Shareholder had personal claim against company following improper allotment of shares
28 November 2024The Privy Council has held that a shareholder in a company had a personal claim against the company when its directors allotted shares to other shareholders other than for a proper purpose.
What happened?
Tianrui (International) Holding Company Ltd v China Shanshui Cement Group Ltd [2024] UKPC 36 concerned a company with four shareholders which was incorporated in the Cayman Islands and listed on the Hong Kong Stock Exchange (HKSE).
In 2018, the company allotted and issued shares to some of its shareholders ostensibly for the purpose of bringing the company’s free float back into compliance with HKSE rules.
However, one shareholder (Tianrui) alleged that the real purpose of the allotment was to dilute its shareholding to such a level that it no longer had sufficient voting rights to block special resolutions of the company.
Tianrui brought proceedings in the court seeking a declaration that the shares had not been allotted and issued for a proper purpose and that the allotment and issue was void (see box below “For what purposes can a company allot shares?”).
The company counterargued that Tianrui had no right of claim, because the duty to allot shares only for a proper purpose was a fiduciary owed to the company by its directors, and not directly to Tianrui.
For what purposes can a company allot shares?
At common law, a company limited by shares has a power to allot and issue new shares from time to time.
(An allotment occurs when a person gains an unconditional right to acquire (or “subscribe for”) new shares in a company. An issue occurs when the shares are actually created and registered in the subscriber’s name. In this article, we will use the term “allot” for simplicity.)
That power lies with the company itself, but the company’s constitution will invariably delegate that power to its directors. As such, the directors exercise the power to allot on behalf of the company and, in doing so, act as agents and fiduciaries of the company.
Company directors, as agents and fiduciaries, are subject to a number of “fiduciary duties”. These include a duty to use the powers delegated to them only in good faith and for a proper purpose. As a result, the directors of a company may exercise the power to allot shares only for a “proper purpose”.
In the United Kingdom, the fiduciary duty to exercise powers for a proper purpose has been codified in statute through section 171 of the Companies Act 2006.
Some other common law jurisdictions have also codified directors’ duties (albeit to differing extents). For example, section 228(1)(c) of the Irish Companies Act 2014 requires a director to use their powers “only for the purposes allowed by law”. Similarly, section 182 of the Australian Corporations Act 2011 requires directors not to improperly use their position.
However, in other common law jurisdictions, directors’ fiduciary duties have not been codified and instead arise out of case law. This includes (among other jurisdictions) the Cayman Islands.
There are various potentially proper purposes of allotting shares. The usual anticipated purpose of doing so is to raise capital for the company. However, in a commercial context, another common purpose is to give employees an economic stake so as to incentive performance.
Case law has previously shown than allotting shares purely to alter the balance of voting control within a company is not a proper purpose. Similarly, allotting shares purely to defeat a takeover offer is not a proper purpose.
Sometimes the position can be complex. For example, it may well be the case that, in allotting shares with the genuine intention of raising capital, the balance of voting power in a company may be altered. This is not an improper use of the power to allot, as it is motivated by genuine purposes and not by a desire to modify control of the company.
If one or more directors cause a company to allot shares for an improper purpose, the starting point is that those directors are in breach of their fiduciary duties. Because the directors are agents and fiduciaries of the company, they owe their duties to the company itself, and only the company may bring proceedings against them for breach of duty.
In particular, a shareholder cannot bring a direct claim against a director of a company for breach of fiduciary duty. Across common law jurisdictions, there are mechanisms for shareholders to seize control and bring proceedings against directors (so-called “derivative claims”), but they do so in the name of the company, and any monetary award is payable to the company, not the shareholders.
There is, however, mixed authority across common law jurisdictions as to whether a shareholder can bring a claim against a company itself if its directors allot shares for an improper purpose.
The weight of case law, particularly in England and Wales, suggests that this is possible, but the precise legal basis for this has so far eluded the courts. The basis cannot be for breach of fiduciary duty by the directors for the reasons explained above.
What did the Privy Council say?
The Council held that Tianrui had a direct right of claim against the company.
Although a novel question of Cayman Islands law, there is already a body of authority in other common law jurisdictions (including in England and Wales and in Australia) that a shareholder has a direct claim against a company if the company’s directors allot its shares other than for a proper purpose.
However, the legal basis for that claim has never been fully and definitively explored and set out.
In its judgment, the Privy Council explains that the basis for a shareholder’s claim is, effectively, for breach of contract.
It is an implied term of a company’s constitution (specifically, its articles of association) that the company’s directors, acting as its agents, will exercise the company’s power to allot shares only for a proper purpose. This sits alongside the separate fiduciary duty owed by the company’s directors to exercise that power only for a proper purpose.
If the directors of a company do allot shares for an improper purpose, they will be in breach of their duty to the company and the company will have a claim against them. However, the company itself will be in breach of its articles of association, and any shareholder that has or may suffer loss will have a right to bring proceedings directly against the company.
The Council also confirmed that, if shares have been allotted for an improper purpose, a majority of the company’s shareholders may be able to “ratify” that allotment, effectively removing the risk that it can be unwound.
However, this will not be possible if, in practice, the majority attempt to use that power to oppress the minority in some way. It has long been the case that a majority of shareholders cannot use their strict legal powers to commit a so-called “fraud on the minority”.
What does this mean for me?
Although technically the decision relates to Cayman Islands law, it will undoubtedly be of significant persuasive authority in England and Wales, and we expect the courts here to follow it.
The decision does not change the existing position in England and Wales. It has been established for some time that a shareholder in a company can bring direct legal action against the company where shares are allotted for an improper purpose.
However, understanding the juridical basis of that claim is important, as it enables shareholders to craft their desired remedy appropriately. The Council’s clarification that this takes the form of a claim for breach of contract means that an aggrieved shareholder will be able to seek damages, a declaration that the allotment is invalid or, if the allotment has not yet happened, an injunction to prevent it.
However, to bring a claim, a shareholder will need to demonstrate to the court that they have suffered some “interference with their rights as shareholders” as a result of the improper allotment. A shareholder cannot launch proceedings simply because an improper allotment has taken place.
The judgment is a useful reminder of some key practical points.
When proposing to allot shares, directors of a company should discuss in a board meeting the reasons for the allotment and set those reasons out in detail in board minutes. This will help establish that the reasons for the allotment are proper and appropriate. As noted above, these reasons could include to raise additional capital for the company, to incentivise employee performance or to bring in a strategic investor.
Where an allotment of shares could have the effect of diluting one or more shareholders’ voting power, directors should consider taking legal advice to mitigate against the allotment being challenged.
Directors should be particularly wary of allotting shares when the company is the subject of a potential or actual takeover. Not only could the allotment be improper, but, if the company is subject to the Takeover Code, it could amount to “frustrating action” that contravenes Rule 21.1 of the Code.
If directors are concerned about potential challenges to an allotment, one option may be to seek shareholder approval in advance of the allotment. Alternatively, if the allotment has taken place and a challenge seems likely, directors could consider seeking ratification by the shareholders.
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