Last week the Court of Appeal dismissed the appeal by DnaNudge Ltd against the first instance decision in Ventura Capital GP Ltd v DnaNudge Ltd which invalidated an attempt by the ordinary shareholders in the company to convert, under a provision in its articles, all its preferred shares, against the wishes of the holders of those shares, into ordinary shares. This would remove from those shares all the preference rights and protections with which they had been issued. Snowden LJ, giving the judgment of the court, endorsed the legal reasoning adopted by the trial judge (except in one relatively minor respect mentioned below) in ruling that the company's articles, despite seemingly expressly providing for this, did not, when properly construed, entitle a simple majority of all shareholders combined, to require the “automatic” conversion of the preferred shares into further ordinary shares. We discussed that first instance decision in our briefing available here.

Automatic conversion v abrogation

Several arguments were made by both sides in this legal dispute but, in summary, the company pointed to the provision in its articles that said that on service of a notice by a majority of all its shareholders (ordinary and preferred) the preferred shares would be “automatically” converted into ordinary shares. The preferred shareholders pointed to the article that said that the special rights attached to their shares could only be varied or abrogated by the consent of 75% of the holders of those shares. They argued that an “automatic conversion" of their preferred shares under the articles could not take place without their 75% consent since such a conversion would inevitably involve the variation or abrogation of their preferred rights when their shares were converted into ordinary shares.

The company argued that these sorts of “automatic conversion” provisions in articles could and often would require preferred shareholder consent but its articles very clearly did not impose such a requirement. In addition, it argued that the rights of the preferred shares were not varied or abrogated by the conversion. Those rights remained, technically at least, as rights attaching to a class of preferred share in the company; it was just that the holders of those shares now found themselves, instead, holding ordinary shares which did not have any such rights. Further, because the preferred shares were issued subject to a right of automatic conversion, exercising that right involved no more than applying (or performing) the rights attached to the preferred shares. The automatic conversion would not be “automatic” if before it could take effect, the consent of the class of preferred shareholders had to be obtained.

How, as a matter of law, could the preferred shares be “converted” into ordinary shares?

Snowden LJ noted that the process of "conversion" of the preferred shares under the articles was “not, in fact, one that is prescribed by English company law and … is not dealt with under the Companies Act 2006.” (at #86 in his judgment). In his view, when converted the preferred shares would not have been cancelled and replaced by new ordinary shares but rather they would continue in existence but now designated as ordinary shares on the company's register of members.

Although Snowden LJ took the view that the preferred shares, when allegedly converted, could technically continue to exist he did not accept the company's argument that this meant there could not therefore have been any variation or abrogation of the rights of those shares - “simply as a matter of the ordinary use of language, … ”abrogation" is entirely apposite to describe the effect of the process by which the special rights … attaching to all of the [preferred shares] entirely cease to apply to the shares when they become Ordinary Shares" (at #88).

Although given obiter (not essential to his judgment), these comments may provide some helpful support for those practitioners who take the view that where there is no change in the nominal value of share capital, shares may be redesignated as a different type of share - in this case by a provision to that effect in the articles - without having to go through the statutory formalities of section 617 Companies Act 2006 (i.e., increasing, reducing or sub-dividing or consolidating its share capital).

“Corrective construction”

The trial judge and Snowden LJ noted that if the company was correct, bizarrely, the articles had provided for a class of preferred shares whose rights, immediately after those shares had been issued, could be removed by a simple majority vote - in this case, the ordinary shares comprised 87% of the issued share capital and so more than enough to deliver that vote without any support from the preferred shareholders. Snowden LJ also noted that, if the company was correct, while a relatively minor change to the rights of the preferred shares would require their 75% consent, totally doing away with all those rights by converting the shares into ordinary shares would not require any consent.

Both judges decided that “something had plainly gone wrong with the drafting" of the relevant provisions in the articles. Those provisions were clearly drafted when viewed in isolation from one another but viewed together - as part of the well-established iterative exercise in interpretation - there was a tension between what each was saying and corresponding lack of clarity or certainty. As Snowden LJ observed: “it has been stressed on many occasions that the process of interpretation is an iterative one in which potential meanings of the clause in question are tested against the other clauses of the contract and the commercial consequences.”

It made no sense for the articles to confer on the preferred shares standard protection for their rights, seemingly without qualification other than the 75% class consent requirement, if that could so easily be removed by applying another article that did not require any level of consent from the preferred shareholders. To read the articles in that way made no rational sense and was not a construction that should be attributed to the members of the company.

