Earlier this month the High Court had to consider:

• how two particular provisions in articles of association operated together (or in conflict), and
• the statutory right (under s. 633, Companies Act 2006 ("s. 633")) of the holders of at least 15% of a class of shares who did not consent to a variation of their rights, to ask the court to disallow a variation of their rights which would unfairly prejudice them.

In Re DnaNudge Limited ([2023] EWHC 437 (Ch)), the court made some instructive observations about the construction of articles of association, as well as the distinction between classes of shareholders and classes of shares and the availability of s. 633 relief. The morale of the tale in this case is clear - to avoid the distraction and expense of litigation it is always better to spell out in detail what you may think are the pretty obvious commercial points that have been agreed.

Background

The dispute arose as a result of the alleged conversion of certain preferred shares in the company into ordinary shares, thereby removing from them valuable preferences as to cumulative dividends and return of capital, etc. The company asserted that its articles of association allowed this to happen by a written notice served by a simple majority of all its shareholders - the preferred shareholders and the vastly more numerous ordinary shareholders taken together. Needless to say, none of the preferred shareholders had signed the written conversion notice and so their shares were converted into much less valuable ordinary shares by the majority wish of the ordinary shareholders.

What the articles said

When the private capital investors subscribed for their preferred shares at a substantial premium, new articles were adopted, setting out the rights of the new class of shares.

Article 9 provided that these shares would "automatically convert into Ordinary Shares: (a) upon notice in writing from an Investor Majority ... or (b) immediately upon the occurrence of a Qualifying IPO" (art. 9.2).

"Investor Majority" was defined as being "the holders of a majority of the [preferred shares] and Ordinary Shares in aggregate as if such Shares constituted one class of share".

Article 10.1 provided the preferred shares with standard protection against the variation or abrogation of their special rights without their consent by stating: "Whenever the share capital ... is divided into different classes of shares, the special rights attached to any such class may only be varied or abrogated ... with the consent in writing of the holders of more than 75 per cent in nominal value of the issued shares of that class."

What the preferred shareholders argued

The preferred investors said that the conversion of their shares amounted to a "variation or abrogation" of the special rights attached to their shares and was ineffective because their consent had not been obtained as required by art. 10.1. You had to read art. 9.2, providing for the conversion of their shares to be "automatic" on service of the Investor Majority notice, as being subject to art. 10.1. Alternatively, if art. 9 was not subject to art. 10.1, they requested the court to exercise its discretion under s. 633 to disallow the variation or abrogation on the grounds that this would - as required by the section for relief - "unfairly prejudice" them as a class.

Essentially, the preferred shareholders argued that the proper construction of art. 9.2 - to give it reasonable business efficiency and reflect what an objective bystander would have understood the parties to have agreed when creating the preferred shares with their special rights and providing for their conversion in certain events - meant that the automatic removal of those rights could not be effected without going through the consent mechanism under art. 10.1. Art. 9.2 provided a simple administrative tool whereby the preferred shares could be replaced by ordinary shares, in connection with an IPO or other corporate reorganisation, but it did not do away with the need to get consent under the art. 10.1 where, as a result of the replacement of the preferred shares with ordinary shares, the rights of those preferred shares were, at least in substance, varied or abrogated.

The articles should not be given a literalist interpretation - as if art. 9.2 operated in isolation from art. 10.1 and as if the preferred shareholders had accepted that the continuance of their special rights, changes to which would normally require their consent, could always be removed, "at a whim", by a simple majority of the shareholders at large converting the preferred shares into ordinary shares. If that was the way the articles were to be construed, clearly something had gone wrong with the drafting since no rational investor would have ever thought they were paying a substantial premium for preferred shares whose preferences could be removed without the need for any class consent, potentially immediately after they had been issued. Applying the well known principle of contractual interpretation coming from the House of Lords decision in Chartbrook Ltd v Persimmon Homes Ltd (2009), in this case the court should correct the error by reading art. 9.2 as if its operation was subject to the consent of preferred shareholders being obtained under art. 10.1.

What the company argued

The company said the articles were clear enough as drafted. The relevant wording had in fact been provided by the preferred shareholders. There was no variation or abrogation of the preferred shares rights but rather an exchange or swap of those shares for ordinary shares. Art. 10.1 was not, therefore, engaged. The rights attaching to the preferred shares remained exactly - at least in theory - the same after the conversion as they did before; it was just that those shares were no longer the shares held by the former preferred shareholders and merely existed as a class of share capital under the company's articles (that might be issued afresh in the future).

The preferred shareholders were confusing the rights of a class or group of shareholders and the impact on their enjoyment that the conversion had with the rights attaching to a class of shares and whether those had been changed (which they had not). The law is clear that a change to the enjoyment of class rights, without those rights in themselves being changed, does not , without more being said as an express term of their rights, amount to a variation of class rights. Thus, for example, the issue of a new class of shares ranking in priority to an existing class will not, by itself, amount to a variation of that existing class's rights. Since there had been no change to the rights attaching to the preferred shares, s. 633 was also not engaged.

Essentially, what the preferred shareholders were asking the court to do was to let them off a bad bargain - having paid a premium for shares whose valuable preferences could be removed without their consent by a simple majority of the other shareholders. To agree with the preferred shareholders and relieve them of their bad bargain would also be to take away from the ordinary shareholders their part of the bargain that had been struck - the ability at any time to be able to replace the preferred shares with ordinary shares if they so wished.

