Diluting shareholders: unpacking the Tianrui decision

Tianrui (International) Holding Co Ltd (‘Tianrui’) was a principal shareholder in China Shanshui Cement Group Ltd (‘China Shanshui’), a company listed on the Hong Kong Stock Exchange. Tianrui was the holder of a 28.16% shareholding, along with Asia Cement Corporation (which held 26.72%) and China National Building Materials Co Ltd (which held 16.67%), amongst others.

In April 2015, China Shanshui was suspended from trading on the Hong Kong Stock Exchange, having fallen below the 25% minimum float threshold required. As a result, the board took the decision to issue and allot new shares to some of its shareholders in order to bring its free float back in line with the HKSE regulations. Tianrui alleged that the purpose of the share issue this was to reduce its shareholding from 28.16% to 21.75% (meaning that it could no longer block special resolutions). China Shanshui argued that Tianrui had no claim, because the duty to allot shares for a proper purpose was owed by the directors to China Shanshui, not to Tianrui.

Upon appeal, the Privy Council held that Tianrui did have a direct claim against China Shanshui. The Privy Council held:

1. Where the Articles of Association of a company allow it to issue shares, there is an implied contractual term between the company and its shareholders that, when exercising their power on behalf of the company, the directors will exercise them in accordance with their fiduciary duties;
2. An allotment of shares must be made for a proper purpose (e.g. to raise new capital) and where they have been issued for an improper purpose (e.g. to dilute a shareholder), a shareholder whose personal rights are adversely affected is entitled to bring a personal claim against the company, notwithstanding that directors’ fiduciary duties are owed to the company, and not to the shareholders personally; and
3. This right to bring a personal claim exists irrespective of: (i) whether the shareholder is a minority or majority shareholder; (ii) whether they also have redress by way of a derivative action; and (iii) irrespective of whether the breach could theoretically have been approved in advance or ratified by the shareholders at a general meeting.

Whilst this decision was made in the Cayman Islands, the case may be given weight in England and Wales. As such courts in England and Wales may agree that the Articles of Association of a company will create a contract between the company and its shareholders and that an improper allotment of shares constitutes a breach of an implied term that directors will comply with their fiduciary duties when they exercise their power to issue shares.

This is separate to other potential claims which a shareholder may bring (including a derivative claim brought in the name of the company, or an unfair prejudice claim under s.994 Companies Act 2006).

The Privy Council decision emphasises the importance for boards to give very careful consideration to share allotments that may result in dilution or loss of voting power for one or more shareholders. If there is any doubt over whether the decision to allot will result in a breach of contract claim, directors should seek legal advice and (ideally) shareholder approval before the allotment is made.