‘Critically analyse the strengths and weaknesses of the current legal provisions relating to a variation of shareholders’ class rights.’

Shareholder Class Rights

The Companies Act 2006[1] (CA 2006) replaced Companies Act 1985[2] and it provides a significant amount of protection for shareholders. The main features of a share include a right to dividends which are declared on the shares, a right to vote at general meetings (unless the share is non-voting), rights of membership attached to the shares, which will be defined in the memorandum and articles of the company, a right to transfer shares in accordance with the articles of association, an obligation to subscribe capital of a given amount, and on the liquidation of a company or upon the reduction of its capital, the right to receive assets which are distributed to the shareholders of that class.[3] The CA 2006 provides a comprehensive legal regime which protects the rights of shareholders.

Shareholders may hold different types of shares, which are generally ordinary shares and preference shares. Preference shares are more complicated. Although they have advantages, in that they carry the right to a guaranteed dividend, and the shareholders of preference shares also rank higher than shareholders who hold ordinary shares, they generally do not carry voting rights. It is important to note that the rights which accompany preference shares will be set out in the articles of association of the company as well as in the terms of issue. Bourne has noted that there are also a number of other possible classes of shares, and that many companies also have redeemable preference shares, which carry the same rights as preference shares, but they can be redeemed at a set rate or at the option of the company.[4] Therefore, the rights that any shareholder will hold in a particular company will depend upon the provisions of the CA 2006, the company’s articles of association, the terms of issue of the shares, and any shareholders agreement. Defining the right structure for share capital is extraordinarily complex.

Defining Class Rights

The definition of class rights is not only determined by statute, but also through the creation of contracts under the articles of association and through case judgements, meaning that companies and shareholders are free to define the equity instruments of a company. Whilst this might cause uncertainty and a certain lack of protection for shareholders, it also provides a flexibility from which they can benefit, as long as prejudice is avoided to other classes of shares. This approach is reflected in the common law, as in Cumbrian Newspapers Group Ltd v Cumberland Newspaper & Westmorland Herald Newspaper & Printing Co Ltd[5]. This case concerned the variation of class rights attached to shares. In the facts of the case, the plaintiff and the defendant carried on the same business. The plaintiff acquired 10% of shares from the defendant, due to their common fears of a competitor. They had a contract which provided for the amendment of the defendant’s articles, notably that the plaintiff was granted rights of pre-emption over ordinary shares and the right to appoint a director, which could be exercised on the condition that the plaintiff held no less than 10% of the shares. When the defendant proposed a meeting to cancel the articles which granted the plaintiff special rights, the plaintiff requested an injunction restraining the defendant from holding the meeting, and a declaration that the shares held class rights and could not be revoked without his consent. The judge held that in exceptional circumstances it is possible for rights to be attached to the shareholder, rather than to the shares. Thus, class rights can be varied, providing the benefit of elasticity and the benefit for a company of being able to adapt to circumstances. This approach has however attracted criticisms, with commentators arguing that an individual, as opposed to a group of shares, should not be protected from variation of class rights.[6] Furthermore, Ferran has argued that if the distinguishing mark of a class right is exclusivity, if the effect of the Cumbrian judgement has the consequential effect of narrowing the scope of protection for minority shareholders it should not be followed.[7]

Although CA 2006 section 629 defines shares as being as of one class ‘if the rights attached to them are in all respects uniform’, a definition which was absent in the CA 1985, this still lacks precision and disputes arise requiring judicial authority. Section 630 replaces s.125 in the 1985 Act regarding the variation of class rights. Ultimately, the weighing up of the interests of shareholders versus statutory rules is a balancing act, and judges have proven willing, through judgements such as that of Cumbrian, to emphasise the rights which are attached to shares which members have contracted between themselves with the company, rather than strictly observing statutory rules. This means that where situations are complex and intricate, judges are willing to take a flexible approach, and allow companies to structure their capital without strict observation of the formalities mandated by s.360 CA 2006. On the other hand, it would be impedimentary for both companies and shareholders if judges were to take too broad a view of the variation of class rights, as if this were to occur, each time new shares were to be issued, it would be necessary to obtain the consent of all class members. Whilst statute does of course provide guidance, it is insufficient as definitions are not provided and novel situations require the consideration of case law.

Thus not all shares are equal. As sections 630 to s.634 CA 2006 replaced the provisions of s.125 of the CA 1985. As case law under CA 2006 has yet to develop; however, there are some principles which may so far be defined. Ultimately, a balance must be maintained between the proper conduct of a business and the protection of shareholders’ class rights. Section 630 is concerned with how rights which are attached to shares may be varied, with such rights including voting right, rights to dividends, and rights to return of capital on winding up. Under s.633, where companies have a share capital, shareholders are entitled to object to the variation. The common law provides some guidance. In White v Bristol Aeroplane Co Ltd.[8], where the company made a bonus payment to ordinary shareholders thereby diluting the voting power of the preference shareholders, the court held that there was no need to obtain the shareholders’ consent.

