Judicial Committee Of The Privy Council confirms that shareholders have a direct right of action against a company in circumstances where shares have been allotted for an improper purpose

The Judicial Committee of the Privy Council in Tianrui v China Shanshui has held that a shareholder has a personal right of action against a Cayman Islands company to challenge the improper issue and allotment of shares by that company's directors. In doing so, the Board has reversed the decision under appeal and has changed what the position on this issue was previously, as a matter of Cayman Islands law. The Board has also provided a detailed analysis of the juridical basis for shareholders' standing to bring personal claims, which it noted had not been decided and had "barely been discussed" in most previous cases.

This is a significant decision for the Cayman Islands and likely other common law jurisdictions where the principles of company law are not materially different to those in force in the Cayman Islands.

The decision arose out of a prolonged battle for control of the respondent company, China Shanshui. The company and its shareholders are competitors in the cement production industry in the People's Republic of China. The company issued convertible bonds in two tranches, the proceeds of which it claimed were primarily used to repay loans. At an EGM, a majority of shareholders passed a resolution mandating the directors to allot and issue shares to certain bondholders. The company claimed this was a response to events that had led to the Hong Kong Stock Exchange suspending trading of the company's shares.

The appellant, Tianrui, issued a writ claiming that the bondholder allottees were acting in concert with the majority shareholder group and the company's directors to consolidate the majority shareholders' control over the company. Specifically, Tianrui alleged that the issue of bonds and allotment of new shares were an improper exercise of the company's power to issue and allot shares, on the basis that the purpose of the issuance of shares was to dilute Tianrui's shareholding from 28.16 per cent to 21.85 per cent so that Tianrui could no longer block special resolutions. If valid, Tianrui would not be able to prevent a merger with another company and might instead have to have its shares bought out under section 238 of the Companies Act.

The company sought to strike out the writ on the basis that it was an abuse of process, alleging that Tianrui did not have standing to sue the company for what are essentially claims arising out of breaches by directors of fiduciary duties that were owed to the company (not to individual shareholders).

At first instance, Segal J rejected the challenge and concluded that the minority shareholder had a personal claim against the company. He held that it followed from the characterisation of the shareholder's claim as a personal right that other shareholders should not ratify the acts of the directors. In addition, he rejected the argument that a shareholder had no personal claim because they could obtain redress by a derivative action. Segal J's decision marked a departure from an earlier first instance decision of the Cayman Islands Grand Court in Gao v China Biologic Products, in which the court struck out a writ action by a minority shareholder on the basis that the plaintiff lacked standing to sue the company for breach by the directors of their fiduciary duties.

The Cayman Islands Court of Appeal subsequently overturned the decision of Segal J and held that an aggrieved shareholder had no personal right of action against the company for a diminution of their voting power caused by the issue of shares in breach of a fiduciary duty owed to the company. The CICA held that a shareholder must instead bring a derivative action consistent with the rule in Foss v Harbottle  or the fraud on the minority exception to that rule (discussed below).

The key feature of the CICA's decision (and the earlier decision of Kawaley J in Gao) was the reasoning that shareholders did not have standing to bring a claim in their own right in relation to a fiduciary duty owed by directors solely to the company. The proper plaintiff in such cases would be the company itself. In those circumstances, shareholders could only bring a claim by way of a derivative action.

This reasoning arises out of the principles in Foss v Harbottle. In summary:

• Where a wrong has been done to a company, only the company and not an individual shareholder can take action. A breach of duty by a director, who owes duties to the company, is a wrong done to the company. This is known as the "proper plaintiff" principle.

• However, where: (i) a step or action has been taken by the directors in breach of their fiduciary duties; (ii) the resulting transaction can be made binding on all shareholders by a simple majority of shareholders; and (iii) the majority does not wish to take action against the directors, the relevant decision can be ratified. This is known as the "majority rule" principle.

There is an exception to the operation of these principles where the wrongdoers have acted dishonestly or have attempted to appropriate the company's property and the wrongdoers themselves are in control of the company. This is known as the "fraud on the minority" exception. In that case, any purported ratification would not be effective. In such a case, the aggrieved shareholder may bring a derivative action seeking relief on behalf of the company in whom the cause of action is vested.

The Board held that a shareholder whose holding is diluted by an improper allotment of shares by the directors may bring a personal claim against the company, challenging the validity of that allotment founded on the corporate contract between the shareholder and the company. In certain circumstances, the claim may be defeated by ratification of the allotment by a majority of the shareholders (other than the allottees) at a general meeting. Those circumstances did not apply to the assumed facts. Gao  was wrongly decided, and the CICA was wrong to follow it.

