Proper Purpose Rule: Examining IsZo Capital v. Nam Tai & Dale v. P.K. Prathapan
The duty to exercise powers, for the purpose for which it is conferred, is set out under Section 171(b) of the Companies Act 2006, a duty which is mirrored under Section 121 of the BVI Business Companies Act 2004. The aim of this article is to analyse these sections and provide a comparative analysis of the fiduciary duties of directors to act in good faith and in the best interests of the company and its shareholders in two jurisdictions ie. The United Kingdom and India, and furthermore, to explore how courts via their verdicts in different cases, have scrutinised this rule, thereby setting a precedent for future corporate businesses.
The proper purpose rule highlights the fact that every company is divided into two basic organs: directors and shareholders. The former is responsible for managing the business of the company, which includes the issuance of shares to maintain a balance between these two organs of the company. Whether directors are fulfilling their duties remains highly debatable, especially when it is believed that their objective element is not fully aligned with the subjective element. Such a phenomenon occurs when the duty to exercise powers for the purpose for which they are conferred are questioned, as was the case regarding allotment of shares in IsZo Capital LP v. Nam Tai Property Inc, Greater Sail Ltd and West Ridge Investment Company Ltd (IsZo Capital). The British Virgin Islands (BVI) High Court held that a private placement of shares was made for an improper purpose and therefore void. This article will therefore, first, examine the context of this case through an analysis of the arguments presented, by tracing the trajectory of events and second, investigate the viability of the proper purpose rule.
IsZo Capital LP v. Nam Tai Property
A United States based investment fund by the name of IsZo Capital (IsZo) was a minority stakeholder in Nam Tai Property Inc. (Nam Tai), a property development company which conducted most of its business in China. IsZo beneficially owned approximately 15% of the outstanding shares of Nam Tai. Holding 23.9% of all shares in Nam Tai, was a Chinese conglomerate by the name of Kaisa Group Holdings Ltd (Kaisa). These shares were held through Kaisa’s investment vehicle, Greater Sail Ltd (Greater Sail).
A divergence of opinion arose between IsZo and Nam Tai regarding the future direction of Nam Tai and the way in which the company ought to conduct its business. IsZo was of the view that Nam Tai “should realise the extraordinarily large profits from the existing Shenzhen land and buy back shares”, while the current management of Nam Tai persisted with the view that the company ought to “develop a long-term business of property development” thereby following a strategy of acquiring more property at the prevailing market rates.
In May and July 2020, following a series of events which included a purchase of land by Nam Tai for RMB 705.48 million, which drained most of its cash reserves, IsZo published two letters to shareholders criticizing (i) the management of Nam Tai and; (ii) the fact that the running of Nam Tai was being done in the best interests of Kaisa. This event led to a substantial drop in the share price of Nam Tai, which the letter suggested was due to the “ruinous leadership, abrogation of corporate governance and haphazard capital allocation strategy under the direction of a Kaisa-controlled management team and Board” and warned that if Nam Tai were to continue to “recklessly deploy capital while ignoring opportunities to monetize existing assets” then its “intrinsic value will be in jeopardy”.
In September 2020, IsZo served a requisition on Nam Tai’s registered agent in Tortola, to hold a special meeting of shareholders and consider resolutions to remove and replace certain directors who were allegedly associated with Kaisa. About three weeks later, in October 2020, following the requisition, a private investment in public equity (PIPE) amounting to US$ 175 million worth of newly issued shares, was approved.
The case sought to address the question regarding whether or not the PIPE was carried out for the proper purpose. Various authorities have suggested that if the power to issue shares is used to affect the voting structure of a company rather than for the purpose of raising capital, it is deemed to be an improper purpose. The ruling of the Privy Council in the case of Howard Smith Ltd. v. Ampol Petroleum Ltd examined the proper purpose rule, for which Lord Wilberforce established a three-step analysis. The first step is to examine the power in question in order to determine its boundaries and whether the same is being exercised for an improper purpose. The second step is to evaluate the reasons for such exercise of power and apply the appropriate legal tests if it seems that the directors have acted for mixed purposes – a step which is vital to determine the substantial purpose for which it was exercised. The last step is to ascertain the consequences.
