Ashurst and Practical Law Corporate Update Q4 2023

1. Conversion of shares: invalid conversion of preferred shares

The Court of Appeal has confirmed that the conversion of preferred shares into ordinary shares under a company’s articles of association was invalid as this amounted to a variation of the rights attached to the preferred shares for which the procedure in the articles had not been followed.

Background. The Companies Act 2006 (2006 Act) does not expressly address whether a share conversion constitutes a variation or abrogation of the rights attaching to a class of shares.

A share conversion involves changing one class of shares into another class in accordance with a provision in the company’s articles. A company must notify the registrar of companies if it assigns a name or other designation to any class of its shares (section 636, 2006 Act).

A share variation involves varying or abrogating the rights attached to a class of shares, either in accordance with a provision of the articles or, where there is no provision, with the consent of the holders of at least 75% of the nominal value of the relevant class of shares (section 630(2), 2006 Act).

The court can disallow a share variation if it would unfairly prejudice the shareholders of the class represented by the applicant (section 633, 2006 Act) (section 633).

Facts. V and S were significant investors and holders of preferred shares in a company, D.

D’s articles contained:

• Special rights attached to the preferred shares.
• A provision for the preferred shares to automatically convert into ordinary shares on notice in writing from an investor majority (the share conversion article), the investor majority being defined as the aggregate of the preferred and ordinary shares as if they constituted one class.
• A provision stating that a class of shares could be varied only with the written consent of the holders of more than 75% in nominal value of the issued shares of that class (the share variation article).

As the ordinary shares accounted for almost 87% of D’s shares, the ordinary shareholders could form an investor majority without V and S. Ordinary shareholders constituting an investor majority gave notice to D requiring the preferred shares to be converted into ordinary shares in accordance with the share conversion article. D’s solicitors informed V and S that their shares had been converted into ordinary shares.

V and S argued that the conversion of their preferred shares into ordinary shares was invalid as their consent had not been obtained to vary the class rights as required under the share variation article, which took precedence over the share conversion article. Alternatively, the variation of their rights effected by the conversion, if valid, unfairly prejudiced them and should be disallowed under section 633.

The High Court held that the conversion of the preferred shares into ordinary shares was invalid as it amounted to a variation or abrogation of the rights attached to the preferred shares for which the consent of V and S had not been obtained, as required by the articles.

D appealed, arguing that the reference in the share conversion article to an automatic conversion of preferred shares on notice from an investor majority excluded the possibility that other conditions might need to be satisfied in order for conversion to occur.

Decision. The court dismissed the appeal.

The High Court had been entitled to investigate the relevant provisions in the articles as a whole and adopt an interpretation that reconciled the conflicting provisions.

The preferred share rights granted to V and S were designed to apply in specific scenarios. D’s interpretation of the share conversion article would create an incoherent scheme with irrational results as the investor majority would have unrestricted power to deprive V and S of the benefits of those rights at precisely the time that they were designed to benefit them; for example, on an exit or liquidation. D’s interpretation would also mean a corresponding benefit being conferred on ordinary shareholders instead.

There was wording in the articles that suggested a continuation of existing shares on conversion. In addition, as the articles stated that a minor amendment to the preferred share rights required class consent, an interpretation that those rights could be extinguished completely without the consent of the preferred shareholders was unrealistic. These factors indicated that there were drafting mistakes in the articles.

While the High Court was wrong to state that the substantial premium paid for the preferred shares represented payment for the special rights attached to them, and to place weight on that in its analysis, its decision was correct.

Comment. This decision reiterates that companies should ensure that the drafting in their articles dealing with the conversion and the variation of shares is clear and consistent. Particular care may need to be taken in relation to provisions that purport to enable a share conversion to be effected without the consent of the relevant class of shareholders other than on the occurrence of a limited set of agreed specified events.

The decision also confirms that where a company’s shares are varied in accordance with its articles, and without any allegation of shareholders acting improperly or in bad faith, it may be difficult to make out a claim for unfair prejudice under section 633.

Case: DnaNudge Ltd v Ventura Capital GP Ltd [2023] EWCA Civ 1142.

