In a recently published judgment in the case of DnaNudge Ltd v Ventura Capital GP Ltd [2023] EWCA Civ 1142, the Court of Appeal dismissed the appeal of DnaNudge Ltd (the "Company") and upheld the first instance decision by the High Court that a purported conversion of Series A Shares into Ordinary Shares (the "Conversion") amounted to a variation of class rights which required class consent under the Company's articles of association. The case highlights the importance of clarity in articles of association as to how provisions for conversion of shares interrelate with any separate provisions dealing with the variation of share rights.
The background
The Company raised significant funding of up to £50 million from external investors (the "Preferred Shareholders") in exchange for Series A Shares. The Preferred Shareholders acquired preferential rights, including a cumulative preferred return on a capital distribution and dividend. The Preferred Shareholders also benefited from a "Put Option" which, if exercised, would require their Series A Shares to be bought by the Company.
In May 2022, the Company issued a circular to its shareholders stating it was running short of cash, and it wished to raise additional working capital. The circular also highlighted some key risk factors facing the Company. One of these key risk factors was the Put Option. The circular stated that "in the event that the Company was obliged to repurchase Series A Shares pursuant to an exercise of the Put Option, its business… and prospects may be materially adversely affected." The circular went on to state pursuant to the Company's articles of association (the "Articles") "…an Investor Majority might seek to nullify the Put Option by converting the Series A Shares into Ordinary Shares…. ahead of any exercise of the Put Option."
The Ordinary Shareholders had the power to form an Investor Majority without the Preferred Shareholders. Three days after the circular, various Ordinary Shareholders constituting an Investor Majority signed a letter to the Company requiring the Series A Shares to be converted into Ordinary Shares at the date of the notice. The Series A Shares were converted into Ordinary Shares and the Company's share registers were updated accordingly (the "Conversion").
The Preferred Shareholders challenged the Conversion, claiming that it amounted to a variation of class rights which required class consent under the Articles. The Company did not accept this stance and maintained that class consent was not required under the Articles and the Conversion was valid.
Analysis
The interplay of articles 9 and 10 were central to the dispute:
- Article 9 (Conversion of Series A Shares) – permitted automatic conversion of the Series A Shares upon notice by an Investor Majority; and
- Article 10 (Variation of Rights) - stated that the special rights attaching to the Series A Shares could only be varied with the consent in writing of the holders of more than 75% of the relevant class of shares.
The Company's interpretation of article 9 would give the Investor Majority an unrestricted power to deprive the Preferred Shareholders particular benefits conferred by the special rights at any time. The Court stated there was no rational or logical justification for such a bizarre regime under which the holders of the Series A Shares would be protected by having to give a class consent to every lesser alteration of their rights but would have no such protection in the event of a conversion in which their special rights would be entirely extinguished.
As such, the Court held that when article 9 was viewed in light of the other provisions of the Articles, it could clearly be seen that there had been a drafting mistake, namely that the power of an Investor Majority to serve notice under article 9 had not been made expressly subject to compliance with article 10. The Court concluded that in order to make rational and coherent sense of the Articles, either article 9 must be interpreted as being subject to article 10, or a term must be implied to that effect. Either way, the result is the same – compliance with article 10 is required as a precondition to conversion at the instigation of an Investor Majority.
The Court of Appeal upheld the High Court's decision - the purported conversion was invalid. It was determined that there was a clear mistake in the Articles and that it was necessary to read article 9 subject to the consent provisions in article 10.
Conclusion
The case illustrates the importance of unambiguous drafting in articles of association. In particular, where articles provide for conversion of shares (for example, conversions into deferred classes of shares, conversions resulting from "Good" and "Bad" leaver terms and of course the rights of preferred shareholders to convert under a preference stack), they should clearly set out both the triggers for conversion and how the conversion articles dovetail with any separate provisions dealing with class rights.