In the recent case of DnaNudge v Ventura, the Court of Appeal considered the validity of an attempt by a majority of the ordinary shareholders in a company to force the conversion of preference shares into ordinary equity, thereby materially reducing the economic benefits of the preference investors' position. The case concerns the interpretation of the company's articles of association. In particular, a conflict between inconsistent provisions permitting the mandatory conversion of the preference shares by an overall shareholder majority and provisions protecting class rights (by requiring a super majority of class members to approve changes to the rights attaching to a specific class of shares).
The Appellant was DnaNudge Limited ("DnaNudge"), a company that supplies clinical testing products and genetic services. The Respondent was Ventura Capital GP Limited ("Ventura"), a general partner for and on behalf of two Cayman Islands exempted limited partnerships.
DnaNudge was originally incorporated in July 2015, and by the relevant time to which the facts of this dispute relate, had 162,561 issued ordinary shares (the "Ordinary Shares"). Following an exercise by DnaNudge to raise money from external investors in 2020 / 2021, Ventura invested £40 million into DnaNudge by purchasing 24,026 Series A Shares (the "Preference Shares"). Together with another investor (who held a further 851 Preference Shares), Ventura and that other investor held all of the company's issued Preference Shares. In connection with the issue of the new shares, DnaNudge adopted new articles of association in January 2021 (the "New Articles").
Despite ranking pari passu with the Ordinary Shares and have equal voting rights, the Preference Shares constituted a separate class of shares and had a number of special rights attached to them by virtue of the New Articles. The Preference Shares entitled the holder to preferable returns and priority over holders of Ordinary Shares on a distribution of assets in a liquidation, return of capital, or sale of DnaNudge.
The two key provisions from the New Articles on which this case turned were: (i) article 9.2(a), which provided that all Preference Shares would "automatically" convert into Ordinary Shares on notice in writing from an "Investor Majority" (defined in the New Articles as a majority of both classes of shares (i.e. the Preference Shares and the Ordinary Shares) in aggregate); and (ii) article 10.1 which provided that the special rights attached to a class of shares "may only be varied or abrogated… with the consent in writing of the holders of more than 75 per cent in nominal value of the issued shares of that class". The shareholders were also party to a shareholders' agreement which contained a put option in favour of the holders of Preference Shares, entitling them to require DnaNudge to purchase the Preference Shares in certain circumstances.
In May 2022, DnaNudge sent a circular to its shareholders setting out its plans for raising working capital (on the basis that it was running short of cash) by issuing between £7 million to £25 million of convertible loan notes. The circular summarised some of the risk factors it faced as a company, which included the put option (which, it was stated, may materially adversely affect the company's business and financial condition if it was exercised). The circular also suggested that the potential impact of the put option could be avoided if an "Investor Majority" forced the conversion of the Preference Shares into Ordinary Shares.
Several days later, various holders of Ordinary Shares, purporting to constitute an "Investor Majority" gave written notice to the company seeking to compel the automatic conversion of all Preference Shares to Ordinary Shares.
Ventura disputed the validity of the purported conversion on the basis that it constituted a variation or abrogation of rights in respect of the Preference Shares, and consequently was invalid as it failed to comply with the obligation to obtain the consent of 75% of the holders of the Preference Shares (i.e. the consent of Ventura). Ventura then brought a claim seeking a declaration that the purported conversion of the shares was void, and alternatively for a remedy pursuant to section 633 of the Companies Act 2006 ("CA 2006") (allowing for variations to rights attaching to classes of shares under section 630 of the CA 2006 to be challenged on the grounds that the variation would cause unfair prejudice).
- HHJ Hodge KC (the "Trial Judge") agreed with Ventura and rejected the defence argument that a conversion of shares constituted an exchange of the Preference Shares with Ordinary Shares, rather than a variation or abrogation of the rights attached to the Preference Shares.
- The Trial Judge identified a "clear tension" between the two key provisions of the New Articles, since article 9.2(a) unambiguously provided for the Preference Shares to "automatically" convert into Ordinary Shares upon the receipt of an Investor Majority notice (which had been given); but article 10.1 provided that the any special share rights could only be varied or abrogated with the written consent of 75% of the Preference Shareholders. He was therefore required to determine how to interpret the New Articles notwithstanding this inconsistency, noting that when construing articles of association the admissible extrinsic evidence was "limited to documents that would be available to a third party from the public file maintained by the Registrar of Companies at Companies House" and commercial common sense. He then undertook an exercise of determining how, in the face of the New Articles making "no rational sense", to give business efficacy and integrity to the New Articles as a whole.
- The Trial Judge reasoned that due to the substantial premium paid for the Preference Shares and the nature of the benefit of owning the Preference Shares as opposed to Ordinary Shares (which were extinguished upon the conversion), it could not be right that article 9.2(a) could be read in isolation to allow a majority of the holders of Ordinary Shares to strip a Preference Share holder of the special rights attached to the Preference Shares. It was the Trial Judge's opinion that something had gone wrong with the drafting, and that to rectify this, a limitation should be implied to the rights in article 9.2 construing them as strictly subject to the protections in article 10.1 of the New Articles.
