“Corrective construction” to achieve commercial common sense in company articles

In the recent Court of Appeal judgment in DnaNudge Limited v. Ventura Capital GP Limited [2023] EWCA Civ 1142, the court confirmed that a provision of the company’s articles allowing for the conversion of Series A shares to ordinary shares should be read as being subject to another provision requiring the consent of 75% of the affected shareholders. This case provides a useful reminder of the importance of ensuring that the articles of a company properly reflect the rights that are intended to be enjoyed by any particular class of share and the restrictions on any abrogation, variation or extinguishment of those rights. However, the case also provides comfort that where one party seeks to rely on a literal interpretation of the articles that makes no commercial sense, the court may conclude that there has been a drafting error and be prepared to remedy the same.

The Series A investment

DnaNudge Limited (the Company) is a medical and health technology company. In 2021, Ventura Capital GP Limited (Ventura) and Sumitomo Mitsui Trust Bank Limited (SMTB) invested in the business and were issued a total of 24,877 Series A shares (24,026 were held by Ventura and 851 by SMTB). There were also 162,521 issued ordinary shares held by individuals and entities, which included the founders and directors of the Company.

New articles were adopted in connection with Ventura’s investment. The articles set out the matters on which the holders of both classes of shares were to be treated equally and the matters on which holders of Series A shares were to enjoy enhanced rights. For example, in certain circumstances, the holders of Series A shares were to enjoy special distribution rights.

There was also a separate shareholders’ agreement under which Ventura had the right to require the Company to repurchase all or any portion of the Series A shares held by it and SMTB (the Put Option).

There were two particular provisions of the articles that became central to the dispute.

Article 9.2(a). This provided that all “Series A Shares shall automatically convert into Ordinary Shares:… upon notice in writing from an Investor Majority at the date of such notice (the ‘Conversion Date’).” “Investor Majority” was defined to mean the prior written consent of the holders of a majority of the Series A shares and ordinary shares in aggregate as if such shares constituted one class of share. In circumstances in which there were only 24,877 issued Series A shares (13% of all issued shares) and 162,521 issued ordinary shares (87% of all issued shares)), the ordinary shareholders could easily deliver an Investor Majority.

Article 10. This provision concerned variation of rights and provided (at Article 10.1) that “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.”

Purported conversion of Series A shares to ordinary shares

In May 2022, the Company sent a circular to all of its shareholders setting out a proposal to raise additional working capital, which involved the issue of convertible loan notes. The circular summarised some of the risk factors facing the Company, including the risks associated with repurchasing the Series A shares if the Put Option was exercised. The circular also noted that an Investor Majority might seek to “nullify the Put Option by converting the Series A Shares into Ordinary Shares (pursuant to Article 9.2), ahead of any exercise of the Put Option” — an act the circular acknowledged might be challenged by the “former holders” of Series A shares in legal proceedings.

A few days later, various ordinary shareholders including the co-founders and directors, constituting an Investor Majority, sent a letter to the Company giving notice that the Series A shares were required to be converted to ordinary shares pursuant to Article 9.2(a). The Company duly informed Ventura and SMTB that the Series A shares had been converted into ordinary shares. Unsurprisingly, Ventura objected to this. It claimed that the purported conversion was invalid because it involved a variation or abrogation of the rights attaching to the Series A shares that would require compliance with Article 10.1 (i.e., that more than 75% of the Series A shareholders had consented in writing).

Proceedings against the Company

Ventura pursued two alternative lines of attack.

• First, it sought a declaration from the court that the purported conversion was void and of no effect because of the failure to obtain the written consent of the holders of more than 75% of the Series A shares under Article 10.1.
• Alternatively, it sought an order (on behalf of itself and SMTB) pursuant to section 633 of the Companies Act 2006 (CA 2006) (Right to object to variation: companies having a share capital) disallowing the variation and cancelling the conversion on the basis that it was unfairly prejudicial to Ventura and SMTB.

Decision at first instance

At first instance (Ventura Capital GP Limited & Anor v. DnaNudge Limited [2023] EWHC 437 (Ch)), the court found in favour of Ventura and that the conversion was invalid because of the failure to obtain the written consent of 75% of the Series A shareholders in accordance with Article 10.1.

