Shareholders rights: challenging improper share allotments

The allotment and issue of new shares by company directors can significantly affect existing shareholders and their shareholder rights in two critical ways.

1. It can alter the balance of voting power, potentially diminishing a shareholder’s ability to influence decisions or block special resolutions.
2. It can dilute the financial value of current holdings, reducing both proportional ownership and potential returns on investment.

These consequences make the proper exercise of directors’ powers particularly important for shareholder protection.

If shares are allotted for an improper purpose, what rights do shareholders have to challenge that allotment?

This was the issue before the Privy Council in Tianrui (international) Holding Company Ltd v. China Sanshui Cement Group Ltd, on an appeal from the Court of Appeal of the Cayman Islands.

The specific issue considered by the Privy Council was to what extent does a shareholder, whether they are a majority or minority shareholder, have the right to bring a claim against a company when the directors allot shares for an improper purpose. More specifically, does a shareholder have a personal right to seek a declaration from the court that the power of the company to allot shares has been invalidly exercised by its directors.

This decision of the Privy Council does not create new law. The English courts have long recognised that shareholders have the right to challenge the allotment and issue of shares by directors for an improper purpose, but the Privy Council took the view that the legal basis for that right had not been clearly articulated in the previous authorities and therefore took the opportunity to review the law on this issue.

Judgment was handed down on 14 November 2024 and serves as a useful reminder of the law on this issue.

Case Background

China Shanshui (the Respondent) was a Cayman Islands exempted company, but was also listed on the Hong Kong stock exchange as a non-Hong Kong company.

Its principal shareholders were Tianrui (the Appellant), with a shareholding of 28.16%, a Taiwanese registered company with a shareholding of 26.72% (ACC), a company registered in the People’s Republic of China with a shareholding of 16.67% (CNBM), and a Hong Kong registered company with 25.09%.

In 2018, the majority of the shareholders of the Respondent voted at an extraordinary general meeting to reconstitute the board of directors of the Respondent. Following that decision, the Respondent issued a number of convertible bonds in two tranches.

The first tranche had a total value of US$210,900,000 and the second tranche had a total value of US$320,700,000.

At a later shareholders meeting a resolution was passed directing that the directors of the Respondent allot and issue 1,067,830.759 new shares, which had the effect of diluting the Appellant’s shareholding from 28.16% to 21.75%.

The Appellant alleged that the decision to issue the convertible bonds and allot new shares constituted an improper exercise of the Respondent’s power to allot and issue securities and was therefore invalid. This was on the basis that the power had been exercised for the primary purpose of enabling ACC and CNBM to obtain control of the Respondent and dilute the Appellant’s shareholding below 25% so as to prevent it from being able to block special resolutions.

The Appellant commenced proceedings before the Grand Court in the Cayman Islands for a declaration to that effect.

The Respondent sought to strike out the Appellant’s writ on the basis that a shareholder does not have the right under the laws of the Cayman Islands to bring a claim personally based on an alleged breach of fiduciary duty on the part of the directors. The proper course of action was to bring a claim on behalf of the company as a derivative action.

Decision of the Grand Court

The Respondent’s argument was rejected at first instance. The Judge held that a shareholder does have the right to bring a personal claim against the company and that the Appellant was entitled to a declaration that the actions of the directors were unlawful.

The Judge also found that the fact a shareholder could also seek redress by way of derivative action did not mean that a shareholder did not have a personal claim.

Decision of the Court of Appeal of the Cayman Islands

The Court of Appeal came to the opposite view and found that an individual shareholder did not have a personal right of action against a company for the dilution of their voting powers even in circumstances where shares were issued in breach of a director’s fiduciary duties.

The Court of Appeal based its decision primarily on the rule in Foss v Harbottle. This is a decision of the English courts, which provides that where a wrong is committed against the company, it is the company, not the individual shareholders, who having standing to bring a claim to remedy that wrong. We return to this point below.

