by multiple causes – some proper and others improper.
According to Lord Sumption, the focus should be on identifying the improper purpose and ask whether the board decision would have been made if the directors had not been moved by it. If the answer is that without the improper purpose(s), the decision impugned would never have been made, then it would be irrational to allow it to stand simply because the directors had other, proper considerations in mind, to which they attached greater importance: Mills v Mills, supra. However, if there were proper reasons for exercising the power, and it would still have been exercised for those reasons even if the absence of improper ones, the decision may be a valid one and not one that would be set aside.
In formulating the “but-for” test, Lord Sumption gave weight to the High Court of Australia decision in Whitehouse v Carlton House Pty (1987) 162 CLR, namely, that regardless of whether the impermissible purpose was the dominant one or but one of a number of significantly contributing causes, the allotment will be invalidated if the impermissible purpose was causative in the sense that, but for its presence, the power would not have been exercised. Lord Sumption thought that this was consistent with the rationale of the proper purpose rule, and which corresponded with the view of the court of equity about the exercise of powers of appointment by trustees.
Lord Mance thought that further consideration needed to be given on the test for determining the proper purpose. The test may involve a director exercising his powers primarily or substantially only for the purpose for which they were conferred. Alternatively, further consideration would need to be given to Lord Sumption’s proposed test which was to treat s.171(b) CA 2006 as requiring a director’s power to be used “with an entire and single view to the real purpose and object of the power”, by assimilating a director’s power in this respect with the exercise of discretionary powers by trustees. Although Lord Sumption relied on the dictum of Dixon J in Mills v Mills to some extent, but Dixon J did not necessarily consider the powers of directors and directors to be analogous. Dixon J thought that consideration should be given to the substantial object the accomplishment of which formed the real ground of the board’s action. If this was within the scope of the power, then the power had been validly exercised.
Although Lord Mance had sympathy with Lord Sumption’s view that the “but for” causation offered a single test which it might be possible or preferable to substitute for references to the principal or primary purposes, he was not persuaded that it should be undertaken as this would be a new development of company law.
On Lord Sumption’s view in the difficulties of identifying the primary or substantial purpose, Lord Mance considered that the difficulties would also be prevalent in the “but for” test. It was just as likely to give rise to artificial and defensive attempts to justify what was done. The principal or primary purpose in mind would be likely to be easier to identify, since it was likely to be reflected in directors’ exchanges before and at the time of the decisions under examination, than the answer to a question whether they would have acted as they did taking into account their main expressed purpose. They will have been less likely to have directed express attention to this.
Lord Mance also stated that if the “but for” test were to be adopted, attention should be given to the standard to which the directors (on whom the onus would lie) would have to show that they would have reached the same decision even if they had not had the illegitimate purpose in mind. It was unclear whether probability would be enough to satisfy this test or whether the test should be that the decision would inevitably have been the same.
- If a power has been validly exercised for the purpose(s) for which it was conferred, this is a proper exercise of power by the directors and in compliance with the statutory duty under s.171(b) CA 2006.
- If a power has been exercised for an improper purpose, contrary to the purpose for which it has been conferred, the court will intervene and may declare this to be an abuse of power or authority.
- JKX’s case failed on the basis that Article 42 was exercised for improper purposes and an abuse of the directors’ powers. But would the board have reached the same decisions even if they had not taken account of the impact of the restriction notices on the resolutions at the AGM? At first instance, Mann J thought that the board would inevitably have reached the same conclusions even if they had confined themselves to the proper purposes of inducing the addressees of the disclosure notices to comply with them, and imposing sanctions on their failure to do so. Lord Sumption thought that on that hypothesis, it would have been difficult to regard the impact on the resolutions as a primary consideration. The lack of information would have been a sufficient justification of the restrictions and the resolutions would have been irrelevant as no more than a welcome incidental consequence. JKX however did not contest its case on the basis of the hypothesis set out by Mann J. JKX’s case was that once the corporate raiders had failed to provide the information, the power to make a restriction order could properly be exercised for the purpose of defeatin their attempt to influence or control the company’s affairs, provided that this was conceived in good faith to be in the company’s interests. JKX’s case should not have addressed the desire to defeat the raiders but one of imposing restrictions for want of information.
