MISUSE OF FIDUCIARY POWERS: THE RIGHT TO PURSUE A PERSONAL CLAIM
20th December 2019
Michael Todd QC and Nigel Dougherty consider rights of action of minority shareholders in light of the decision of the Grand Court of the Cayman Islands in China Biologic.
In Gao v China Biologic Products Holdings, Inc (Cause No FSD 157 of 2018 (IKJ)), the Grand Court of the Cayman Islands (Financial Services Division, Kawaley J) determined that a minority shareholder would have no personal right of action in order to impugn the propriety of the directors’ purpose in pursuing a new issue of shares. However, if the plaintiff had been a majority shareholder prior to the impugned issue of new shares, the judge considered that such a person would have been able to bring a personal claim to challenge the propriety of the issue.
Rather than being able to pursue a personal claim, a minority shareholder in these circumstances would be required to pursue his complaint by way of a derivative claim (an unfair prejudice petition not being a form of action existing under Cayman Islands’ law).
A further complication on the facts of the case was that the plaintiff was not, in fact, a registered shareholder in the company at all. The court concluded that a beneficial owner had no standing as such to pursue a complaint before the court. However, if the plaintiff were able to secure registration as the legal holder of shares, he could look to bring a derivative claim in respect of matters that occurred before his registration as legal holder. Any such claim would require the plaintiff to bring his claim within the criteria for derivative claims, including demonstrating the existence of ‘wrongdoer control’.
Analysis
A number of questions arise:
1. Was the claim properly brought as a personal claim?
2. What is the scope of the ‘exception’ allowing a ‘majority’ to pursue a personal claim?
3. Does a beneficial owner of shares have standing to complain?
Was the claim properly brought as a personal claim?
English authorities
Under English law, it has long been considered possible for a minority shareholder to bring a personal claim to complain about the misuse of powers by directors. In terms of rationalising the availability of such a claim, the reasoning may be summarised as follows:
(a) the directors’ powers are derived from the constitution of the company;
(b) the company’s constitution is a contract between the company and its members and between the members inter se (s 33(1) Companies Act 2006 (CA 2006));
(c) if directors exceed those powers, whether by disregarding their terms or by seeking to exercise them in a manner which is not for the purpose for which they were conferred, a member may bring a personal claim in order to enforce the constitution; and
(d) in effect, the member is allowed to advance the complaint that the directors are not exercising the power that was actually conferred on them by the contract created by the company’s constitution.
In Re a Company [1987] BCLC 82, Hoffmann J was faced with an application seeking an indemnity against costs incurred by a shareholder in pursuing an unfair prejudice petition that sought to challenge an allotment of shares as being for an improper purpose. Hoffmann J said:
“[The challenge to the validity of the allotment], whether brought by [claim form] or petition under [s 994 CA 2006] this is not, in my judgment, a derivative action [at common law]. Although the alleged breach of fiduciary duty by the board is in theory a breach of its duty to the company, the wrong to the company is not the substance of the complaint. The company is not particularly concerned with who its shareholders are. The true basis of the action is an alleged infringement of the petitioner’s individual rights as a shareholder. The allotment is alleged to be an improper and unlawful exercise of the powers granted to the board by the articles of association, which constitute a contract between the company and its members. These are fiduciary powers, not to be exercised for an improper purpose, and it is generally speaking improper-
“for the directors to use their fiduciary powers over the shares in the company purely for the purpose of destroying an existing majority, or creating a new majority which did not previously exist.”
(see Howard Smith Ltd v Ampol Petroleum Ltd [1974] UKPC 3). An abuse of these powers is an infringement of a member’s contractual rights under the articles.”
One instance where this issue is especially acute is in circumstances where the misuse of powers by directors serves to alter the ‘constitutional balance’ within the company in a way considered desirable (perhaps in perfect good faith) by the directors. This may involve the directors issuing new shares, perhaps for the purpose of increasing the voting power of one shareholder, or group of shareholders, as against others. Alternatively, it may involve the board exercising powers to restrict the votes attached to particular shares in the company, perhaps with the purpose of ensuring that particular company resolutions can then be passed, as was the case in the recent decision of the Supreme Court in JKX Oil & Gas plc v Eclairs Group Ltd [2015] UKSC 71. By either means, a board of directors might be said to have looked to manipulate what would otherwise have been the voting position within the company.
