Corporate Law Update

• A company’s directors breached their duties when they allotted shares to defeat shareholder resolutions
• FCA rules for SPACs come into force

Directors breached duties by allotting shares for an improper purpose

The High Court has found that certain directors of a company breached their statutory duties when they allotted shares in order to defeat resolutions at a general meeting requisitioned by members.

What happened?

TMO Renewables Ltd (in liquidation) v Yeo and others [2021] EWHC 2033 (Ch) concerned a company whose business was research into thermophilic micro-organisms with a view to producing chemicals.

The company was constantly in short supply of cash and needed to engage in several restructurings and fundraisings. In some cases, new investors were given a seat on the company’s board. This led to the company having six directors, two of whom held substantial indirect shareholdings in the company.

In summer 2013, the company instructed VSA Capital as its financial adviser to assist with putting in place a significant fundraising to see the company through for the next 18 months. The terms of VSA’s appointment entitled it to a cash commission on completion of the fundraising.

Separately, in autumn 2013, the company’s CEO began discussions with three individual financial advisers based out of Tetbury, Gloucestershire, two of whom purported to represent high net worth individuals, again with a view to identifying potential investors for the company.

In September 2013, a dispute arose between the company’s directors over the wording of a circular to be sent to shareholders reporting on the company’s business strategy and the intended fundraising. Two of the directors refused to put their names to the circular in the form proposed.

This created a rift between the two dissenting directors and the remaining four directors (described in the judgment as the “defendant directors”) and precipitated the following events:

• The two dissenting directors and a third individual (the “requisitioners”) requisitioned a general meeting of the company, as permitted by section 303 of the Companies Act 2006, to remove two of the defendant directors and appoint one of its beneficial owners as a director. This would effectively give the requisitioners control of the board.
• In response, the defendant directors exercised a power under the company’s articles to remove the two dissenting directors from office.
• The requisitioners amended their requisition to add (among other things) resolutions to re-appoint themselves as directors of the company.
• The defendant directors gave notice of a general meeting, to be held 24 days later. In the meantime, they continued to explore funding possibilities with the Tetbury financial advisers.
• Over the subsequent days, it became clear that the requisitioners had sufficient shareholder support to pass the resolutions to be proposed at the general meeting.
• The defendant directors issued 75 million shares in the company to an entity (“Marketplace”) owned by one of the Tetbury advisers for a total amount of £3 million in cash, but on the basis that payment would be made not immediately but within two years.
• Two days later, the defendant directors issued a further 2,625,000 shares to VSA Capital in place of the cash retainer VSA was to receive on completion of the fundraising.
• At the EGM the resolutions were defeated, with the two new shareholders voting against them.

Around two months later, having declined a further offer of funding that was conditional on an almost complete change of its board, the company entered administration and the administrator sold its business and assets as a going concern. A year later, the company entered liquidation.

The liquidators brought various claims against the defendant directors. Among other things, they claimed that the directors had breached their statutory duty under section 171 of the Companies Act 2006 and sought compensation for the company.

Section 171 requires a director of a company to act in accordance with the company’s constitution (which means, principally, its articles of association) and only to exercise their powers as directors for the purposes for which they are conferred.

In particular, case law has recognised that the powers of a company’s directors to allot shares are conferred for the purpose of raising equity capital. A director cannot use their power to allot shares in a company purely to consolidate their own control over the company or to block a shareholder resolution.

In this case, the liquidators claimed that the directors had breached section 171 in the following ways.

• They used their power under the company’s articles to remove the dissenting directors purely to remove an obstacle to defeating the proposed resolutions at the general meeting, rather than because the dissenting directors were unfit for office.
• They used their power to allot shares to Marketplace, and then later to VSA, purely to garner votes to defeat the proposed resolutions, rather than to raise capital for the company.

In both cases, the purpose of exercising their powers was to defeat the proposed resolutions and block a change of control of the company’s board. The defendant directors agreed that this would be an improper purpose. The dispute was whether that had in fact been their intention.

What did the court say?