Application for Class Meetings

However, when a company or shareholders wish to vary class rights, a certain procedure must be followed and Sections 334 to 335 CA 2006 provide further protection for shareholders in these circumstances. Special Resolutions are required for the variation of class rights, as per ss 630 and 61 CA 2006. Section 334 concerns application to class meetings, and it is important to note that when an application is made for a meeting for a variation of class rights, section 318 concerning a quorum and section 321 regarding the right to demand a poll are not relevant. For a quorum for a variation of class rights meeting the requirements are, under s334 (4) for two persons holding at least one-third in nominal value of the issued shares of the class in question. Importantly, section 334(7) (a) provides that any alteration of a provision for the variation of class rights, or the insertion of such a provision, is itself to be treated as a variation of those rights. Section 335 of the CA 2006 applies to the meetings of companies without a share capital. The reason for the requirement of statutory rules which govern the convening of a meeting to discuss the variation of shareholder class rights is to ensure that all shareholders can attend the meeting in person or by proxy. Such a necessity can be seen in the case that was brought in Cumbrian Newspapers Group Ltd v Cumberland Newspaper & Westmorland Herald Newspaper & Printing Co Ltd [9] where the plaintiff in the case requested an injunction to restrain the defendant from holding a meeting to vary the class rights. The question was whether a new share affected the rights of preference shareholders. The court held that preference shareholders would not be affected by the proposed resolutions. In the 1994 case of Re Northern Engineering Industries Plc[10] however, the consent of the preference shareholders to the proposed reduction of capital which involved a variation of class rights was judged to be a prerequisite. Whilst sections 630 to 634 of the CA 2006 provides guidance, the current position ‘must be regarded as uncertain.’[11]

Shareholder Actions

Shareholders are able to bring actions against a company where it is feared that the rights of the majority shareholders are infringing upon the rights of minority shareholders. Decisions in a company are validated by majority vote, but minority shareholders who find that they are dissatisfied with an action are able to bring an action against the company only on the grounds that the decision of the majority is either illegal, or is ultra vires, so is contradictory to the stipulations of the memorandum or articles of association, or infringes the personal rights of a shareholder. However, as Goo notes, where a company is alleged to have suffered a wrong, or the act is one which the majority is entitled to lawfully perform, or to ratify, the courts have been extremely reluctant to investigate such complaints by minority shareholders, and the law must ‘strike a delicate balance between safeguarding the company’s legitimate business from being obstructed by tiresome complaining minorities on the one hand, and restraining unfair and wrongful acts which the majority can exploit to its own advantage thereby prejudicing the legitimate interests of the minority.’[12]

The rule of Foss v Harbottle[13] is also relevant. Under s.33(1), the articles and memorandum form a contract between the company and its member, and a company is a separate legal entity from its members, so that if a member contravenes the company’s constitution in a way that another member’s rights are contravened, court action can be taken. The general rule of Foss v Harbottle is that if the majority shareholders are able to ratify the alleged wrong, then a court will be unlikely to intervene. The rule does however have exceptions, such as where the majority shareholders exercise their voting rights in such a way as to defraud the minority shareholders, which was the cause of action in Clemens, and where directors, who often control a company through their shareholdings, have breached their fiduciary duty, which usually involves a fraud on the minority, so that the two exceptions will overlap. In such circumstances directors are likely to use their majority voting rights to avoid action being brought against them, so such exceptions to the rule in Foss v Harbottle are extremely important.

