Convertible Preference Shares – dive on problems early

Convertible preference shares are a popular financing tool – especially for start-ups. They have priority over ordinary shares, but not creditors. Distributions are treated as dividends (not interest). They provide considerable flexibility in relation to distributions to decide if and when they are made.

Preference shares allow investors to maintain some form of priority while still benefiting from the equity upside of owning shares. This also means that the company is not required to expend cash until it is able to covert. In economic terms this results in convertible shares being classified as a debt instrument (a bond) coupled with an option to convert to equity.

A recent case Cadre Investments Ltd v Activedocs Ltd [2016] NZHC 1489 provides some sharp lessons about the need to address problems (such as the inability to pay dividends) when they arise.

Background

In 2002, Activedocs Limited (a software developer) was in desperate need of more working capital and offered Preference Shares to existing shareholders. A group of existing shareholders subscribed. Subsequently, the company was not able to pay dividends on the Preference Shares – and then, several years later, a dispute arose between Activedocs and the subscribers over the extent of the subscribers’ entitlement to preferential dividends and whether the Preference Shares have been validly converted to ordinary shares.

Under the terms of issue, the Preference Shares were issued, a preferential dividend of 15% pa was payable when the shares were converted to ordinary shares. Conversion was to occur 2 years from the date of issue unless Activedocs was unable to pay the dividends that had accrued at that date. If that happened, conversion was to be postponed until either the accrued dividends were paid or a preferential shareholder required shares to be converted.

As it happened, Activedocs could not pay any dividend on the nominated conversion date. It treated the preferential dividends as continuing to accrue and made provision for the accrued dividend entitlement in its financial statements each year. In 2007 and 2008 it made dividend payments in respect of the 2003 and 2004 years’ entitlements. No other dividends were authorised. In 2013, Activedocs changed its position; it determined that the Preference shareholders had no entitlement to any further dividend and purported to convert the Preference Shares to ordinary shares.

The subscribers claimed that as at the nominated conversion date in 2004, dividends had accrued in respect of 2003 and 2004 and Activedocs inability to pay them meant that conversion was postponed. As a result, dividends continued to accrue until conversion of the shares, which has not yet occurred. (They also claimed that Activedocs purported conversion of the Preference Shares in 2013 was invalid).

By contrast, Activedocs maintained that dividends cannot accrue until they have been authorised, and because no dividends were authorised prior to 2004 – there were no accrued dividends as at that date so the Preference Shares converted automatically. Alternatively, only two years’ worth of dividends were ever payable and had been paid by 2008 so that the Preference Shares either converted automatically in 2008 or were validly converted in 2013.

Terms of issue

The terms of issue of the Preference Shares provided for:

• The right to be paid a preferential dividend of 15%pa in priority to the payment of dividends on the ordinary shares – payable at the time of conversion into ordinary shares.
• The right on the liquidation of Activedocs to be paid $1.00 per share plus any accrued but unpaid preferential dividend in priority to the ordinary shares but ranking behind creditors of Activedocs.
• Subject to the exceptions specified below, automatic conversion into 4 ordinary shares – 2 years from the date of issue. The exceptions being:
o Activedocs may accelerate conversion by written notice to the holder if at any earlier time an offer is made for 50% or more of its ordinary shares or there is a change in ownership of 50% or more of the ordinary shares through one or more linked or related transactions or there is a sale of all or substantially all of Activedocs’ business or assets.
o Conversion will be postponed in the event that Activedocs is unable to pay dividends accrued as at the conversion date until either Activedocs makes payment of all accrued dividends or a holder of Preference Shares by notice in writing to Activedocs requires that the Preference Shares held by that person are converted.
• In all other respects the Preference Shares ranked equally with the ordinary shares (and, in particular, carried the same voting rights).

The Preference Shares were issued on 8 November 2002, making the Conversion Date 8 November 2004.

Were there accrued dividends at the 2-year date (i.e. cumulative or non-cumulative)?