2. Auditors: duty to buyer of shares

The High Court has held that the buyers of shares in a company had a realistic prospect of proving that auditors owed them a common law duty to exercise reasonable skill and care in preparing the company’s statutory accounts and completion accounts for the transaction.

Background. Completion accounts are usually drawn up for a target company after its acquisition in accordance with an agreed methodology specified in the acquisition agreement. A common price method is a net asset adjustment, which determines the target’s net asset value at completion and adjusts the purchase price to the extent that the actual net asset value at completion departs from an agreed target figure.

Liability can arise in contract under the terms of an adviser’s engagement letter, or under the tort of negligence as an adviser will usually have assumed a duty to act with reasonable care.

A Bannerman clause in an engagement letter usually provides that the adviser’s advice is limited to the specified client and for the specific transaction (Royal Bank of Scotland v Bannerman Johnstone Maclay and others, The Times, 23rd July, 2002).

In Barclays Bank plc v Grant Thornton LLP, the High Court held that a Bannerman clause excluding an auditor’s liability for negligence to third parties was effective ([2015] EWHC 320 (Comm)).

Facts. A bought shares in B on the basis of completion accounts prepared by auditors, E.

A later discovered several alleged accounting frauds committed by B before the share purchase agreement was entered into, the effect of which was to inflate B’s net assets at completion and cause A to overpay for the shares in B.

A did not have a copy of E’s engagement letter, only a schedule to the engagement letter that included a Bannerman clause providing that E was only liable to B for its audit work.

A issued a claim against E, arguing that E owed both a contractual and a common law duty to exercise reasonable skill and care in preparing B’s statutory accounts and the completion certificate. A relied on several facts including the existing commercial relationship between A and E, E’s possession of documents provided by the seller to ascertain the net asset value of B, E’s knowledge that A would use the completion certificate to calculate the final price and that E had addressed the completion certificate to A and the seller, not B.

E argued that the Bannerman clause in the schedule prevented a duty of care arising in favour of anyone other than B (Barclays). E also argued that there was similar disclaimer wording in the original audit report and accompanying cover letter.

E applied to the court to strike out B’s claim and, in the alternative, to grant summary judgment.

Decision. The court struck out A’s claim in contract and granted summary judgment. However, it upheld A’s claim in tort.

There was no realistic prospect of showing the existence of a specific contract between E and A for the preparation of B’s statutory accounts or completion accounts, which would have formed the basis of a successful contractual claim. However, A had a realistic prospect of succeeding at trial in a claim for negligence.

The present case was distinguishable from Barclays on the facts. In particular, the continuing communications between the parties after the audit engagement started, and the direct correspondence between E and A’s solicitor in connection with the completion accounts, suggested a continuing and direct commercial relationship of a kind that did not exist in Barclays.

Comment. Where there is doubt about whether professional advice is covered by a previous disclaimer, it is prudent to remove uncertainty by entering into a new engagement letter. Advisers should ensure that the scope of work is addressed in each engagement letter and that clear disclaimer language is included with the objective of preventing a duty of care arising to anyone other than the immediate client.

The decision does not create new law, but suggests that there is a risk that a professional adviser advising a target company on completion accounts may, under certain circumstances, be held to owe a duty of care to the buyer of shares in the target company, even if there is a Bannerman clause. Advisers should avoid engaging and communicating with the third party to a significant degree in relation to the provision of professional advice without the benefit of a suitable engagement letter.

Case: Amathus Drinks Plc v EAGK LLP [2023] EWHC 2312 (Ch)

3. Company names: similar names

The High Court has held that a company had to change its name on the grounds that it was sufficiently similar to the name of another company and confirmed that the court will not overturn a Company Names Tribunal decision unless there has been a distinct and material error.

Background. The initial registration of a company name does not guarantee that it is protected from challenge. An objector can apply to the Company Names Tribunal if a company name is the same as a name associated with the objector in which they have goodwill, or where the name is sufficiently similar to such a name that it would be likely to mislead.