Decision of the Privy Council

The judgment of the Privy Council opens by conclusively stating that:

… the Board concludes that a shareholder has a right of action against the company to challenge the allotment of shares by the board of directions on the basis that the allotment was made for an improper purpose in circumstances where the allotment will cause detriment to the shareholder.

The judgment goes on to consider four specific questions:

1. Given that the duty alleged to have been breached by the directors is owed to the company, not to the individual shareholder, does the shareholder have a cause of action and if so, what is it?
2. To what extent can that cause of action be pursued given the rule in Foss v Harbottle?
3. Is the improper exercise of the director’s power void or only voidable?
4. Is the alleged breach of duty capable of being ratified?

Rule in Foss v Harbottle

The Privy Council began by summarising the rule and explaining why it did not operate to preclude a shareholder from bringing a personal claim.

The Privy Council identified the rule as being made up of two interlinked principles.

First, the ‘proper plaintiff’ principle, which provides that where a wrong is committed against the company, whether by its own directors or a third party, the proper claimant is the company. The power to manage the affairs of the company is usually delegated to the directors and the decision whether or not to commence court action usually lies with them.

Consequently, if a director commits a breach of duty, it is the company, not its shareholders, that has the right to take legal action to remedy the wrong.

Secondly, the ‘majority rule’ principle, which provides that, as a general rule, the will of the majority prevails over the minority. If a decision can be taken by simple majority, and that majority does not wish to take action against a director for breach of duty, the majority should be able to waive or ratify the breach.

This rule, if too strictly applied, clearly has the potential to cause prejudice because a director who has committed wrongdoing is very unlikely to vote to bring an action against themselves. Turkeys are not in the habit of voting for Christmas. It is for that reason that English law has developed various exceptions to the rule in Foss v Harbottle.

Derivative claim

A derivation claim is originally a creation of the common law, but it is now set out in Chapter 1 of Part 11 of the Companies Act 2006 (the CA 2006).

Section 260 of the CA 2006 allows a member of a company to bring a claim in their own name on behalf of the company against a director for negligence, default, breach of duty and breach of trust. However, in order to continue with the claim, it is necessary for the member to obtain permission from the court.

Personal rights belonging to shareholders

As the Privy Council recognised in its judgment, the rule in Foss v Harbottle is “only part of the picture.”

English law also recognises that shareholders have personal rights against a company, which can be enforced independently of the company. In other words, outside of a derivative claim.
One such example is where a director, acting on behalf of the company, exercises his or her powers granted to them under the articles of association for an illegitimate purpose.

The Privy Council summarised the law in the following terms:

All powers conferred on the directors are fiduciary in nature and they are required by equity to exercise such powers for proper purposes. An exercise of a fiduciary power for an improper purpose is a breach of duty owned by the directors of the company. Although the duty is owned to the company, and not to shareholders personally, shareholders whose personal rights are adversely affected by the directors’ exercise of the power have been held in the context of a range of different powers to be entitled to maintain a personal action against the company to remedy the wrong done to them.

The Privy Council confirmed that the English courts (and courts of other common law jurisdictions) have “for a long time recognised the right of a shareholder to challenge the allotment and issue of shares by a company’s directors for an improper purpose, such as to alter the voting power of shareholders.”

Legal basis of the shareholder’s personal action

Having determined the existence of a suite of rights that are personal to shareholders, the Privy Council then went on to consider the legal basis for such a claim.

The Privy Council concluded that the claim was essentially contractual in nature. It recognised that where an individual is registered as a shareholder of a company this comes with certain legal rights. This includes the right to participate in the distributable profits of the company and to attend and vote at any general meeting and influence the management of the company.

The power to allot and issue shares was reserved to the Respondent by its memorandum of association, but the power to direct the company to take such action was conferred on its directors by the articles of association. When exercising that power the directors act as fiduciaries and as such, the directors are required by law to exercise their powers for a proper purpose.

An example of a proper purpose for the exercise of that power includes the raising of further capital where that is considered to be in the best interests of the company. However, the Privy Council stated that a proper purpose did not extend to action deliberately aimed at “altering the balance of power between shareholders.”