In China Biologic, Kawaley J relied particularly on the statement by Harman LJ in the Court of Appeal in Bamford v Bamford [1970] Ch 212:
“It is trite law, I had thought, that if directors do acts, as they do every day, especially in private companies, which, perhaps because there is no quorum, or because their appointment was defective, or because sometimes there are no directors properly appointed at all, or because they are actuated by improper motives, they go on doing for years, carrying on the business of the company in the way in which, if properly constituted, they should carry it on, and then they find that everything has been so to speak wrongly done because it was not done by a proper board, such directors can, by making a full and frank disclosure and calling together the general body of the shareholders, obtain absolution and forgiveness of their sins; and provided the acts are not ultra vires the company as a whole everything will go on as if it had been done all right from the beginning… The only question is whether the allotment, having been made, as one must assume, in bad faith, is voidable and can be avoided at the instance of the company – at their instance only and of no one else, because the wrong, if wrong it be, is a wrong done to the company.”
and on the statement by Russell LJ:
“It is true that the point before us is not an objection to the proceedings on Foss v Harbottle (1843) 2 Hare 461 grounds. But it seems to me to march in step with the principles that underlie the rule in that case. None of the factors that admit exceptions to that rule appear to exist here. The harm done by the assumed improperly-motivated allotment is a harm done to the company, of which only the company can complain.”
In Bamford v Bamford, the Court of Appeal concluded that the directors’ allotment of shares for an improper motive did not involve them acting in excess of their powers; the allotment was simply voidable. On that basis, so it was held, the power to remedy the defect was in the hands of the general meeting, which could exercise that power by simple majority (although the votes attaching to any shares issued in the impugned allotment would not be counted in assessing whether the majority was attained).
Bamford v Bamford has long been viewed as something of a difficult case (see, for example, Wedderburn, ‘Unreformed Company Law’ (1969) 32 MLR 563). It sits uneasily with earlier authority, eg Fraser v Whalley (1864) 2 Hem & M 10 and Punt v Symons & Co Ltd [1903] 2 Ch 506. The final conclusion is also strange: if the fiduciary duty of directors is correctly reflected in s 171(b) CA 2006, could it ever really be said that an infringement of that duty did not involve them acting in excess of their powers? And, even then, why should the control of a company be thought to be a matter of collective concern of shareholders?
Judgment of Kawaley J
In terms of his reasoning process, much of Kawaley J’s judgment marginalised such authority as might have favoured the plaintiff’s arguments in support of the existence of a personal action. In fundamental respects, his reasoning process appears flawed:
(a) First, Kawaley J was wrong in concluding that there was no instance under English law where the courts had allowed a personal action to proceed where an issue of shares was being impugned. The decision of Goulding J in Mutual Life Insurance Co of New York v Rank Organisation Ltd [1985] BCLC 11, was itself brought by way of a personal action (albeit constituted as a trust derivative claim – see further below) and looked to upset an issue of shares that was said to be ‘discriminatory’. Unfortunately, Mutual Life does not appear to have been cited to Kawaley J. While the question of whether a claim was appropriately brought by way of a personal claim was seemingly not disputed in Mutual Life, there can be no doubt, given the eminence of the counsel involved, that if a good point had been thought to exist about the way in which the action had been advanced, it would have been taken.
b) Second, the decision of the Privy Council in Howard Smith v Ampol was, perhaps, a very clear example of a case where a personal action had been maintained. Kawaley J dismissed the relevance of that decision on the basis that “the issue of standing was not considered or decided”. However, it would, again, seem odd if any such issue was truly missed, especially as the case involved a first instance decision by a future Chief Justice of Australia (who was well versed in company law) and a leading decision of the Privy Council.
(c) Third, Re a Company [1987] BCLC 82 is another decision from a powerful tribunal that was sidelined. The approach that the contract created by the articles is itself breached by the misuse by the directors of the powers conferred on them to distort the constitutional balance – and that it is this that gives rise to the personal claim – was not analysed by Kawaley J. Hoffmann J’s comments were simply said to be obiter dicta and “unpersuasive”. But they appear to find some endorsement in the extra-judicial comments of Lord Sales in his Speech to the Chancery Bar Association on 2 April 2019.
