The Court of Appeal has held that the automatic conversion of preference shares into ordinary shares was void and of no effect, overriding “clear and unambiguous” language to the contrary in the company’s articles.
DnaNudge Limited -v- Ventura Capital GP Limited  is an example of a case in which the court has been prepared to imply a term into articles in order to address otherwise commercially irrational drafting.
DnaNudge is a healthtech company. In 2021 Ventura invested just over £40m to acquire Series A shares. The Series A shares carried rights to enhanced returns on dividends and capital distributions in certain circumstances. A separate shareholders’ agreement also gave Ventura the benefit of a put option under which DnaNudge could be required to buy back Ventura’s Series A shares if the company had not floated by November 2023.
DnaNudge’s articles provided that the Series A shares could be converted “automatically” to ordinary shares “upon notice in writing from an Investor Majority at the date of such notice”. A conversion to ordinary shares would have the effect of (a) removing the enhanced benefits attached to the Series A shares, and (b) even more significantly, circumventing the put option which did not apply to ordinary shares.
A key term was “Investor Majority”, which was defined as the holders of a majority of the Series A shares and the ordinary shares in aggregate. Given that nearly 87 per cent of the company shares were ordinary, this definition in principle gave the ordinary shareholders the power to push through a conversion without the consent of Series A shareholders such as Ventura.
In May 2022, DnaNudge was suffering from cashflow difficulties and issued a circular to its shareholders which noted that a key risk to the business was the prospect that Ventura would exercise its put option, requiring the company to buy back its Series A shares. The circular went on to observe that “an Investor Majority might seek to nullify the Put Option by converting the Series A Shares into Ordinary Shares (pursuant to Article 9.2) ahead of any exercise of the Put Option”.
Three days later, various ordinary shareholders, including the company’s co-founders and directors, gave written notice requiring all of the Series A shares in issue to be converted.
Ventura responded by issuing proceedings which raised three key issues.
1. Was the conversion a variation of class rights requiring Ventura’s consent?
Ventura relied upon Article 10.1 which required the prior written consent of at least 75 per cent of affected shareholders before any variation or abrogation of special rights attaching to their class of shares.
DnaNudge argued that the conversion was a different kind of transaction: either a performance of rights which already existed under the articles, or a share-for-share exchange, rather than a variation or abrogation of the rights attaching to Ventura’s shares.
The Court of Appeal found in favour of Ventura, holding that “the term “abrogation” is entirely apposite to describe the effect of the process by which the special rights … entirely cease to apply” and therefore that their consent was required.
2. Did the requirement for consent override the automatic right of conversion?
The requirement for consent set out in Article 10.1 was in apparent conflict with the provisions of Article 9.2 which anticipated conversion “automatically” upon written notice from the Investor Majority.
The court may resolve conflicts between contractual provisions by testing rival interpretations of the document and considering which would produce a coherent and commercially sensible scheme overall.
It was held that DnaNudge’s proposed interpretation would “give an Investor Majority comprising only Ordinary Shareholders, an unrestricted power to deprive the holders of the Series A Shares of the particular benefits conferred by those special rights, at any time chosen by the Ordinary Shareholders”. They could, and indeed would, be motivated to do this precisely when those special rights were supposed to benefit Ventura (for example ahead of a preferential distribution to the Series A shareholders) or even immediately after the Series A shares were issued. The Court of Appeal described these outcomes variously as “bizarre”, “incoherent” and “irrational” and accordingly found that it was appropriate for the court to intervene.
This was achieved by interpreting the right to convert shares at Article 9.2 as being subject to the requirement for class consent under Article 10.1, which would take precedence. Alternatively, it was held that it would be appropriate to imply a term to that effect into the articles in order to bring commercial and practical coherence and give business efficacy to them.
3. Unfair prejudice
Under Section 633 of the Companies Act, shareholders holding at least 15 per cent of a company’s shares may ask the court to disallow a variation to the rights attaching to their class of shares and to cancel a conversion on the grounds that the variation is unfairly prejudicial.
Accordingly, a subsidiary argument run by Ventura was that, if DnaNudge’s interpretation of the articles was correct (so as to permit the ordinary shareholders to push through the conversion without Ventura's consent), that conversion would have been an unfairly prejudicial variation.
This argument was withdrawn mid-hearing, but the court nonetheless expressed the view that had the variation been effective, Ventura would need to establish that it was both prejudicial and unfairly prejudicial. The court considered that it would not be unfair for the company to give effect to its articles and hold Ventura to its “bargain”, even if the consequences were prejudicial. In circumstances where Ventura had voluntarily agreed to subscribe for the shares subject to the terms of the articles “there is nothing inherently unfair” in taking this approach.
The key lesson to be taken from the case is to ensure that any conversion mechanism is drafted clearly and unambiguously. With the benefit of hindsight, it is obvious that the prioritisation of these two key competing rights of conversion and class consent should have been considered and addressed expressly in the articles.
This decision also provides useful insight into how the court will approach the construction of articles of association and in particular the requirement in the event of conflict for the articles to be interpreted in a coherent and commercially rational manner. It was noted that, in contrast to ordinary commercial contracts, a more circumspect approach will be taken when considering the background facts because of the potentially fluctuating body of shareholders who may or may not have knowledge of how the articles came to be drafted or amended.
This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.
© Farrer & Co LLP, October 2023