- Although we now have clarification as to what is meant by proper purposes and its relationship to the scope of authority and powers, the Supreme Court was unable to agree in identifying the test to be applied in determining whether or not directors exercised their powers for proper purposes. The law is still not clear on the actual test that should be applied in these circumstances. This aspect has been left for further debate and discussion for a subsequent case addressing this point in the future.
- Consideration should be given to ss.170(3) and 170(4) CA 2006. Section 170(3) provides that the general duties of directors (including the proper purpose rule under s.171(b) CA 2006 is based on certain common law rules and equitable principles as they apply to directors and have effect in place of those rules and principles as regards duties owed to a company by a director: s.170(3) CA 2006. Further, this duty is to be interpreted and applied in the same way as the common law rules or equitable principles, and regard shall be had to the corresponding rules and equitable principles in interpreting and applying the general duties: s.170(4) CA 2006. The courts can therefore have regard to previous cases and developments at common law and equity in interpreting the proper purpose rule and its particular application to company law. For example, the courts may adapt and develop principles relating to trustees exercising discretionary powers under the trust instrument, as such principles may apply to directors exercising their powers for proper purposes. Previous cases have demonstrated that directors may be considered as trustees for the company and its shareholders collectively: Re Forest of Dean Coal Mining Co (1878) 10 Ch D 450. This “trusteeship” principle may be appropriately applied to directors’ general duties because ss.170(3) and (4) permit such applications and developments to apply in these circumstances.
- Proper consideration was not given to the leading Privy Council decision in Howard Smith Ltd v Ampol Petroleum Ltd  AC 821. This case was concerned with attempts by directors to prevent a taleover. The directors contended that the only proper purpose for which the power was being exercised was to raise new capital and to issue new shares. The Privy Council held that the power to raise capital and to issue shares was used for the predominant purposes of defeating a takeover by the directors. The decision concerning the takeover was a matter for the shareholders to decide. Lord Wilberforce applied the “primary purpose” test. The starting point was to look at the power whose exercise was in question. A wider investigation as to the facts would need to be made to determine the purposes for which the powers were conferred. This is evident from Viscount Finlay’s dictum in Hindle v. John Cotton Ltd. (1919) 56 Sc.L.R. 625, 630-631:
“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, and you may go into the question of what their intention was, collecting from the surrounding circumstances all the materials which genuinely throw light upon that question of the state of mind of the directors so as to show whether they were honestly acting in discharge of their powers in the interests of the company or were acting from some bye-motive, possibly of personal advantage, or for any other reason."
Next, according to Lord Wilberforce, having ascertained on a fair view the nature of this power and having defined in the light of modern conditions any limits within which the power may be exercised, it was then necessary for the court to examine the “substantial purpose” for which the power was exercised and to reach a conclusion as to whether or not that power was exercised for a proper purpose. In this regard the court would give credit to any bona fide opinion of directors and will also respect their judgment. The court is entitled to look at the situation objectively in order to estimate how critical or pressing a substantial or insubstantial requirement may have been. If it finds that a particular requirement though real, was not urgent or critical at the relevant time, it may have reason to doubt or discount the assertions of individuals that they acted solely for proper purposes. According to Lord Sumption, the terms “substantial or primary purpose” as used by Lord Wilberforce meant the purpose which accounted for the board’s decision. Lord Sumption was of the view that Lord Wilberforce had adopted Dixon J’s test in Mills v Mills and concluded that although the directors in Howard Smith case were influenced by the company’s need for capital, the decisive factor was 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 in time. It is respectfully submitted that Lord Wilberforce was not advocating a “but for” test but simply to address the substantial or primary purpose after examining the power that was in question. The predominant test remains the “substantial or primary purpose” in the exercise of the power(s) conferred on directors. This test would still require an examination into the minds of directors, background of facts, surrounding circumstances, exchanges between directors to ascertain the substantial or primary purpose. It would also require the court to undertake a balancing exercise in weighing up the proper against improper purposes (assuming there are multiple purposes involved), and then consider overall whether the directors were motivated by proper or improper purposes.