The Companies Act 2006 (2006 Act) lists the circumstances that raise a presumption that a company name has been adopted legitimately (section 69, 2006 Act) (section 69). An objection is usually upheld if the registered company name holder cannot show that any of these circumstances apply or that the company name was adopted in good faith (section 69(4)(d)). There is also a defence where the interests of the objector are not adversely affected to any significant extent (section 69(4)(e)).

If an objection is upheld, the adjudicator will order the registered company name holder to change its name under section 73 of the 2006 Act (section 73), although the adjudicator’s decision may be appealed in court (section 74, 2006 Act).

Facts. A wholesale trader, A, was established as a private company in October 2020. In November 2020, a worldwide insurance and financial services business, B, with a substantial reputation and goodwill in the UK, applied to the tribunal under section 69 for A’s name to be changed on the grounds that it was sufficiently similar to B’s name, and that the use of A’s name in the UK would be likely to mislead by suggesting a connection between A and B.

The tribunal upheld B’s objection and made an order under section 73 requiring A to change its name within one month. A appealed.

Decision. The court dismissed the appeal.

The tribunal was correct in finding that B had goodwill in the registered company name. A had failed to make out the defences of registration in good faith under section 69(4)(d) and lack of significant adverse effect on B’s interests under section 69(4)(e).

The court noted that it would be reluctant to interfere with a decision of the tribunal where the decision was based on an assessment of several factors but would do so if a distinct and material error of principle was shown.

The court takes the same approach on appeals from the tribunal as with appeals from the trademark registration decisions of hearing officers in the Intellectual Property Office (IPO). This approach is appropriate because the legal exercise undertaken by the hearing officers of the IPO and company names adjudicators of the tribunal is similar.

Comment. This decision provides clarity on the approach that the court will take to appeals against decisions of the tribunal. Where the tribunal has reached its decision by using a multifactorial assessment of the evidence and the correct application of the law, an objector would be better advised to avoid the time and expense of an appeal that is likely to be unsuccessful.

Case: AXA Wholesale Trading v AXA [2023] EWHC 1339 (Ch).

4. Corporate reporting: FRC annual review 

The Financial Reporting Council (FRC) issued its annual review of corporate reporting (the review).

Background. The FRC’s corporate reporting review team is responsible for reviewing the annual reports of quoted and large private companies and limited liability partnerships in accordance with the operating procedures of the FRC’s conduct committee.

Facts. The review reports on the findings of the FRC’s monitoring activities, including the issues that are most commonly raised with companies, together with its expectations for the coming reporting season. In particular, the FRC expects companies to:

• Ensure that disclosures about uncertainty are sufficient to meet the relevant requirements and for users to understand the positions taken in the financial statements.
• Give a clear description in the strategic report of risks facing the business, their impact on strategy, business model, going concern and viability, and cross-reference them to relevant detail in the reports and accounts.
• Provide transparent disclosure of the nature and extent of material risks arising from financial instruments, including changes in investing, financing and hedging arrangements.
• Provide a clear statement of consistency with Task Force on Climate-related Financial Disclosures (TCFD) which explains, unambiguously, whether management considers that they have given sufficient information to comply with the framework in the current year. The FRC may challenge companies that have not disclosed information that the Financial Conduct Authority particularly expects to be provided. Companies must in any event comply with the new mandatory requirements for the disclosure of certain TCFD-aligned information, where applicable.
• Perform sufficient critical review of the annual report and accounts. This includes:
  • considering whether the report as a whole is clear, concise and understandable;
  • omitting immaterial information;
  • deciding whether additional information is required to understand particular transactions, events or circumstances; and
  • conducting a robust pre-issuance review to consider issues that are commonly challenged, including internal consistency, whether accounting policies address all significant transactions, and presentational matters, such as cash flow and current or non-current classification.

The FRC also expects companies to consider how current economic conditions may affect financial and narrative reporting in 2024, including high inflation and rising interest rates as well as the increased uncertainty over a number of economic factors.

Source: FRC: Annual Review of Corporate Reporting, 5 October 2023

The articles above were written by Ashurst LLP and Practical Law Corporate in Q4 2023 and first published in the company law section of PLC Magazine, the leading monthly magazine for business lawyers advising companies active in the UK.