The articles of association of Cedar Ltd provide that the company’s business is the production of organic food. The articles further provide that the company has the power to borrow money and the power to purchase plant and machinery in furtherance of the business of the company. Since the company’s formation in 1995, the company’s business of producing organic food has been profitable. However, in the light of a recent economic downturn, the company has not been able to make a profit from the business as demand for organic food has waned. Cedar Ltd’s board of directors resolve that, in order to arrest the decline in the company’s fortunes, the company should switch to the production of non-organic food.
For this purpose, the directors enter into the following contracts on the company’s behalf:
(i) A secured loan agreement with HBAS Bank plc.
(ii) The purchase of a substantial quantity of chemical fertilizers, insecticides and pesticides from Direct Land Ltd.
Giles, a minority shareholder of Cedar Ltd and a committed organic grower, is concerned with the activities of the board of directors, in particular (a) the validity of the two contracts and (b) the action, if any, that can be taken.
Advise Giles as to his legal position.
Answer plan
You will need to consider the principles dealing with the capacity of a company and a company’s board of directors to enter into binding arrangements of the kind that have taken place and the action if any that can be taken by an aggrieved shareholder. This will include a consideration of the further reform of the doctrine of ultra vires by the Companies Act (CA) 2006, a task previously undertaken by the CA 1985 and the CA 1989. It might be advisable to consider these issues from an ‘external’ as well as an ‘internal’ perspective.
Answer
EXTERNAL ASPECTS OF CORPORATE TRANSACTIONS
Making reference to the ‘external’ phpects of corporate transactions, means considering the capacity of a company to enter into transactions of a binding nature with another party. The issue, therefore, that arises, is whether the transactions between Cedar Ltd and HBAS Bank plc and between Cedar Ltd and Direct Land Ltd are valid and binding.
Under the CA 2006, a company is no longer required to have an objects clause. However, it can choose to have objects, but such restrictions relating to its objects must be contained in the company’s articles (s 31 CA 2006); under the CA 1985, objects had to be stated in a company’s memorandum of association. Section 31 CA 2006 applies to new and existing companies. Here, Cedar Ltd has restrictions on its objects contained in its articles, perhaps serving as a ‘reminder’ to the directors and shareholders of the company of the company’s business ethos.
Given the restrictions contained in Cedar Ltd’s articles, it must be considered whether the two transactions are valid and binding. Given Giles’ keen interest in the matter, he may believe that the company has acted ultra vires, that is, beyond the powers of the company, and that, by virtue of the doctrine of ultra vires, the transactions are void and unenforceable. However, the effect of s 39 CA 2006 is to nullify the doctrine of ultra vires to the extent that there is no limitation on a company’s capacity to enter into contracts.
Section 39 CA 2006 provides that no act, such as a contract, can be questioned on the ground of a lack of capacity in the company’s constitution. Therefore, from an external perspective, the contracts between Cedar Ltd and HBAS Bank plc and Cedar Ltd and Direct Land Ltd are valid and enforceable. Similarly, where an act of a company is within the company’s powers but outside the powers of the directors, a third party dealing with the company can assume there is no limitation on powers of the board of directors or those authorised by the board of directors (s 40(1) CA 2006). It is a requirement of s 40 CA 2006 that the third party is acting in good faith. However, the section states that a third party is not bound to enquire as to any limitation on the directors’ powers and neither is mere knowledge on the part of the third party that the directors have exceeded their powers sufficient to amount to a lack of good faith (s 40(2) CA 2006). There is no indication from the facts of the question that either HBAS Bank plc or direct Land Ltd have acted in bad faith, the burden of proof being on the company.
Section 40(4) CA 2006 does, however, provide for a shareholder to seek an injunction to prevent the company from acting beyond the powers of the board of directors, but obtaining an injunction is limited by any ‘legal obligation’ arising from the act of the company (s 40(4) CA 2006); ratification of the act by the company (s 239 CA 2006); whether, in fact, the act is beyond the directors’ powers, and whether, given the discretionary nature of the relief, the court would grant an injunction where it considered that ratification would be likely or imminent. Given that both contracts have been entered into, it would appear that Cedar Ltd is under a legal obligation to fulfil the contracts.
There have been two reported decisions on s 40 CA 2006, in which it was held that the section could not be relied on by the third party. However, both cases related to the meaning of ‘person’ within s 40 CA 2006 and the extent to which an insider, as a third party, was protected by that section. In Smith v Henniker-Major & Co (2002), in a mistaken, but honest, breach of the articles, a director entered into a contract with the company at an inquorate meeting of the board of directors and he attempted to rely on s 40 CA 2006 to validate the transaction. The Court of Appeal held that, although a requirement for a quorum of directors was a limitation on the powers of the board of directors and that s 40 CA 2006 was wide enough to include a director of the company, s 40 CA 2006 could not protect a director relying on his own mistake in order to validate something which had no validity under the company’s constitution. In EIC Services Ltd v Phipps (2004), the Court of Appeal held, that a shareholder of a company, as an ‘insider’, could not rely on s 40 CA 2006 in respect of an issue of shares that was beyond the powers of the directors of the company. The share issue was void and unenforceable. As ‘outsiders’ it does not appear that HBAS Ltd or Direct Land Ltd are affected by either decision.
Section 41 CA 2006, provides a different conclusion on the issue of contractual validity where a third party to a contract with a company is a director of the company or is connected to a director of the company. Under s 41 CA 2006, any transaction between the company and the director is deemed voidable, at the instance of the company, where the transaction exceeds any limitation placed on the powers of the board of directors or is beyond the powers of the company. It will cease to be voidable, however, where the company affirms the transaction or some other limit to rescission operates (s 41(4) CA 2006). The section further provides that the third party or the directors of the company who authorised the transaction are liable, where relevant, to indemnify the company for any loss or damage resulting from the transaction and to account to the company for any gain made from the transaction (s 41(3) CA 2006). Given the facts of the question, it does not appear that HBAS plc or Direct Line Ltd is such a third party.