The Board reviewed a number of well-known decisions from other common law jurisdictions. Previous English and Australian decisions have recognised the right of shareholders to bring a personal action against the company, rather than a derivative action, by way of a challenge to the validity to an allotment of shares by its directors on the basis that the directors acted for an improper purpose. However, there had been limited, if any, discussion in those decisions regarding the jurisdictional basis for the standing of shareholders to bring such claims.

The Board approached the issue from first principles.

• The registration of a person as a shareholder brings with it a bundle of rights. That which benefits or harms the company will correspondingly increase or reduce the value of the person's shares. Subject to class restrictions, shareholders have a collective power to influence or control the general direction of the company through their ability to attend and vote at general meetings. The active power of a shareholder is critically dependent upon the proportion of shares held. Possession of more than 25 per cent of shares confers what is sometimes referred to as negative control through the ability to block steps requiring a special resolution and is critically sensitive to dilution.

• The power to allot and issue shares is conferred on directors and is necessarily a fiduciary power. It must, therefore, be exercised only for proper purposes, not (for example) to deliberately alter the balance of power between shareholders other than for a legitimate purpose. This will exclude an allotment of shares deliberately aimed at altering the balance of power between shareholders so as to advance the power of one group at the expense of the other.

• It is implicit in the contract constituted by the memorandum and articles of association that the company's power to allot and issue new shares – which power is delegated to the directors by the company's articles – will be exercised by the directors properly in accordance with their fiduciary duties including the 'proper purpose' duty. A failure to do so amounts to an actionable harm by the shareholder because the impropriety in the exercise of the power contravenes the corporate contract binding on the shareholder and the company, even though the relevant fiduciary duty is owed to the company, not the shareholder.

• While the claim is based upon the fact of a commission of a breach of fiduciary duty by directors, the cause of action is the breach of contract between the shareholder and the company.

The Board also held:

• The right of a shareholder to sue the company is not dependent on the alteration in the balance of power being adverse only to a minority of shareholders, the claiming shareholders being, or being part of, a majority. The size of the claimant's shareholding is, in principle, irrelevant. What matters is that the claiming shareholders have suffered an interference with their rights as shareholders brought about by the improper issue and allotment.

• It is, in principle, irrelevant whether the company itself, separately, has a cause of action against the directors for the breach of fiduciary duty owed to it. The shareholder's action against the company may coexist with an action by the company in respect of the same duty, so that the availability of the latter does not exclude the former.

• The mere theoretical possibility of ratification is not sufficient to deprive the claimant shareholder of a cause of action. There will always be cases where a personal claim by a shareholder may be defeated by ratification either before or after proceedings have begun, where it does not amount to oppression on the minority. There will also be cases where the nature of the breach of duty is such that ratification will not be possible. For example, a breach constituted by the directors having the improper purpose of assisting an existing majority to oppress a minority could not be ratified by the majority without falling foul of the constraint against majority oppression.

The Board ultimately held, on the assumed facts of the case, that this was a strong case for the availability of a personal shareholder's action. The effect of the dilution on Tianrui's shareholding would be to deprive it of negative control of the company. It would, therefore, be an interference with Tianrui's rights as a shareholder to have a say in the collective control of the company's affairs. The directors would therefore be acting for an improper purpose by exercising their power to issue and allot the disputed shares. Any purported ratification would also be intended to oppress Tianrui as a minority shareholder. The recipients would be unlikely to be able to resist the setting aside of the allotments if it is proved that they were acting in concert with the majority.

The decision clarifies the standing of shareholders of Cayman Islands companies to bring personal actions against the company for an improper allotment of shares by directors. Shareholders will now be able to pursue claims falling within the scope of the decision without being required to satisfy the procedural steps and requirements for derivative actions. The decision is therefore favourable to shareholders.

It is likely that future shareholder claimants will seek to apply this decision to claims for breaches of other types of fiduciary duties. The extent to which the principles in this decision apply in a wider context is not expressly addressed by the Board and would therefore need to be considered on a case-by-case basis. Claimant shareholders will, however, need to demonstrate that the particular complaint in issue is founded on a cause of action arising out of the corporate contract between the company and its shareholders, and that the shareholder has suffered an interference with their rights as shareholders brought about by the exercise of that power or step.