Section 994 CA 2006 (formerly s.459 CA 1985) allows a statutory remedy for minority shareholders. Section 994 regards the petition to court for an order by a company shareholder on the grounds that the ‘company’s affairs are being or have been conducted in a manner that is unfairly prejudicial to the interests of members generally or of some part of its members’ or ‘that an actual or proposed act or omission of the company (including an act or omission on its behalf) is or would be so prejudicial.’[14]I The common law also provides support in a precedent that demonstrates that in certain circumstances minority shareholder action will be protected. In the 1976 case of Clemens v Clemens Bros[15] a majority shareholder was prevented from using her voting powers to affect the rights of a minority shareholder. The majority shareholder held a 55% stake in a small company and intended to use her vote to issue new shares with the intention of increasing her own control. As this reduced the shareholding of the plaintiff to 25%, and the company did not require extra capital, the court set aside this resolution that was so prejudicial to the minority shareholder. This case does show that the court will in some cases be prepared to take the perspective of the minority shareholder. Where prejudicial conduct by majority shareholders is proven, the court is able to orer specific remedies, as stipulated in s.996(2) CA 2006, including the regulation of the conduct of the company’s affairs in the future, requiring the company to refrain from an Act, or to perform an act which the plaintiff has complained that the company has omitted to do, authorisation of civil proceedings, requiring the company to refrain from making changes to its Articles of Association without the leave of the Court, and providing for the purchase of shares of any members of the company and the potential reduction of the company’s capital. [16] Thus the court will have discretion as to the precise nature of the remedies that it chooses to apply. Interestingly, however, in the 1999 case of O’Neill v Phillips[17] the court was not willing to apply a remedy, judging that a situation where the plaintiff alleged that the previous relationship of trust and confidence had irreparably broken down was not evidence of prejudicial conduct.

The Insolvency Act 1986 s.122(g) also hands the courts the power to wind up a company if it considers it just and equitable to do so. Whilst there are benefits from using the s.122(g) procedure for shareholders, it is likely to have negative, serious consequences for a business.[18] Just as Foss v Harbottle established the ‘proper plaintiff rule’, in which a shareholder may bring an action to the courts on the grounds that there has been a breach of fiduciary duty, so will the s.122 (g) procedure benefit the shareholder by providing a means of gaining justice. The statute allows an individual shareholder to petition the court as an individual, which makes it an extremely important remedy for an aggrieved shareholder. However, it is important to note that s.125 (2) of the Insolvency Act 1986[19] states that where an alternative remedy is available, a court will not support a winding up, which is obviously a destructive remedy, and prejudicial to directors and other shareholders, which shows that whilst s.994 CA 2006 orders and s.122 (g) orders are not mutually exclusive, as winding up under s.122 (g) is a significantly more drastic remedy, the evidence suggests that it will be used ‘only rarely.’[20] Nevertheless, certain cases have given indications of the circumstances in which a court will support a shareholder’s petition for a winding up under s.122 (g) of the Insolvency Act. These include circumstances where the company is established for a fraudulent purpose, as in Re Bleriot manufacturing Aircraft Co Ltd[21], or where the directors display a lack of probity, as in Loch v John Blackwood Ltd.[22]

Conclusion

Therefore, the main strength of the current legal provisions relating to the variation of shareholder class rights, which are contained within the CA 2006, is that the rights of a shareholder will also depend upon the company’s articles and memorandum of association, as well as the terms of issue of shares, an any other shareholder agreements. Defining the interlinking provisions of share capital agreements is extremely complicated and it is not as simple as stating the strengths or weaknesses of provisions.

The ability to vary shareholder class rights is a strength for a company which can adapt to circumstances. For some shareholders this will be a benefit also, whilst for others it will be a weakness. This is demonstrated by the fact that whilst statute plays a role, company contracts such as the articles of association create a web of interlinking contracts between the various shareholders, between the shareholders and directors, and between the individual shareholder and the company itself as a separate legal entity. As discussed, statutes do not always provide clear definitions, so the common law provides guidance. Yet judgements are often contradictory. Therefore, whilst one strength of the legal provisions is that both shareholders and directors benefit from flexibility, this is simultaneously a weakness; that of uncertainty.

Bibliography

Statute

Insolvency Act 1986

Companies Act 2006

Cases

Foss v Harbottle (1843) 67 ER 189

Clemens v Clemens Bros [1976]2 ALL ER 268

Cumbrian Newspapers Group Ltd v Cumberland Newspaper & Westmorland Herald Newspaper & Printing Co Ltd [1987] Ch. 1, [1986] 3 W.L.R. 26, [1986] 2 All E.R. 816

Re Bleriot Manufacturing Aircraft Co Ltd (1916) 32 TLR 253 (Ch) 255

Loch v John Blackwood Ltd [1924] AC 783 (PC).

White v Bristol Aeroplane Co Ltd. [1953] Ch 65

Re Northern Engineering Industries Plc [1994] BCC 618

O’Neill v Phillips [1999] s All ER 961

References

Bourne, N. Bourne on Company Law (Routledge, 2013)

Ferran, E. Principles of Corporate Finance Law (Oxford: Oxford University Press 2008)

Goo, S.H. Minority Shareholders’ Protection: A Study of Section 459 of the Companies Act 1985 (Routledge, 1994)

Pollack, K. ‘Company Law Class Rights’ (1986) CLJ 399

Roach, L. Card and James’ Business Law for Business, Accounting and Finance Students (Oxford University Press 2012) 640