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M&A Diligence: amendments to drag rights in articles immediately before sale did not constitute unfair prejudice
In Arbuthnott v Bonnyman and Others  EWCA Civ 536 Geoffrey Arbuthnott (“A”), a former director of, and shareholder in, Charterhouse Capital Limited (the “Company”) sought to challenge amendments to the Company’s articles on the grounds of unfair prejudice under s.994 of the Companies Act 2006 (the “Act”).
Drag provisions in the Company’s articles provided that:
- where a buyer acquired more than 50% of the voting rights in the Company’s shares as a result of a general offer, the buyer could require any shareholders that had not accepted the general offer to sell their shares at the same price as the general offer;
- a general offer was defined as an offer to all members to purchase their shares by a person proposing to acquire a controlling interest (i.e. 50%) in the Company, such offer to be approved by a founder majority;
- a general offer was to conform to the requirements of the City Code on Takeovers and Mergers (the “Code”); and
- if a founder majority transferred or agreed to transfer their shares, they could determine that the drag provisions applied to all members.
The shareholders’ agreement relating to the Company (“SHA”) also provided that if a founder majority agreed to pursue an exit, each shareholder would agree to sell their shares on the same terms offered to the others, and also that the SHA was to prevail over the articles.
Certain executives of the Company became concerned about the misalignment between the shareholders and active executives, on the basis that they thought it would make it difficult for the Company to raise funds from investors. In 2011, a proposal emerged for the sale of the Company’s shares to the executives in the investment team who intended to continue in the business after the sale (the “Buyers”). An offer was made to all of the shareholders by WSL, an entity newly incorporated by the Buyers for the purposes of the transaction, for a purchase of their shares for £15.15 million. The offer was conditional on, amongst other things, amended articles being adopted in the form circulated with the offer. The key amendments to the articles were:
- the removal of a reference to a general offer complying with the Code;
- the introduction of a new majority drag provision, allowing a buyer who had purchased 50% or more of the voting rights in the Company’s shares (where such purchase had been approved by a founder majority) to require any non-participating shareholders to sell their shares to the buyer; and
- an amendment to the definition of founder majority.
The proposed amendments were approved by a written resolution, signed by all shareholders in the Company except A. The sale of the shares to WSL was approved by a founder majority (as required under the amended articles) on 16 December 2011 and by a majority of the non-continuing shareholders at a meeting on 30 January 2012. A refused to approve the acquisition, on the basis that he thought the Company was worth substantially more than the offer price. Nevertheless, the transfer of all of the shares in the Company to WSL, except the shares held by A, took place on the terms of the WSL offer on 6 February 2012.
A presented a petition for unfair prejudice under s.994 of the Act on the basis that (amongst other things) the WSL offer, the amendments to the articles and the manner in which the WSL offer, were carried out improperly in order to obtain A’s shares at a gross undervalue rather than for any genuine corporate purpose.
The High Court rejected A’s claim, finding that:
- there was no evidence of bad faith or improper motive by any of the directors/shareholders;
- compulsory transfer provisions existed in the articles before they were amended and formed part of the original bargain between the parties (as reflected in the SHA) - as such, the amendments were merely a tidying up exercise;
- there were reasonable grounds for the shareholders to believe that they were acting in the best interests of the Company – the misalignment between the shareholders and the investment executives needed to be rectified to secure the long-term stability of the Company;
- there was no evidence to suggest that there was any realistic prospect either of a third party purchaser or the need or business efficacy of a substantial cash injection from a third party or present investor in return for a minority stake in the Company; and
- therefore, it was in the best interests of a hypothetical member to vote in favour of the resolutions to amend the articles and facilitate a sale, so as to provide a permanent solution to the alignment issue.
The Court of Appeal dismissed A’s appeal against the High Court’s decision. The Court rejected A’s assertion that the original agreement between the founders, as reflected in the articles and the SHA, only contemplated that the drag provisions would operate where the majority shareholders were selling their shares to an unconnected third party. On the contrary, the SHA and the original articles expressly contemplated a sale in which a founder was a proposed purchaser or was connected with a third party purchaser.
Turning to A’s argument that the amendments to the articles were invalid on the basis that they facilitated, and were specifically directed at, the expropriation of his shares, the Court set out the following principles:
- an alteration to a company’s articles, even if passed by a requisite majority of shareholders, may be invalid in certain circumstances;
- the limitations on the exercise of the power to amend articles arises because, in the case of all powers, the manner of their exercise is constrained by the purpose of the power and because the framers of the power of a majority to bind a minority will not, in the absence of clear words, have intended the power to be without limitation;
- a power to amend the articles will be validly exercised if exercised in good faith in the interests of the company;
- it is for the shareholders (and not the court) to say whether an alteration to the articles is for the benefit of the company, but it will not be for the benefit of the company if no reasonable person would consider it to be such;
- the view of the shareholders, acting in good faith that a proposed amendment is for the benefit of the company (and which cannot be said to be a view that no reasonable person could hold) is not impugned by the fact that one or more shareholders were acting under some mistake of fact or lack of knowledge or understanding;
- the mere fact that an amendment adversely affects (even if intended to do so) some minority shareholder(s) and benefits others does not of itself invalidate the amendment if it was made in good faith in the interests of the company;
- a power to amend will be also be validly exercised, where the company has no interest in the matter and it is exercised for the benefit of the shareholders or some of them, provided that the amendment does not amount to oppression of the minority, is otherwise unjust or is outside the scope of the power; and
- the burden is on the person impugning the validity of the amendment to the articles to satisfy the court that there are grounds for doing so.
In relation to A’s challenge to the amendments to the articles, the Court applied the above principles to the facts of the case. The Court agreed with the High Court that there was no evidence of bad faith or improper motive in the exercise of the power to amend the articles by the shareholders of the Company. The amendments were, as the High Court had found, merely a tidying up of the drag along provisions to make the articles clearer and more consistent (which benefited the company as well as the shareholders).
In addition, the Court agreed that the respondent shareholders had considered that they were acting in the best interests the Company as a whole, because they were concerned to resolve the alignment issue to secure the Company’s future. It was for A to show that no reasonable person would have thought that the amendments to the articles were in the Company’s best interests, and A had not demonstrated that. The Court also rejected A’s other arguments of unfair prejudice.
This decision gives some comfort to majority shareholders who seek to amend drag along provisions in the articles immediately before sale of the company. The Court of Appeal made it clear that a minority shareholder who seeks to challenge such amendments has a high bar to meet.
However, both the High Court and the Court of Appeal placed much emphasis on the fact that there were drag along provisions in the original agreement between the parties. It remains unclear whether drag along provisions introduced for the first time immediately before a sale would be more open to challenge. A court faced with this situation is likely to apply the same principles as set out above. However, the outcome of such a case is more difficult to predict, and would depend on the specific facts of the case. Therefore, caution is advised before introducing drag, or equivalent, provisions, in a company’s articles (or shareholders’ agreement) ahead of a sale.