Directors’ Dispute: The Case of Tianrui

Preliminary

The Judicial Board of the Privy Council (the “JBPC”) recently held in Tianrui (International) Holding Company Ltd v China Shanshui Cement Group Ltd [2023] UKPC36 (14 November 2024) that a shareholder has a right of action against the company to challenge the allotment of shares by the board of directors on the basis that the allotment was made for an improper purpose in circumstances where the allotment will cause detriment to the shareholder.

Background

The appeal arose out of a prolonged battle for control of the respondent company, China Shanshui Cement Group Ltd (“CSCGL”), a Cayman Islands exempted company listed on the Hong Kong Stock Exchange.

CSCGL is a holding company of a group of operating subsidiaries registered in Hong Kong and the People’s Republic of China (“the PRC”). These subsidiaries are principally engaged in the production, distribution, and supply of cement and related construction products in the PRC.

The principal shareholders in CSCGL were (i) the appellant (“Tianrui”) with a shareholding of 28.16%, (ii) Asia Cement Corporation (“ACC”) with a shareholding of 26.72%, (iii) China National Building Materials Co Ltd (“CNBM”) with a shareholding of 16.67%, and (iv) China Shanshui Investment Company Ltd (“CSI”) with a shareholding of 25.09%.

Each of CSCGL, Tianrui, ACC and CNBM were competitors in the cement production industry in the PRC.

In May 2018 a majority of shareholders of CSCGL, including ACC, CNBM and CSI, voted to reconstitute the board of directors in order to comprise one director from CNBM, one director from ACC and three independent non-executive directors.

In August and October 2018 CSCGL issued convertible bonds in two tranches.

On 30 October 2018, a majority of the shareholders of CSCGL passed a resolution mandating the directors to allot and issue new shares to the holders of convertible bonds.

Tianrui contested these actions, alleging that (i) because the PRC government had imposed restrictions on cement production capacity in 2014, CSCGL had become a target for takeover, (ii) the bondholders, ACC and CNBM were acting in concert to take over voting control of CSCGL; (iii) the issue of the bonds and the allotment and issue of the new shares were an improper exercise of CSCGL’s power to allot and issue securities and (iv) the shares were issued to enable ACC and CNBM to control CSCGL and achieve a dilution of Tianrui’s shareholding to under 25% (in fact 21.85%) with the result that Tianrui could no longer block special resolutions and thus could not prevent the merger of CSCGL with another company.

The JBPC ultimately concluded 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, although in certain circumstances (not applicable here) the claim may be defeated by ratification of the allotment by a majority of the shareholders (other than the allottees) at a general meeting. In reaching this conclusion, the JBPC set out its own reasons based upon first principles:

69. The power to issue shares is conferred upon CSCGL by its memorandum of association, but the power to cause the company to allot and issue shares is conferred upon the directors, acting as fiduciaries, by the articles of association. The power is therefore necessarily a fiduciary power and must therefore only be exercised for proper purposes. The proper purposes for the exercise of the power to allot and issue shares include the raising of new capital where that is genuinely considered by the directors to be in the best interests of the company, but there can be other legitimate purposes. No part of those proper purposes includes deliberately altering the balance of power between shareholders…
70. …It is a term of the corporate contract that, if the exercise of the power to allot and issue new shares by the directors as agents for the company is to be valid and binding as between the individual shareholder and the company, it should comply with all conditions necessary to make it a proper exercise. These include compliance with the directors’ fiduciary duty owed to the company. This is a constraint implied by law as inherent in the relationship between the shareholder and the company.
71. It is not, of course, any 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 between shareholders, so as to advance the power of one (or one group) at the expense of another.
72. This is, in the Board’s view, the basis of the shareholder’s right to bring an action against the company to challenge an improper exercise of the directors’ power to allot and issue shares. 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 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 not owed to him.

Conclusion

In the final result, the JBPC regarded Tianrui’s case as a strong one and held that if the assumed facts are proved to be true, the directors acted improperly in the issue and allotment of the disputed shares and that the purported ratification of their actions was itself vitiated by the majority’s intent to oppress Tianrui as a minority shareholder.

AUTHOR

N. Leroy Smith

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