The judge decided that there were settled canons of construction relating to the nature of dividend entitlement. Where (as here) the terms of issue are silent as to whether the Preference Shares are cumulative or non-cumulative as to dividend they are presumed to be cumulative, though that presumption can be rebutted by language showing that the dividend is to be paid only from the profits of the particular year.

In doing so, the judge rejected Activedocs’ argument that:

• the lack of modern authorities and the recent changes to New Zealand company law, as well as modern principles of contractual interpretation, made the dividend entitlement a question of interpretation rather than presumption; and
• the fact that, under the Companies Act 1993, directors are precluded from authorising any dividend unless the company can satisfy the solvency test (and so the parties must have contracted on the basis of the statutory constraint – the issue could not have contemplated that any dividend entitlement would accrue in years when no dividend could legally be authorised).

Did the terms of issue displace the (cumulative) presumption?

Activedocs argued that, since it was known to all parties that the directors could not authorise a dividend unless the solvency test was met, the phrase “accrued dividends” in the second exception is properly interpreted as meaning dividends that have been authorised. Since the Company’s financial position did not allow a dividend to be authorised on or before the (2-year) conversion date there were no “accrued” dividends for the purposes of the second exception. Therefore the shares automatically converted on 8 November 2004 (the 2-year date). This argument was based on general principles of contractual interpretation but, given the judge’s conclusion that the Preference Shares are presumed to be cumulative, the judge approached it as an argument that the wording of the second exception operates to displace the presumption that the Preference Shares were cumulative.

On Activedoc’s argument the right to be paid a preferential dividend would arise only if a dividend had been declared prior to November 2004.

The judge agreed with authority cited by the holders – that the word “accrue” connotes the ability to calculate a precise amount of money. And the word “due” connotes that it is payable whether or not the time for payment has arrived. As a result, judge stated that the second exception is concerned with dividend entitlement in the future, not whether dividends are currently payable. In that context there is no basis for interpreting “accrued” as being limited to dividends that have actually been declared so as to rebut the presumption that the shares are cumulative. The natural and ordinary meaning of the word describes a right to be paid at a future date, not the existence of a debt actually payable.

Did the terms of issue displace the (cumulative) presumption? – other aspects

The judge found that there were three other aspects of the wording of the terms of issue that make it clear that the Preference Shares were cumulative so that the presumption is not rebutted:

• First, providing for conversion to be postponed is consistent with the Preference Shares being cumulative – because no dividend can be declared once the shares have been converted, postponing conversion preserves the holders’ rights to have their dividend entitlement carried through to later years. By contrast, where Preference Shares are non-cumulative the right to a dividend in relation to a particular year is lost at the expiry of that year if no dividend is declared; whether conversion occurs immediately or is postponed makes no difference to the entitlement of non-cumulative preferential shareholders. In particular, postponing conversion would not address the concern that the company cannot pay a dividend that has already been authorised. Once a dividend is authorised it becomes payable as a debt whether or not the shares have been converted.
• Secondly, the law is clear that when a cumulative dividend of an amount that reflects prior short or non-payment is paid, it is treated as a single dividend for the year in which it is paid, not as a dividend in respect of any previous year. Therefore, the dividend entitlement under a cumulative preference share cannot depend on a dividend being declared in a particular year; otherwise there would be no possibility of a dividend being declared in later year in respect of that earlier year, which is the defining feature of a cumulative preference share.

In the present case, the fact that two years’ dividends were expected to be declared at once, and that it was explicitly provided that payment of dividends could be delayed if necessary through the postponement of conversion, points to the Preference Shares being cumulative. If they were not cumulative the dividend entitlement would be lost at the end of each year and postponing conversion would not prevent that.