- The Trial Judge also determined that had he been wrong, and if the conversion had properly been undertaken in accordance with the New Articles, there was no basis to grant relief under section 633 of the CA 2006. He accepted that section 633 created a "comprehensive scheme applicable to all variations of class rights, whether effected pursuant to a provision in a company's articles or under statute outside the articles", and that on the facts the conversion of the shares was prejudicial. However, the Trial Judge did not think that the situation would be unfair in circumstances where (in order to reach this part of the argument) he had determined that the action was permitted by the New Articles and therefore formed part of the parties' bargain.
The Court of Appeal, with Lord Justice Snowden (the "Appeal Judge") giving the leading judgment, upheld the first instance judgment:
- The general approach to written contracts, which has been the subject of a number of significant judgments over the last decade (including Arnold v Britton), was considered and confirmed to have equal application to the interpretation of articles of association of a company (with the exception of the ability to consider factual matrix or background material, which is limited as highlighted above).
- DnaNudge argued that article 9.2 unambiguously provided for automatic conversion of the Preference Shares on notice from an Investor Majority. It was submitted that, given that the Trial Judge accepted that article 9.2 was "clear on its face", he was not entitled to imply a term to the contrary or to read an implied limitation into that provision. The Appeal Judge disagreed with this submission, reasoning that the concept of "automatic" conversion is not limited to a singular meaning, and referenced a different part of the New Articles (article 9.4) in which something described as "automatic" also had separate conditions attached. In context, "automatic" was taken to describe something which would happen without anything more being required after receipt of the requisite notice to authorise the company to give effect to the conversion.
- The Appeal Judge reflected on the Trial Judge's investigations into potential rival meanings of article 9.2(a), and whether such meanings were consistent with the rest of the New Articles and produced a coherent and commercially sensible scheme on the whole. The Appeal Judge agreed that DnaNudge's contention as to the meaning of article 9.2(a) would lead to an incoherent scheme and irrational results. Examples were given, such as that the Ordinary Shareholders could potentially serve a notice under article 9.2 (a) as soon as the Preference Shares were issued; or (b) precisely at the time at which the special rights were designed to benefit the Preference Shareholders (on a proposed liquidation or Exit). The Appeal Judge agreed that there was an error in the drafting of the New Articles, as there was no logical or rational justification for why Preference Shareholders would be protected by having to give class consent to lesser alterations 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 a result, the Trial Judge was correct to adopt a corrective construction to rectify the error in the drafting.
- It was noted that the process of "conversion" is not prescribed by English law and so not dealt with by the CA 2006. The Trial Judge reasoned that the drafter must have intended the Preference Shares to continue in existence and be re-designated as Ordinary Shares in the register of members as opposed to the Preference Shares being cancelled and Ordinary Shares issued in their place. This was accepted by the Appeal Judge.
- The determination of the issue of how to apply section 633 of the CA 2006 was not considered in detail by the Court of Appeal (which expressly left the point over for "an appeal in which it is determinative". However, the obiter comments from the Appeal Judge indicate that section 633 does not give the Court an "entirely free discretion" to determine whether a particular variation of rights was unfairly prejudicial such that the remedy would be unlikely to be of any assistance in a situation where the New Articles had been properly complied with.
So what are the takeaways from this decision?
Those drafting articles of association (or equivalent documentation) should take note! This is a case that, as framed by the judge in the first instance, was one of "those rare cases where there has been a drafting error" and with impactful consequences; the conversion was invalid.
When drawing up articles with more complex share rights (often seen in companies with venture capital and private equity investment or as part of sophisticated reorganisations), it has always been important to ensure the content is unambiguous, fits within the rest of the constitutional infrastructure and correctly reflects what the parties have agreed. This case highlights that this remains the case and extra care and consideration should be applied when drafting: (i) a provision, which whilst agreed commercially, could subsequently be perceived as prejudicing a party (and therefore creates a need to make it very clear in the drafting that the relevant event could occur, for example, without the agreement of the party that could be so prejudiced); and/or (ii) for processes/matters where there are no express provisions dealing with the relevant subject matter under the CA 2006 (for example, conversions of shares). This case is also a helpful reminder to always consider whether something constitutes a variation of class rights (and if so, get that consent).
There are a number of interesting aspects of this case from a litigation perspective, including the guidance provided around how to construe and interpret company articles of association, the rarely utilised attempt to rely on section 633 of the CA 2006, and the potential power of seeking declaratory relief. However, the judgment primarily highlights the risk of drafting inconsistencies in constitutional and/or investment documentation and what can be done when those issues arise.
As these documents get ever more complex, to accommodate investor needs and protections, it remains vital to ensure drafting consistency to avoid potentially costly disputes. When disputes do arise, understanding the rights and the action which is being taken in the wider context (even if a specific issue appears to turn on a discrete element of the complex contractual and constitutional framework) can give a vital steer to parties trying to determine what legitimate action can be taken (or, from the other perspective, what may be open to challenge).
It is also worth remembering that whilst everyone is often in a collaborative mood when an investment is being made, by the time the protections which are put in place at that stage come to be tested, the situation and relationships between the parties can be very different.
If you would like to discuss this decision, please contact Amar Adatia or Sean Adams.