(d) Fourthly, Kawaley J’s decision involved little consideration of the discussion of the Supreme Court in Eclairs Group as to the limitation on the powers given to the directors, namely that powers conferred on directors were not unlimited but were, instead, to be regarded as limited to the purpose for which those powers were conferred. Powers such as the power to issue shares could not be used for the improper purpose of seeking to control or influence decisions that the company’s constitution assigned to the general body of shareholders.
It is, of course, true that the Supreme Court decision in Eclairs Group did not analyse whether the claim was properly brought by way of a personal claim. But it would seem odd if any concern over the constitution of the claim as a personal action went unnoticed by another august tribunal.
In fact, in Eclairs Group, the issue of standing was before the first instance judge ([2013] EWHC 2631 (Ch), at paras 8 to 13 and 248 to 255) and the Court of Appeal ([2014] EWCA Civ 640, at paras 33 to 38); Eclairs Group Ltd was successful on this point at both stages and it was not further pursued before the Supreme Court.
Instead, in the Supreme Court, in considering the exercise by directors of their powers for the purpose of influencing the outcome of a general meeting, Lord Sumption said (at para 16):
“This is not only an abuse of power for a collateral purpose. It also offends the constitution and distribution of powers between the different organs of the company.”
Implicit in that statement is the notion that it is open to those affected by the abuse of power to seek to have it remedied: see Fraser v Whalley.
Rather than approach matters in this way, Kawaley J sought to reject the relevance of Eclairs Group to the case before him on the basis that Eclairs Group had not involved an issue of shares. This is true but it is not a logical reason for rejecting the reasoning in Eclairs Group. As explained above, Eclairs Group was simply a different manifestation of the way in which directors may misuse their powers in order to alter the voting balance within a company. If the ultimate effect is the same in terms of distorting the balance of voting power in the company, should it really matter whether the directors manipulate voting control by pursuing a selective issue of new shares or by way of a selective disenfranchisement of some?
Whatever the omissions in Kawaley J’s reasoning process on this first point, it must be kept in mind that the plaintiff in China Biologic was not the registered holder of any shares in the company. Subject to the points made about standing below, it would have been open to Kawaley J to have taken the more straightforward course and simply hold that, whether or not the action was properly brought as a personal claim or a derivative claim, the actual action before him could not be brought or maintained by a mere beneficial owner. Rather than take this last course, the judge ventured to go further and, it is respectfully submitted, fell into error: a personal action can be brought and maintained by any member to challenge the propriety of the purpose for which directors sought to pursue an issue of shares.
What is the scope of the ‘exception’ allowing a ‘majority’ to pursue a personal claim?
Kawaley J’s analysis led to an exception to his general conclusion: a pre-existing majority shareholder who had ceased to be a majority because of an issue of new shares would be able to bring a personal claim to challenge the issue and not left to pursue a derivative claim.
What is really meant by a ‘majority’ in this context? Should the existence, or otherwise, of a pre-existing ‘majority’ be defined in some bright-line fashion as requiring more than 50% of the voting power at shareholder level? If so, this may be a somewhat unreal distinction; very often, de facto control of a company will be conferred at a level below 50% of the voting power, since not all shareholders will choose to vote or be able to vote (for example, because the voting rights attaching to shares of a deceased member are suspended pending the registration of a new holder).
So questions arise on Kawaley J’s exception:
(a) Bearing in mind that effective control of a company may be conferred at a level below 50% of the voting power, would a de facto ‘majority’ be sufficient?
(b) What evidence would be required to establish a de facto ‘majority’? If it is a de facto ‘majority’, on what issues must that ‘majority’ have existed?
(c) How does this apply if a pre-existing ‘majority’ might have existed but only in combination with other shareholders who are unwilling or unable to litigate alongside the plaintiff? After all, Kawaley J drew attention to the fact that in Howard Smith v Ampol, the plaintiffs were a pre-existing majority (albeit only in combination). If that is the case do all members of the ‘pre-existing majority’ need to litigate? Is one would-be plaintiff able to litigate in his own right, maybe joining as defendants those that he considers might have supported him before the time of the impugned issue and throwing upon them the burden of showing that they would not have done so?
Such questions may give rise to issues that are hardly ideal for determination on a summary basis and which could require a fully contested hearing. This does not seem an attractive way to set up an issue as fundamental as standing to pursue an action.