Company counsel later tried to argue that the cases in which the courts have held that a reduction and cancellation of preferred shares - in accordance with the preferred return rights of those shares - was not an abrogation of the rights attached to those shares, showed that the conversion of the preferred shares here also could not amount to a variation or abrogation of their rights. This was roundly rejected by the judge - in those cancellation cases, the company concerned was giving effect to the preferred shareholders' special rights whereas here the opposite was happening, with the company purporting to take away (and not give effect to) the preferred shareholders' rights.

The court's decision - did the conversion of preferred shares amount to a variation and was art. 9.2 subject to art. 10.1

Despite the bold and powerfully deployed arguments of the company, the judge held that the conversion of the preferred shares into ordinary shares did amount to a variation or abrogation of their rights. He also held that that variation was caught by the requirement under art. 10.1 for preferred shareholders' consent to be obtained and as it had not been, the conversion was "invalid, void and of no effect". Art. 9.2 had to be read as if the words "subject always to having first obtained the consent required under art. 10.1" were added to it.

The judge reached his conclusions about the proper interpretation of articles 9 and 10 with some caution, admitting to having been "chastened by the treatment accorded to [his] decision in Britvic", a case in which the Court of Appeal had roundly criticised and rejected the judge's overly "purposive and corrective" interpretation of the certain pensions documentation.

His rationale was straightforward - "any reasonable reader of the articles would regard the conversion of preferred shares into ordinary shares as varying or abrogating the rights attached to the former class of shares. In my judgment, one has to look at the reality of the situation. .... once the share conversion takes effect, for all practical purposes the special rights that formerly attached to the preferred shares have been taken away from them, and no longer exist, because there are no longer any preferred shares in issue. The special rights attached to the preferred shares have been extinguished, and ceased to exist, because the preferred shares are now ordinary shares. I agree with [counsel for the preferred shareholders] that the fact that redundant rights might persist in the articles, bereft of any shareholder entitled to take any advantage of them, is neither here nor there. With respect to [counsel for the company], his submissions on this aspect of the case are unduly legalistic and technical, and they are not founded in reality."

As to the proper construction of the conversion right enjoyed by an Investor Majority under art. 9.2(a), that was "both so obvious that it goes without saying, and also necessary to give business efficacy to the contract constituted by the articles - ... it cannot operate to effect any removal or abrogation of the special rights attached to any shares to be converted without the consent required by art. 10.1".

This wasn't a case where the provision to be construed in a document was ambiguous or where clearly the wrong word or definition had been used. Rather, as mentioned in the Britvic case, it was one of those rare cases where "the mistake does not readily appear when reading the provision but it becomes apparent on examination that this cannot have been what the drafter meant, as it makes no rational sense".

The court's decision - would a s. 633 application be available to the preferred shareholders if their rights had been varied under the articles?

The judge did not need to decide this issue since he found that there had been a variation of class rights, nevertheless he made three important observations about it.

First, he rejected the company's argument that a s. 633 application is only available where the disputed variation has been carried out under the statutory default provisions in s.630 (which require class consent where there are no such provisions in the relevant articles) and not where it has been carried out under a provision in the articles (as would have been the case here because of art. 10.1).

Secondly, although in deciding whether there has been any unfair prejudice the court has to have regard to "all the circumstances", the court should only consider variations of the rights attached to the relevant shares and not any other legal rights that the class of shareholders may have, under (say) a shareholder agreement.

Thirdly and more significantly, if the variation in this case had been carried out in accordance with the articles - e.g., if art. 9.2 had said the shares could be converted without any requirement to obtain any class consent under art. 10.1 - the preferred shareholders would have failed to demonstrate that the variation resulting from the conversion would unfairly prejudice them. A variation carried out in accordance with the terms of the articles could not be held to be unfairly prejudicial to the shareholders concerned.

Takeaways

This litigation shows that even sophisticated investors like PE and VC funds, and especially their advisers, need to take great care when drafting their investment rights in articles (and elsewhere) to ensure that the agreed commercial deal and the legal mechanisms adopted to implement that deal, hang together as a coherent whole.

The judge's comments are also a useful illustration of how the court will approach construing articles of association as a special type of statutory contract (see s. 33(1), Companies Act 2006). Company counsel had argued that whereas the courts take a slightly narrower approach to construing a pension scheme than a normal commercial contract, that approach was even narrower in the case of articles of association. The court should construe the articles having regard to the natural meaning of the words used and the only extrinsic evidence which it should take into account was the Form SH01 filed on the issue of the preferred shares, which set out their special rights, and the fact that they were subject to the right of conversion. The judge did not dissent from this view but still felt able to rule that the articles contained an obvious drafting error and that it was clear from the "limited admissible extraneous evidence", what needed to be done to correct the clear mistake on the face of article 9.2(a) (in failing expressly to provide that it was subject to the consent required by art. 10.1).

Finally, it is not surprising that the judge said that if the conversion of the preferred shares had been effective under the articles he would not have found that any resulting variation in their rights unfairly prejudiced the preferred shareholders. He did not go into what might constitute unfair prejudice in these circumstances and so we are left to speculate that an example of this might be a variation that was approved by a class consent not given by members acting in good faith in the interests of the class a whole.

The judge noted that the company had indicated that it may intend to appeal the court's ruling, so we will have to wait and see if the judge's ruling discussed above remains the last word on this quite remarkable dispute between a PE investor and its investee company.

"So the problem is clear; and once the problem has been clearly identified, the solution to it is equally clear: “All roads lead to Rome.” Article 9.2 (a) is subject to article 10.1, which takes precedence. That is the clear solution, and clearly what a reasonable person at the time would have understood the parties to have meant.", Judge Hodge KC, (para 86, summarising the preferred shareholders' argument)

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