In conclusion, therefore, from an external perspective, the advice to Giles is that, although the board of directors may have acted in breach of the articles, the respective contracts involving HBAS Bank plc and Direct Land Ltd appear to be valid and binding.
THE INTERNAL ASPECTS OF CORPORATE TRANSACTIONS
Giles is concerned further with the activities of the board of directors and how, from an ‘internal’ perspective, action can be taken against the directors for entering into contracts that appear to be valid but which breach a restriction contained in the company’s articles.
Action could be taken against the directors for breach of duty in failing to act in accordance with the company’s constitution (s 171(a) CA 2006). Additionally, or alternatively, directors are under a duty to act bona fide in a way that is most likely to promote the success of the company for the benefit of the members as a whole (s 172 CA 2006). The duties, based on case law, are owed to the company and not to any individual shareholder (s 170(4) CA 2006 – Percival v Wright (1902); Peskin v Anderson (2001).In Percival v Wright (1902), the directors of a company were privy to confidential information, which, once released, was likely to increase the value of the company’s shares. P, a shareholder, offered to sell his shares to the directors, who accepted his offer. When the confidential information was released, P sought to have the contract of sale set aside and to recover the shares, on the ground that the lack of disclosure was a breach of fiduciary duty by the directors. Swinfen-Eady J, in rejecting P’s claim, held that the directors did not, simply by being directors, owe a fiduciary duty to an individual shareholder; they did owe such a duty to the company but they had not broken it. In Peskin v Anderson (2001), the directors were held not to owe a duty to former shareholders to inform them of the disposal of a company asset, which resulted in existing members each receiving a windfall of £34,000, as there was no special factual relationship generating a fiduciary obligation such as a duty of disclosure. These fiduciary duties require a director to exercise his powers in a way that has regard to the interests of the person to whom the duties are owed and not to abuse his position of trust and influence within the company.
Although the directors may have the power to sue, by virtue of the wide, general power of management vested in them (art 3 (draft) model articles, 2008), where the directors are the wrongdoers, the shareholders can exercise a residual power to sue on behalf of the company. Section 260 CA 2006 also provides that a member can bring a derivative claim on behalf of the company against a director for breach of duty, but such a claim requires the shareholder to establish a prima facie case (s 261 CA 2006) and to obtain the permission of the court to continue with the claim (s 263 CA 2006). Section 260 CA 2006 provides that the shareholder must establish that the directors are in breach of duty and the company has a cause of action arising from such a breach. Assuming that provision was satisfied, the shareholder must establish a prima facie case. Where the court is satisfied that there is a prima facie case, it has the power inter alia to give directions as the evidence to be provided by the company and, on hearing the application, to give or to refuse permission to continue the claim (s 261 CA 2006). Under s 263 CA 2008, the court must refuse to give permission where the court is satisfied that a person acting in accordance with s 172 CA 2006 (duty to promote the success of the company) would not seek to continue with the claim, or where the act has been authorised or ratified by the company (s 263(2) CA 2006). Where this is not the case, factors the court can take into account in deciding whether to allow the claim to proceed include whether the shareholder is acting in good faith, the importance that a person acting in accordance with s 172 CA 2008 would attach to continuing the claim, whether the act in the circumstances would be likely to be authorised or ratified by the company, whether the company has decided not to pursue the claim, whether the member could pursue an action in his own right, and whether there are any views of other members who have no personal interest (s 263(3)(4) CA 2006). The Secretary of State has the power to add to the circumstances in which permission is to be refused or granted (s 263(5) CA 2006). Any decision by the company to ratify the conduct of the directors amounting to a breach of duty must be taken by the members, the votes of the directors as shareholders not counting (s 239 CA 2006), unless consent is unanimous (s 239(6) CA 2006). The common law and equitable rules on acts which are incapable of ratification are preserved by s 239 (7) CA 2006. In Smith v Croft (No 2) (1988), Knox J held that, where the decision by the company not to litigate had been made ‘by an appropriate independent organ’, the shareholder was not allowed to bring a derivative claim - for in such a case it was not the fraudsters who were blocking litigation but others unconnected with the fraud. He pointed out that the appropriate independent organ might have good reason to refuse to litigate, for example, by reason of unnecessary expense or the unlikelihood of any judgment being satisfied. In Franbar Holdings Ltd v Patel (2008) [2008] EWHC 1534 (Ch), the court refused to grant permission to a minority shareholder to continue with a derivative claim, on the basis that the allegation relied on by the shareholder gave rise to causes of action already being pursued by the company and that a director, acting in accordance with his duty in s 172 CA 2006 to act bona fide in a way likely to promote the success of the company, would have attached little importance to continuing the derivative claim (s 263(2)(a)&(b) CA 2006).
As a minority shareholder, it is not easy for Giles to bring proceedings against the directors of Cedar Ltd in this case. Action by a minority shareholder in these types of cases is usually very difficult and any decision of the company that might satisfy the minority shareholder is likely to depend on the action, if any, of the majority shareholders. That, in turn, is likely to depend on whether the majority shareholder(s) also feel aggrieved at the activities of the directors. They may, however, be supportive of the activities of the directors.
NOTE
You could comment on a shareholder’s position where there has been a breach of the articles in respect of the ‘s 33 contract’. Further, you could possibly consider whether a minority shareholder could petition for relief under s 994 CA 2006 on the basis of unfair prejudicial conduct.