The court found that the defendant directors had not improperly used their power to remove the dissenting directors.

The judge said that the defendant directors had had “genuine reasons” to be frustrated that the dissenting directors had refused to put their names to the circular. They had been understandably concerned at the potential a general meeting to be requisitioned to disrupt the fundraising being managed by VSA and had removed the dissenting directors to prevent any further impact on it.

However, the court agreed that the directors had used their powers improperly when allotting the shares in the company. In essence, between the time of the requisition and the holding of the meeting, what had started out as a legitimate concern about the viability of the fundraising had evolved into a desire to maintain control over the company. By the time the directors came to allot the shares, several factors indicated that the allotment was designed purely to defeat the resolutions:

• Over time, it had become doubtful that the Tetbury advisers would be able to raise funds. The directors had become suspicious of initial promises of an investment by a high-profile celebrity and, rather than conducting due diligence on the advisers, had simply relied on FCA authorisation.
• Correspondence suggested that the primary motivation behind issuing shares to Marketplace had shifted from raising cash for the company to gaining votes to defeat the resolutions. This was underscored by language such as needing to “bring in votes” and “winning the vote”.
• In particular, the number of shares issued to Marketplace appeared to be calculated to give a sufficient margin of votes to defeat the resolutions.
• The fact that payment for the shares issued to Marketplace was postponed for up to two years was inconsistent with a desire to stave off the company’s immediate cash concerns and made “little commercial sense for a company on the verge of insolvency”.
• Further correspondence suggested that the primary motivation behind issuing shares to VSA was to cover off any risk of the vote becoming “too close to call”. This was underscored by discussions about the urgency of entering VSA’s name on the company’s register of members before the meeting.
• VSA had no immediate contractual entitlement to commission, as the fundraising had not yet completed. The share issue did not satisfy any binding payment obligation owed to VSA, but rather provided a means to obtain more votes against the resolutions.

As a result, the defendant directors were in breach of their duty in section 171. The judge also found that, by issuing the shares, they had breached their duty in section 172 to promote the company’s success, which, at that point, had to be viewed having regard to the interests of the company’s creditors.

The court also found that the directors had breached their duty in section 172 when they made certain dishonest or inaccurate representations to the shareholders. These are particularly specific to the facts of this case and so we do not cover them here.

What does this mean for me?

The decision emphasises the powers of a company director and the limits imposed on them.

Directors are able, by virtue of their office, to exercise numerous wide-ranging powers of a company. These commonly include the power to allot shares, pay dividends, call general meetings and conclude contracts on behalf of the company. They may also include bespoke powers from time to time, such as the power in this case to remove one of their number.

A director should always bear in mind that they are a fiduciary of a company and act as a “quasi-trustee”. Their powers are entrusted to them by the company and (indirectly) its shareholders. Directors must not exercise a power except for the company’s benefit and to achieve the objectives which the power is designed to attain.

A director must not exercise their powers for a “collateral purpose” to advance their own position or consolidate control over the company. Even if a director is acting honestly and in good faith, any exercise of a power beyond the parameters set by the company will be a breach of duty.

Before taking a decision, the directors of a company should ask themselves the following.

• What is the purpose of this power? Why should I be exercising it and to what end? For example, the power to allot shares is designed to raise capital, not to consolidate control or block a takeover. A power to decide dividends cannot be used to favour some shareholders over others.
• Am I exercising the power for that purpose? What is the reason I am taking the particular action? Is it consistent with the objective of the power? Will it benefit the company in any way?
• Are there mixed motives? In many cases, a particular course of action may benefit both the company as well as its directors or certain shareholders. Exercising the power will amount to a breach of duty if the “dominant” or “primary” purpose is improper.

Also this week…

• FCA rules for SPACs come into force. Changes to aspects of the Listing Rules relating to special purpose acquisition companies (SPACs) came into force on 10 August. These changes remove the rebuttable presumption that listed securities of a SPAC should be suspended from trading when it announces a reverse takeover, so long as certain investor protections are put in place. For more information on these changes see our previous update.