In the IsZo Capital case, IsZo claimed that the purpose of the PIPE was not to tackle a liquidity crisis and “mitigate meaningful risks to [our] financial stability”, as claimed by Nam Tai and Greater Sail, but rather to substantially defeat the proposed resolutions to replace the current board and increase Kaisa’s de facto control over Nam Tai, thereby ensuring that the company remained under Kaisa’s control. Arguments were raised stating that the PIPE interfered with members’ decision-making skills, was unfair to the other shareholders and that Nam Tai had deliberately delayed action on the requisition.
It was held that the board of Nam Tai had breached their fiduciary duties to act in the company’s best interest under Section 120(1) of the BVI Companies Act 2004 and had acted for an improper purpose when initiating the private placement. It further recognized that Companies that intend to make controversial decisions must ensure that their decision-making process clearly focuses on the purposes for which the decision is made and that such purpose is ultimately a legitimate one. Such decisions may be challenged where it is suspected that the company has acted with improper motives.
The case of IsZo Capital was interesting in the sense that it shows how even an isolated event can shift power in the company, thereby triggering a proper purpose rule. Lord Sumption in Eclairs Group Ltd and Glengary Overseas Ltd v. JKX Oil & Gas Plc voiced the opinion that, 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” but rather, it is concerned with an “abuse of power, by doing acts which are within its scope but done for an improper reason”. He went on to state that in the event of a power struggle between different groups of shareholders, the directors should not issue additional shares in a manner so as to affect the balance of power or influence the outcome of shareholders’ resolutions, regardless of any additional capital or benefits this may bestow upon the company.
Under Indian laws, Section 166 of the Companies Act 2013 requires a director to act in good faith to promote the objectives of the company and states that a director owes a duty of responsibility towards its shareholders. In the Indian context, while the proper purpose rule has been referred to in the case of Dale and Carrington Invt. P. Ltd. v. P.K. Prathapan & Ors., (Dale Carrington) the scope of the rule remains unexplored. The case dealt with further issue of share capital by the managing director of a company and it was held that “neither the allotment of additional shares” was bonafide or “in the interest of the company” and nor was “a proper and legal procedure” followed to make such allotment. It was also stated that the motive for such allotment was malafide, the only intention being to gain control of the company and hence, the allotment was liable to be set aside. Specifically, with regard to the issuance of shares, the Indian Supreme Court in Sangramsinh P. Gaekwad and Ors. v. Shantadevi P. Gaekwad and Ors. held that “directors are not entitled to use their powers of issuing shares merely for the purpose of maintaining their control…over the affairs of the company, or merely for the purpose of defeating the wishes of the existing majority of shareholders”.
The Supreme Court in Dale Carrington went on to highlight the fact that a company is a juristic person and that the directors of the company are its agents, trustees or representatives, capable of making decisions in good faith, with reasonable care and diligence. Finally, the court also placed reliance on various judgements where all the decisions had one singular point of commonality – if authority is exercised towards extraneous purposes like the acquisition of control over the affairs of the company, the action cannot be upheld. While the extent of a director’s fiduciary duties under Section 166 of the Companies Act 2013 remains largely uncharted, the Dale Carrington case does highlight that Indian jurisprudence is also aligned with similar provisions under English law.
An analysis of the jurisprudence of cases that debate the issue of “improper purpose” has revealed that these tend to arise in the context of allotment of shares. As the flagbearers of any corporate entity, directors are highly regarded for their ability to espouse good corporate governance principles. In 2019, the High Court of Madras referred to the proper purpose rule in the case of G. Vasudevan v. Union of India, and stated that “a director…by virtue of the fact that he holds a position of directorship cannot claim immunity for the defaults of the company” and, given “the fact that people invest their hard earned money in companies in which there are persons of repute holding the position of a director”, a director “cannot absolve himself of the misdeeds of the company after holding a position in the company”.
Within a legal framework which is ever evolving, the earlier Companies Act 1956 did not codify the statutory duties of a director, the way the Companies Act 2013 has. The proper purpose rule was established to ensure that directors exercise their powers solely for the purpose these are conferred to minimize the situation of potential risk to the company. When such powers are misused (as in the case of an improper allotment of shares), it may invariably affect the constitutional balance of a company and cause a breach of duty to act in good faith. Ultimately, even if a directors primary purpose is to act in the best interests of the company, he / she is also benefitting as a result and particularly in the context of a private company, there is greater onus to ensure there is no misuse of power for personal gains or for satisfying ulterior motives.
†Ayesha Bhattacharya is an associate at Khaitan & Co., Mumbai, India and an alumna of the WB National University of Juridical Sciences, Kolkata (batch of 2019)