Automatic Conversion of Shares Ruled a Variation of Class Rights

Introduction

A company’s constitution may provide for the conversion of one class of shares into shares of a different class upon the occurrence of specified events. Companies Act, 2014 regulates variations to the rights attaching to a class of shares. Typically, in order to validly vary such rights it will be necessary to secure the approval of a particular proportion of the holders of the class concerned as specified in the company’s constitution or of all of the company’s members. How do the conversion of shares and the variation of class rights interact?

In the recent decision of the High Court of England and Wales in Ventura Capital GP Ltd v DnaNudge Limited,[1] it was held that an attempted ‘conversion’ of preference shares to ordinary shares pursuant to the articles of association of a company was “invalid, void and of no effect”[2] because it constituted a variation or abrogation of the rights attached to the preference shares which required the consent of the preference shareholders.

Background

The defendant, DnaNudge Limited (the “Company”), is a medical and health technology company which received investments of £42 million from Ventura Capital GP Limited (“Ventura”) and £2 million from Sumitomo Mitsui Trust Bank (“SMTB”) in 2021/2022 in return for Series A preferred shares in the Company. Ventura and SMTB (together the “Preferred Shareholders”) held all the preferred shares (24,877 each of £0.0001) in the Company. A substantially greater number of ordinary shares (162,651 each of £0.0001) had been issued by the Company.

The Preferred Shareholders had acquired a number of preferential rights attached to the shares which were recorded in an amended articles of association and an amended shareholders’ agreement. The shareholders’ agreement provided that if a ‘Qualifying IPO’ (a defined term but effectively a listing on an identified or recognised exchange with an offering of at least £900m) does not occur prior to 19 November 2023”, that the Preferred Shareholders would have a ‘put option’ to require their shares to be bought by the Company.[3] Articles 5.1 and 6 of the amended articles also provided that the preferred shareholders would have “preferred payment of arrears of dividends and return of capital plus a cumulative 8% preferred return (compounding annually), in priority to ordinary shareholders” on distribution or exit.

In May 2022, the Company issued a circular to all shareholders stating that the Company wished to ‘raise additional capital’ and that the potential exercise of the ‘put option’ by the Preferred Shareholders could have an adverse impact on the Company’s business. The circular also stated that an ‘Investor Majority’ (‘the holders of a majority of the Series A Shares and Ordinary Shares in aggregate as if such Shares constituted one class of shares)’ may nullify the put option by converting the preferred shares to ordinary shares pursuant to article 9.2 (a) of the articles of association of the Company before the Preferred Shareholders could exercise their put option.

The Investor Majority, formed by a sufficient number of ordinary shareholders, followed through with this warning and informed the Preferred Shareholders in June 2022 that their preference shares had been converted into ordinary shares and that the register of members had been updated. The principal claim made by Ventura on behalf of the Preferred Shareholders was that the issuing of a conversion notice pursuant to article 9.2 (a) was void because it did not comply with article 10.1 of the articles of association of the Company.

Articles of Association of the Company

This case was ultimately decided on the interpretation of articles 9.2 and 10.1 of the articles of association of the Company.

Article 9.2 of the articles of association of the Company provided that:

“All Series A Shares shall automatically convert into Ordinary Shares:

• upon notice in writing from an Investor Majority at the date of such notice (the ‘Conversion Date’);
• immediately upon the occurrence of a Qualifying IPO.”

Article 10.1 of the articles of association of the Company provided that:

“Whenever the share capital of the Company is divided into different classes of shares, the special rights attached to any such class may only be varied or abrogated (either whilst the Company is a going concern or during or in contemplation of a winding-up) with the consent in writing of the holders of more than 75 per cent in nominal value of the issued shares of that class”.

Principal Submissions

Ventura argued that article 9.2 (a) must be read as being subject to article 10.1 such that the purported conversion of preference shares to ordinary shares is in effect an abrogation or variation of the rights attached to those shares. Thus, the purported conversion would only be valid if the Investor Majority had received written consent from the holders of more than 75 per cent in nominal value of the preference shares. In this case, written consent from the Preferred Shareholders was not received and therefore, a claim was made to declare the purported variation or abrogation of the rights attached to the preference shares as void.