The court recognised the tension in the articles with, on the one hand, Article 9.2(a) clearly permitting the conversion of Series A shares upon notice from an Investor Majority (which, in reality, amounted to the special rights being extinguished) and, on the other hand, Article 10.1, which required consent in writing of 75% of the holders of any shares that were to be subject to a variation or abrogation of special rights. The first instance judge observed that Article 9.2(a) was perfectly clear when read literally and in isolation but made no rational sense when considered in the context of the protection of Article 10.1. The court considered it was clear that there had been an error in drafting and that the solution was also clear: “Article 9.2(a) must be read subject to the consent required in accordance with Article 10.1… it matters little what route one takes to arrive at this result: whether by a process of corrective construction, or by the implication of a term.”

While it was not strictly necessary for the court to do so, as it did not have an impact on the decision, the judge stated that he did not consider that Ventura had made out the alternative case of unfair prejudice to enable relief under section 633 CA 2006. If the conversion of the Series A shares had been authorised under the Company’s articles, the judge considered there was nothing inherently unfair in holding the Series A shareholders to the bargain they had struck in the articles.

The Company appealed the decision.

Court of Appeal decision

The Company’s appeal failed. In coming to its decision on the appeal, the Court of Appeal considered the relevant principles of interpretation and implication of terms.

1. Principles of contractual interpretation applied to articles. The Court of Appeal noted that where the contract to be interpreted is the articles of association, the usual principles of contractual interpretation apply. However, the consideration of the facts and circumstances known to the parties at the time the articles were adopted must be very limited. The reason for this is that the articles of a company apply to a potentially ever-changing body of members, some of whom will not have any knowledge of the circumstances that applied when the articles were adopted. Accordingly, the interpretation of articles should principally be based on: (i) the natural and ordinary meaning of the words; (ii) any additional information about the company or its membership that could reasonably be ascertained from reading its constitution or from public filings at Companies House; and (iii) commercial common sense.
2. Iterative approach. Where the parties have used clear and unambiguous language, the court must apply the meaning of the words. However, that does not mean that the process of interpretation should focus only on the literal meaning of the words and in isolation from the commercial consequences. Instead, “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.”
3. Corrective construction. Where the process leads the court to conclude that there has been a drafting error, the court’s primary method of remedying the mistake is by “corrective construction” provided it is clear what correction is required. Alternatively, the court may imply a term in order to give business efficacy to the contract provided that the same is clear and obvious and does not contradict any express term of the contract.

A significant factor for the Court of Appeal was that “when viewed in the context of the special distribution rights attached to the Series A Shares by Articles 5 and 6, and the protection for those special rights conferred by Article 10.1,…the Company’s contention as to the meaning of Article 9.2(a) would lead to an incoherent scheme and irrational results.” It would allow the ordinary shareholders the power to deprive the Series A shareholders of the benefits conferred by the special rights at any time. Indeed, the ordinary shareholders could have chosen to do this as soon as the Series A shares were issued or just at the point at which the Series A shareholders were about to benefit from their special rights. This made no commercial sense and pointed to the Company’s interpretation of the articles as being irrational. Ultimately, the Court of Appeal concluded that the first instance judge was correct “to reach the conclusion that in order to make rational and coherent sense of the Articles, either Article 9.2(a) must be interpreted as being subject to Article 10.1, or a term must be implied to that effect.”

On the question of section 633 CA 2006 relief, the Court of Appeal noted that members of a company are not ordinarily entitled to complain of unfairness unless there has been a breach of the articles or breach of the terms of shareholder agreements, or “unless the circumstances surrounding the association are such as to bring equitable considerations into play which operate as a constraint on strict legal powers.” In this case, the evidence in support of the claim did not identify other factors beyond the terms of the articles that might lead to equitable considerations being brought in. As such, if the Company had been correct as to its interpretation of Article 9.2(a), the Court of Appeal agreed with the first instance judge that there could be nothing unfair about the ordinary shareholders and Company giving effect to it.