And it is not necessarily an answer to say that these issues are ‘similar’ to the sort of issues that a court might face in determining whether or not there is ‘wrongdoer control’ for the purposes of allowing a common law derivative claim to proceed. In determining the issue of ‘wrongdoer control’, the court is examining a real scenario: is the company now prepared to bring a claim in respect of the matters complained of by the claimant or not? In the scenario proposed by Kawaley J, the court is required to look at a pre-existing position that may, following an issue of new shares, be entirely hypothetical. Any assessment of what that hypothetical scenario might have been will inevitably be altered by the shifting views and alliances of other shareholders as they assess whether or not their best interests truly lie in supporting the plaintiff or accepting the political reality of the company after the new issue of shares. On this aspect too, Kawaley J’s judgment appears to give rise to more questions than answers.
Does a beneficial owner of shares have standing to complain?
In terms of the standing to bring the claim, the natural starting point is that any claim of the type made in China Biologic should be brought by a ‘member’ not by a mere beneficial owner. The plaintiff in China Biologic was only a beneficial owner.
Nevertheless, there have been a number of cases where a beneficial owner of shares has brought a claim before the courts by way of a ‘trust derivative claim’. In a trust derivative claim, the claim is brought by the beneficial owner but the nominee holder is joined as a defendant (together with any intervening custodians and sub-custodians). In Roberts v Gill [2010] UKSC 22, the Supreme Court gave guidance on the circumstances in which a beneficiary would be permitted to bring such proceedings on behalf of a trust, holding that it might be permitted where “special circumstances” are found to exist. In effect, such an action is treated as being brought by the legal holder, albeit articulated by the beneficial owner and with the beneficial owner being the actual named ‘claimant’.
The plaintiff in China Biologic had not adopted this course and the attitude of the legal holder there is not recorded in the judgment. But, if the plaintiff in China Biologic had sought to frame his claim as a trust derivative claim, and had been able to demonstrate suitable ‘special circumstances’, should he have been permitted to carry on the claim? Respectfully, the answer should have been ‘yes’. On the basis of the arguments rehearsed above, the plaintiff should have then been found to have been able to maintain his claim as a personal claim.
Trust derivative claims are clearly important in this context and in circumstances in which shares are often held through a nominee (including a CREST account). As noted above, the claim in Mutual Life had been constituted as a trust derivative claim. In Eclairs Group, a trust derivative claim was pursued all the way to the Supreme Court and relief granted in respect of restrictions that had been imposed upon shares in a listed company under a power contained in the company’s articles that broadly paralleled the powers of the court under Part 22 CA 2006. The question of Eclairs Group Ltd’s standing to sue, as the beneficial owner, was not disputed in the Supreme Court. However, at both first instance and in the Court of Appeal, it had been found that the action was properly constituted. Kawaley J quoted Briggs LJ in the Court of Appeal as follows:
“I have been no more persuaded by JKX’s submissions in relation to standing than was the judge. Indeed, I would go further. Part 22 of the 2006 Act is a remarkable exception to the general principle that companies are only concerned with the legal owners of their shares.”
But this quotation is potentially selective by omission – read in its full context, it was certainly not requiring that trust derivative claimants need to show the sort of concerns covered by Part 22 CA 2006. The circumstances of that Part were, in fact, a further example of ‘special circumstances’ justifying why a trust derivative claim should be available. The circumstances of urgency in Eclairs Group (a need to apply for interim injunctive relief) and the unwillingness of the registered shareholder (and the intervening custodians) to take action, were themselves and on the facts of the case, already sufficient ‘special circumstances’ justifying the action being constituted as a trust derivative claim.
It also appears that Kawaley J slipped into error in not always appreciating the test that was being applied by the court in Eclairs Group, describing it as involving observations on a legal matrix of an “exceptional nature”. While there were certainly ‘special circumstances’ involved in Eclairs Group, (within the meaning of Roberts v Gill), these were not that remarkable. To suggest that it was a case involving a legal matrix of an “exceptional nature” would appear to suggest that the bar was far harder to overcome than was actually the case.
In the event, the notion of a trust derivative claim did not matter on the facts of China Biologic, since the plaintiff did not even seek to constitute the claim as anything other than one brought by him as a beneficial owner.
This case feature was first published by FromCounsel on 4 December 2019.