The principal submission from the Company, as defendant, was that the conversion of preference shares to ordinary shares was not a variation or abrogation of the rights attached to the preference shares. Instead, the conversion was simply an ‘exchange’ of preference shares for ordinary shares i.e. the rights attached to preference shares were not extinguished; these rights remained but the holders of the preferred shares no longer held those shares; and preferred shares were no longer in issue following the conversion. The relevant question for the Court, as submitted by the Company, was whether the rights attaching to the class of share have changed, not whether the rights of the holder of the shares have changed. As a result, article 9.2 (a) cannot be read as subject to article 10.1 because there has been no abrogation or variation of the rights; the conversion is simply an ‘exchange’ of one class of share for another class of share. Article 9.2 (a) and article 10.1 should be construed together according to the Company; the Preferred Shareholders should not be able to renege on the bargain they struck when the articles of association were agreed.

Analysis and Decision

In construing the articles of association of a company, Judge Hodge KC clarified that the Court cannot analyse evidence which is only “known to the parties by way of commercial context.”[4] Instead, the Court must only consider public sources such as a company’s constitutional documents which are available at the UK’s Companies House.

In following these steps, the Court noted that the Company’s publicly available returns of allotment of shares (Form SH01)[5] highlighted that the holders of the preferred shares had paid a “substantial premium” for their shares in contrast to the ordinary shareholders.[6] This led the Court to state that any reasonable reader would consider that this premium was paid by the Preferred Shareholders in order to attain special rights.[7] These special rights were evident under articles 5 and 6 of the articles of association which conferred on the Preferred Shareholders “preferential interest and priority on distribution or exit”. [8] It was not the intention of the Company or its shareholders to extinguish these rights without any “effective protection”[9] i.e. consent. It was also noted that an ‘officious bystander’ upon observation of the case would not have considered it permissible for the Preferred Shareholders to lose their rights at the whim of the ordinary shareholders and without any formal consent. [10]

In considering what constitutes a variation or abrogation of class rights, the Court concluded that rights attached by the shareholders’ agreement, namely a right to board representation and the put option should be ignored as they were not conferred by the articles of association. [11]

The purported conversion was in effect an abrogation or variation of the rights attached to the preference shares. As a result, article 9.2 (a) of the articles of association of the Company was held as incompatible with article 10.1; it would be absurd if the “special rights of the preferred shareholders can be lost at the whim of an Investor Majority [made up of ordinary shareholders] simply by the service of a conversion from those with an interest in inflicting such a loss”. [12]

In agreeing with Counsel for Ventura, Judge Hodge KC stated that there had been a “drafting error” [13] and that the only way to give ‘business efficacy’ to the articles of association was for a term to be implied so that article 9.2 (a) would read as being subject to article 10.1. It was held that an attempted conversion of shares under article 9.2 (a) should be “subject always to having first obtained the consent required under article 10.1”.[14] This means that the conversion could only apply if 75% of the holders of the relevant share class had given their consent in writing. As a result, the purported conversion in June 2022 which lacked the requisite consent, was held as void and the Company was ordered to reinstate Ventura and SMTB as preferred shareholders in the register of members.

Ventura also claimed that the conversion constituted an “unfair prejudice” under section 633 of the English Companies Act, 2006 (the closest Irish equivalent being oppression or disregard of interests contrary to section 212 of Companies Act, 2014). This claim failed.

Comment

This case highlights the potential tension that can arise between provisions of a company’s constitution compelling the conversion of shares, on the one hand and the necessity to obtain shareholder approval to validly vary/abrogate the rights which are attached to a class of shares being converted, on the other hand. The Irish courts are not bound by the decision in Ventura, but it is likely to be of persuasive value. The facts of Ventura were extreme. Nevertheless, Irish companies considering the making of provision for the conversion of one class of shares to another in its constitution or implementing such a conversion should consider carefully the interaction between such conversion and the rules on the variation of class rights applicable to the company.

[1] [2023] EWHC 437 (Ch).

[2] Ibid. at [114].

[3] Ibid. at [6].

[4] Ibid. at [101].

[5] Irish Equivalent CRO Form B5.

[6] [2023] EWHC 437 (Ch) at [102].

[7] Ibid. at [105].

[8] Ibid. at [113].

[9] Ibid. at [112].

[10] Ibid. at [108].

[11] Ibid. at [113].

[12] Ibid. at [111].

[13] Ibid. at [110].

[14] Ibid. at [109].