• Finally, the provisions of the winding up clause do not detract from the interpretation of the second exception. This clause confers the right to payment of “any accrued but unpaid preferential dividend” in priority to any payment to the holders of ordinary shares. Since dividends only become payable if declared, then arrears (even of cumulative dividends) are prima facie not payable on a winding up unless previously declared. Activedocs relied on Mosgiel (1995) as clear authority that there would have been no “accrued but unpaid preferential dividend” unless such dividends had already been declared. The judge added that this must be right. However, it is the additional words “but unpaid” that make it clear that a declaration of the dividend was required because those words carry the implication that the dividends had become payable.

Was the right to the preferential dividend limited to 2 years?

Activedocs also argued (as an alternative) that the preferential dividend was payable only for 2 years and that, since 2 years’ worth of dividend was subsequently declared and paid, nothing further was owing. This argument was based on the wording of the authorising Board resolution for issue of the Preference Shares stating that the Preference Shares will automatically convert to ordinary shares – 2 years from the date of issue (subject to the delay in conversion until the dividend is paid in full).

The judge rejected this argument, based on:

• interpretation of the relevant resolution (and a subsequent Board resolution); and
• its inconsistency with the circumstances in which the Preference Shares were issued – when all parties knew that Activedocs’ situation was precarious.

The judge also rejected a commercial absurdity defence (the effect of accumulating preferential dividends at $193,000 pa produced an accumulated dividend slightly over $1.9m in the context of a business with a total operating revenue of slightly over $1.6m and total liabilities (excluding dividends) of slightly over $1.3m). Such a level of liability would not only deter potential investors but also mean that the Company was insolvent.

But, as the judge noted, even if this meant that, no dividends can be declared and, in the event of liquidation, the holders will not recover any of the claimed dividends because no dividend will have been authorised. However, there is no obligation on the directors to authorise a dividend – and the company is not insolvent merely by reason of making provision for accrued dividends. Therefore, whilst the result was not anticipated (though it could have been by the Board at the time of issue) and is disadvantageous to Activedocs – it is not commercially absurd.

Impact of accrual in financial statements

For 10 years, Activedocs treated the dividend entitlement as accruing and made provision for it in its financial statements. For reasons that I find less than compelling the judge concluded that the financial statements are not a reliable indicator of the company’s intentions. The judge focused on the fact that the directors who determined that the financial statements would show preferential dividends continuing to accrue after 2004 were not the same directors as those who finalised the terms on which the preferential shares were issued.

As a result, the fact that their identity differed in the relevant periods means that the acts of Activedocs in subsequent years is not necessarily a reliable objective indicator of its previous intention.

A decade is a rather long time to continuing accruing dividends on the basis that conversion had not occurred. From where I sit, the prospect that the holders would have relied on this, to their detriment, seems not to have bene given sufficient weight.

Were the Preference Shares validly converted to ordinary shares?

The judge concluded that the second exception was triggered in November 2004 as a result of Activedocs being unable to pay the accrued dividends. Consequently, conversion did not occur then but was postponed until all the accrued dividends were paid.

As a result, the holders’ dividend entitlement continued beyond November 2004 until conversion of the Preference Shares. Conversion would only occur upon payment of the accrued dividends. The dividend payments made in 2007 and 2008 represented only 2 years’ worth of dividends and therefore did not constitute payment of all the accrued dividends. Consequently, conversion of the Preference Shares did not occur in 2008.

Since entitlements to the preferential dividend continued to accrue each year and dividends of the accrued amount have never been authorised the shares could not have been validly converted. The purported conversion of the shares in 2013 was therefore invalid – and the Preference Shares remained in existence.

Takeaways

I find most of the judgement unsurprising and, as a result, I am left wondering how the matter came before a Court. If there is a lesson here, it is to underline the need to dive on problems quickly. In my view, the board should have had discussions about conversion to equity as soon as it became apparent (in 2004) that the company as not able to pay the accumulated dividends – and certainly any decision in 2007/8 to pay a dividend should have been predicated on removal of the overhang created by the Preference Shares.

Further information

If you would like more information about any of the matters discussed in this note, please contact me.