The Privy Council recognised that:

It is not, of course, part of the corporate contract that a shareholder’s holding will not be diluted, or that nothing will be done by the directors which alters the balance of power between shareholders. The Board may for example perfectly legitimately decide to issue shares for proper business purposes to new shareholders and that issue, while diluting all existing shareholders’ holdings in equal proportions, incidentally alters the balance of power by depriving a shareholder or group of majority control, or of negative control. But it is part of the corporate contract that, if this is to happen, it is done only by a proper exercise of the power, ie one that is exercised bona fide for the benefit of the company as a whole and exercised for the purposes for which the power was conferred. This will necessarily exclude, for example, an allotment and issue of shares which is deliberately aimed at altering the balance of power shareholders, so as to advance the power of one (or one group) at the expense of another.

The Privy Council concluded that this was the legal basis for a shareholder’s right to bring a claim against a company to challenge an improper exercise of the directors’ power to allot and issue shares.

The Privy Council stated that:

It is implicit in the contract constituted by the articles of association that the company’s power to allot and issue new shares, delegated by the articles of association to the directors, will be exercised properly, which is to say by the directors on behalf of the company in accordance with their fiduciary duties. The harmful consequence to the shareholder is the alteration (adverse to him) in the balance of power between the company’s shareholders and the particular harm which that does to the value of the rights embedded in his shares. It is an actionable harm because the impropriety in the exercise of the power contravenes the corporate contract binding him and the company, even though the relevant fiduciary duty breached by the directors is now owed to him.

The basis of the claim, or the cause of action, is therefore the contract that exists between the shareholder and the company, represented by the company’s constitutional documents, and the term implied into that contract that, when exercising the power to allot and issue shares, the directors will, as agents of the company, do so in accordance with their fiduciary duties.

Ratification

The Privy Council recognised that any wrongdoing on the part of a director was always going to be potentially subject to ratification by the majority of the shareholders, which would operate to ‘forgive’ the breach. But this power cannot be exercised in such a way that oppresses the dissenting minority. It is therefore not an unfettered right.

Judgement

The Privy Council concluded that the decision of the Court of Appeal was wrong and the Appellant’s writ should not have been struck out.

The Privy Council found that, if the assumed facts of the case were proved to be true, the directors of the Respondent had acted for an improper purpose in allotting and issuing the new shares, and that the purported attempt to ratify their actions was vitiated by the intent of the majority to oppress the Appellant as a minority.

Conclusion

This Privy Council decision reinforces a fundamental principle: directors cannot use their powers to allot shares for improper purposes, particularly when aimed at deliberately altering the balance of power between shareholders.

When faced with potentially improper share allotments, shareholders have personal rights to take action. The case clarifies that these rights derive from the contractual relationship between shareholders and the company, as embodied in the company’s constitutional documents.

Importantly, shareholders need not rely solely on derivative actions. They can pursue personal claims when directors have acted improperly in ways that diminish their voting power or dilute their financial stake.

How can Morr & Co help?

Our Commercial Disputes team combines deep expertise in shareholders rights with practical commercial understanding. We can guide you through:

• Assessing whether directors have allotted shares for an improper purpose
• Evaluating your legal position and available remedies
• Developing strategic approaches to protect your shareholder interests
• Preparing and managing personal claims against improper board actions
• Navigating complex corporate governance issues

Whether you’re a majority shareholder concerned about voting power or a minority investor facing potential dilution, we provide clear, strategic advice tailored to your specific circumstances.

If you have any concerns or questions about shareholders rights, please do not hesitate to reach out by calling our Dispute Resolution team on 01737 854500 or email info@morrlaw.com

Disclaimer
Although correct at the time of publication, the contents of this newsletter/blog are intended for general information purposes only and shall not be deemed to be, or constitute, legal advice. We cannot accept responsibility for any loss as a result of acts or omissions taken in respect of this article. Please contact us for the latest legal position.