The solution to this conflict was, as the quotation from Snowden LJ's judgment below states, for the court to construe the relevant article so as to correct the mistaken drafting. This meant that the automatic conversion right of a simple majority of all shareholders had to be read as being subject to the requirement that the conversion of the preferred shares received the necessary 75% class consent.

This “conditioning” of the conversion right did not remove any meaning from its designation as an “automatic" conversion right; provided the preferred shareholders class consent was obtained, the change in designation of the affected shares would take place automatically without the need for any other corporate action or process (beyond the required Companies House filings) by the company.

How articles of association should be construed

Snowden LJ's judgment provides a useful summary of the approach the courts take when construing disputed provisions in articles of association. Since articles are a form of statutory contract between shareholders and the company, standard or established principles of contractual interpretation generally apply (see ##38-48 of Snowden LJ's judgment). However, while the facts and circumstances known or assumed by the parties at the time the document was executed (Lord Neuberger at #15 in Arnold v Britton (2015) is a relevant consideration when courts have to construe the words used in a commercial contract, this factor has a very limited application when construing articles of association, whether that exercise involves construing the words used or considering whether a term may properly be implied into the articles.

In the case of articles, the factual background or matrix is limited to what “would reasonably be ascertainable by any reader of the company's constitution and public filings at Companies House, and commercial common sense” (Snowden J (as he then was) in Euro Accessories Limited (at #34)).

The company had argued that any reader of the articles would have realised from the other Companies House filings that the simple majority required to effect an automatic conversion did not need to include any preferred shareholders. While that was true, that did not close off consideration of how that right was to apply and be exercised in conjunction with the preferred shares class consent protection article.

The trial judge had also placed some reliance on his interpretation of the articles by noting that the public filings would have shown that preferred shareholders had paid a large premium for their shares. He saw this as an indication that it could never have been intended that the preferred rights could be removed by the vote of ordinary shareholders alone. Snowden LJ disagreed with this reliance, since some of the premium paid for the preferred share investment could and probably was attributable to the existing value of the company's business and was not wholly attributable to the new investment in the company.

Section 633 Companies Act

A subsidiary point was raised at trial and further on appeal and this concerned the application of section 633 which provides that where share rights are varied under section 630, the holders of at least 15% of the shares whose rights have been varied and who did not support the variation may apply to the court for the variation to be cancelled. If the court is satisfied, having regard to all the circumstances of the case, that the variation would unfairly prejudice the relevant shareholders, it can disallow the variation.

Section 630 provides that share rights can be varied either in accordance with provisions in articles or, if there are no such provisions, by the required class consent given in accordance with section 630 itself. At first instance, the judge rejected the company's argument that the section 633 right to object to the court only applied where the variation was carried out under the statutory default provisions (in the absence of any process for variation in the articles). He also held that if the purported conversion or variation had been effective and section 633 had applied, he would not have found the variation to be unfairly prejudicial (since it would have simply been a consequence of how the conversion right properly operated under the articles).

Snowden LJ said that he did not need to come to a view about this question since the question did not arise in view of his ruling that any variation involved in the purported “conversion” of the preferred shares was ineffective and void. He did, however, venture to express a view in relation to the requirement under the section that the court must find the petitioning shareholders to have been “unfairly prejudiced” by the variation before it can cancel it - the court was not being given an entirely free discretion to decide whether a particular variation was “unfairly prejudicial”. He is not the first judge to observe that “the court does not sit under a palm tree” and that, as in other areas of jurisdiction where the court has discretion, “the concept of fairness must be applied judicially and its content must be based upon rational principles” (at #103). Like the trial judge, if the conversion of the preferred shares had been effective, Snowden LJ would not have found any unfair prejudice such as to justify the cancellation of the conversion and variation.

Final comment

The background to this case shows that the company knew all along that it was likely face a legal challenge to any attempt to convert the preferred shares into ordinary shares by simple majority vote of the ordinary shareholders alone. Nevertheless, it was represented by highly respected leading counsel in its defence and appeal and clearly thought that the very clear and unambiguous wording in its articles - some of which had been provided by the preferred share investors - would be sufficient to enable it to remove the preference rights in the way it did.

This Court of Appeal judgment provides a very useful and instructive example of those cases where, despite unambiguous drafting, the court will be prepared to step in and correct what it finds to be clearly mistaken drafting. These will, however, be rare occurrences - not all deficient or even mistaken drafting will be amenable to correction by the court. The judges have said repeatedly that their role is not to improve or correct or “balance” bad bargains made by parties (or investors). Only where the particular wording used produces an outcome that, in Snowden LJ's words, “makes no rational sense”, and there is clarity about what the mistake is and what drafting correction is necessary to correct it, will the court be ready to come to the help of the hapless draftsperson and rescue of (at least one of ) the parties.

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