The 'proper purpose rule', which is now codified in English law by section 171(b) of the UK's Companies Act 2006 (the Companies Act), is a principle of company law that ensures that directors of companies only exercise powers for the purposes for which they are conferred.
It is a rule rooted in equity and it is concerned, not so much with the objective legality of the exercise of a power, but with the subjective motivation behind its exercise.
As a result, a decision made by a director in good faith and in a company's best interests may still be in breach of the rule if the decision is made for a collateral purpose, outside of the purposes provided for in the company's constitutional documents.
The 'proper purpose rule' has now been subjected to detailed consideration by the Supreme Court of the United Kingdom in Eclairs Group Ltd v JKX Oil & Gas plc  UKSC 71 (2 December 2015), in a decision which is likely to have highly persuasive effect in jurisdictions such as Bermuda, the Cayman Islands, the British Virgin Islands and the Isle of Man.
The dispute in the case concerned the decision by the directors of JKC Oil & Gas plc (the Company) to impose restrictions on the exercise of rights attaching to the shares of two minority shareholders, Eclairs Group Ltd and Glengary Overseas Ltd (the Shareholders), whom the Company considered were planning a 'corporate raid'.
Due to this perceived threat, in March 2013, the Company issued disclosure notices to the Shareholders under section 793 of the Companies Act requesting information about the number of shares held, their beneficial ownership and any agreements or arrangements between the persons interested in them. The Shareholders admitted the existence of interests in the Company's shares but denied any agreements or arrangements.
On 23 May 2013, however, Eclairs publicly invited shareholders to oppose resolutions for the re-election of certain directors at an upcoming Annual General Meeting (AGM) and on 30 May 2013, the Company considered that there were, in fact, agreements or arrangements between the Shareholders which had not been disclosed. Pursuant to article 42 of the Company's Articles of Association, which enabled the directors of the Company to impose restrictions on the exercise of rights attaching to shares, the Company issued restriction notices suspending the Shareholders' right to vote at general meetings and their right of transfer.
The Shareholders challenged the notices on the ground that the directors had, contrary to section 171(b) of the Act, exercised their powers under article 42 for an improper purpose as article 42 provided expressly for three purposes only: to induce the shareholders to provide the information; to protect the Company from having to make a decision without the information; or to punish a shareholder that failed or refused to provide the information.
In the High Court of England and Wales, Mann J invalidated the directors' decision, holding that the notices had been imposed for the improper purpose of influencing the outcome of the resolutions at the AGM. This decision was overturned, however, by the Court of Appeal (by a majority) on the basis that the proper purpose rule did not apply to article 42.
The Supreme Court subsequently overturned the Court of Appeal's decision, confirming that the proper purpose rule did apply to the exercise of powers such as those provided under article 42.
The Supreme Court rejected the Court of Appeal's reasoning that a power under article 42 was not a unilateral power, i.e. that the shareholder could overcome the restrictions by simply providing the information requested in the disclosure notice.
In Lord Sumption's view (with which all of the Supreme Court Justices agreed), if the exercise of a power would otherwise be an abuse 'it cannot be an answer to say that the person against whom it is directed had only himself to blame'.
Lord Sumption also expressed a view on the position of shareholders in a company as distinguished from the position of directors: 'Directors owe a duty of loyalty to the company, but shareholders owe no loyalty either to the company or its board. Within broad limits ... they are entitled to exercise their rights in their own interest as they see it and to challenge the existing management for good reasons or bad'.
Where the purpose of a power is not expressly provided for in a company's constitutional documents (as they were in article 42), the Supreme Court held that the purpose would be inferred from the 'mischief of the provision conferring it, which is itself deduced from its express terms, from an analysis of their effect, and from the court's understanding of the business context'.
Although all of the Supreme Court Justices were in agreement as to the application of the proper purpose rule to article 42, and that the directors' decision to impose restrictions on the shares was liable to be set aside on the basis that it was made for an improper purpose, there was a split between the Justices as to the proper causation test applicable where powers are exercised for multiple purposes.
In his judgment, Lord Sumption (with whom Lord Hodge agreed), relied on Australian case law, and preferred the imposition of a 'but for' test, i.e. a decision should not be set aside if, but for the improper purpose, the decision still would have been made in any event. Such a test would depart from the current test that the principal purpose is the one which weighs heaviest in the directors' minds, i.e. that which they felt the strongest about.
However, the majority of the Supreme Court (Lord Mance, Lord Neuberger and Lord Clarke), preferred to defer a final determination on the appropriate causation test until a future case, where it could be more fully argued.
In practical terms, directors of offshore companies, and their professional advisors, should keep the 'proper purpose' rule in mind whenever making a corporate decision, and recording such a decision in their minutes and resolutions.
In light of the Supreme Court's judgment, the 'proper purpose' rule is likely to be an increasingly fertile ground for corporate complaints, whether asserted by shareholders, creditors or liquidators, in the event of a dispute.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.