The Court of Appeal has recently ruled, in DnaNudge Ltd v Ventura Capital GP Ltd, that the automatic conversion of preferred shares into ordinary shares under a mechanism in the articles was void. The Court said the mechanism amounted to a variation of class rights and as a result was invalid, as class consent was not obtained. While the case concerned an unusual set of facts, it raises some doubts as to whether other instances of automatic share conversion, or removal of rights attaching to a class, could require class consent before taking effect.
Background
In early 2021, DnaNudge Limited, a medical and health technology company, undertook a funding round with two new investors: Ventura Capital and Sumitomo Mitsui Trust Bank Limited. Two Ventura Capital funds subscribed around £40 million and Sumitomo invested £2 million, for Series A shares (being all of the issued Series A shares). New articles of association were adopted by DnaNudge at the time.
The Series A shares were entitled to a preferential repayment of the amount subscribed, plus a cumulative 8.0% preferred return until a further funding round at a specified pre-money valuation. Wording (taken from the BVCA model articles for early stage investments) provided for automatic conversion of the Series A shares into ordinary shares upon an IPO and also upon written notice from the 'Investor Majority'.
However, the 'Investor Majority' was defined as the holders of a majority of the ordinary shares and the Series A shares in aggregate, as if one class of share. In this case, an Investor Majority could be made up solely of holders of ordinary shares, as the ordinary shares represented about 87% of the issued share capital - Ventura and Sumitomo, who held all the issued Series A shares, held only about 13% of the issued share capital.
The articles also contained customary wording for the variation of class rights with the consent of the holders of 75% of the shares of a class.
In May 2022, an Investor Majority, made up of holders of ordinary shares, gave notice requiring automatic conversion of the Series A shares into ordinary shares. Ventura challenged this.
Court of Appeal ruling
The Court of Appeal upheld the first instance judgment: the automatic conversion provision had to be interpreted as subject to the class consent requirement and, therefore, the conversion was invalid as no consent was given.
The Court of Appeal found it made no commercial sense that the automatic conversion provision would give an Investor Majority, comprising only ordinary shareholders, an unrestricted power to deprive the Series A shareholders of the benefits conferred by the special rights attaching to the Series A shares, at any time chosen by the ordinary shareholders. The Investor Majority could choose to deprive Ventura and Sumitomo of their special distribution rights by serving a conversion notice at precisely the time at which those special rights were designed to benefit the Series A shareholders (and benefit themselves).
DnaNudge's argument that automatic conversion of the Series A shares under the mechanism set out in the articles was something to which those shares were always subject (so that the conversion was not a 'variation or abrogation' of rights which brought the class rights provision into play) was rejected.
The Court said that the word 'automatic' in the share conversion provision did not exclude the possibility that other conditions might have to be satisfied for conversion to occur. Conversion was 'automatic' in the sense of not requiring anything more to be done after receipt of the Investor Majority notice to authorise DnaNudge to give effect to the conversion.
There was no rational or logical justification for interpreting the provisions so as to give rise to a 'bizarre regime' under which Ventura and Sumitomo 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.
The Court noted that, in interpreting articles of association, the principle of contractual interpretation is not applicable, under which the facts and circumstances known or assumed by the parties at the time the document was executed is applied. Instead, this was limited to extrinsic facts about the company or its membership that would reasonably be ascertainable by any reader of the company's constitution and public filings at Companies House, and commercial common sense.
Commentary
Automatic share conversion and share right variation provisions are a common occurrence in private equity and venture capital transactions. However, this was an unusual case, in which the Court noted that something had plainly gone wrong with the drafting.
Out of caution, parties wishing to rely on automatic mechanisms of this type may now go further than previously in clarifying that they are not intended to be subject to class consent. In some cases, they may also seek to include wording in investment or shareholders agreements, to confer class consent in the event it is needed.
In most cases, we don't expect parties to amend existing articles just for this, but they may well take the opportunity to do so when amending them for other matters, eg a new funding round. When they do so, it will often be prudent to seek class consent for any changes, although it will be arguable that, if the changes merely confirm the existing position, no such consent is needed.
In clearly drafted articles giving effect to a coherent commercial deal, the risk of the courts implying additional conditions should be low.
