What happened?

Ventura Capital GP Ltd v DnaNudge Ltd [2023] EWHC 437 (Ch) concerned a medical and health technology company that was partly financed by venture capital.

The company was incorporated in 2015. In 2021 and 2022, it raised a total of £44m from two investors by issuing “series A preferred shares”.

The preferred shares carried the same rights, and had the same nominal value, as the existing ordinary shares in the company, except that the preferred shares carried a right to a cumulative preferred return on any dividend or capital distribution. For this reason, the preferred shares and the ordinary shares were separate classes of share in the company.

The preferred shareholders also had the benefit of a separate contractual put option, under which they could require the company to buy back some or all of their preferred shares if the company did not successfully IPO before a specific deadline.

The company’s articles of association set out circumstances in which the preferred shares would be “automatically converted into” ordinary shares. These included, in article 9.2(a):

“upon notice in writing from an Investor Majority at the date of such notice”

However, the articles did not set out exactly how the share conversion would operate (see box, “What is a share conversion?”).

The articles defined an “Investor Majority” as:

“the holders of a majority of the [preferred shares] and [ordinary shares] in aggregate as if such [shares] constituted one class of share.”

The ordinary shares accounted for 86.7% of the company’s shares, meaning that the ordinary shareholders had the power to form an Investor Majority without the preferred shareholders.

Finally, the articles also stated, in article 10.1:

“Whenever the share capital of the Company is divided into different classes of share, the special rights attached to any such class 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.”

In May 2022, the company proposed to raise additional working capital and sent a circular to shareholders outlining its proposals. In the circular, the company noted that, if the preferred shareholders were to exercise the put option, the company’s “business, financial condition, results of operations and prospects may be materially adversely affected”.

The circular also noted that “an Investor Majority might seek to nullify the Put Option by converting the [preferred shares] into [ordinary shares] (pursuant to Article 9.2)” and that “former holders of the [preferred shares] might seek to challenge any conversion of the [preferred shares]”.

Three days later, various ordinary shareholders served a notice on the company purporting to convert the preferred shares into ordinary shares under article 9.2(a).

The preferred shareholders brought legal proceedings to declare the conversion null and void. They argued that the conversion amounted to a variation or abrogation of the rights attaching to their preference shares, and that they had not given their consent to that variation under article 10.1.

Alternatively, if their consent was not required and the variation was valid, they argued that the variation should be set aside because it was unfairly prejudicial to them (see box, “What is a variation of class rights?”).

The parties ran various arguments which the court had to examine. We have set them out below separately, along with the court’s conclusions.

Was there a variation of class rights?

The preferred shareholders’ entire challenge rested on the idea that there had been a variation of the rights attaching to their preferred shares.

The company argued that there had been no variation of share rights. Instead, the conversion had taken the form of a “share-for-share exchange”, with the preferred shareholders simply swapping their preferred shares for new ordinary shares, rather than keeping the same shares but with altered rights.

The company gave various reasons for this, including that:

• the preferred shareholders were required to surrender their share certificates and the company would issue new ones;
• the company’s register of members would be updated to remove the preferred shareholders as holders of preferred shares and insert them as holders of ordinary shares; and
• the conversion mechanism also included provisions dealing with “fractional entitlements”, which would not arise if there were simply a variation of share rights.

The company also argued that there could not have been a change to the rights attaching to the preferred shares because, under the company’s articles, that class of shares continued to exist after the conversion. There had been no amendment to the company’s articles to change the rights of the preferred shares as a whole. Although there would be no preferred shares in issue after the conversion took place, the company could issue more preferred shares and those shares would have the same rights as the preferred shareholders had enjoyed before the conversion.

Because there was no variation of class rights, the company said, there was no need for consent from the preferred shareholders under article 10.1.

The court disagreed. There had been an attempted variation of the preferred share rights.

The judge said it was necessary to look at “the reality of the situation”. There was “no doubt that any reasonable reader of the articles would regard the conversion of the preferred shares into ordinary shares as varying or abrogating the rights attached to the former class of shares.”

It did not matter that the articles continued to contain a class of shares with preferred rights. For all practical purposes, the conversion would result in the special rights attaching to the preferred shares being taken away and no longer existing, because there were no longer any preferred shares in issue.

Was the preferred shareholders’ consent required?

Having established that the conversion did amount to a variation of class rights, the next question was: did the variation require the preferred shareholders’ consent under article 10.1?

The issue centred around a drafting inconsistency between articles 9.2(a) and 10.1. Article 10.1 stated that the rights attaching to the preferred shares could be varied only with the consent of 75% of the preferred shares. Article 9.2(a) stated that any conversion under that article was “automatic”.

The question, therefore, was whether article 9.2(a) overrode article 10.1, meaning that no consent was required from the preferred shareholders, or article 10.1 overrode article 9.2(a), meaning that a conversion could only happen once consent had been given.

The company argued that no consent was required. The conversion could not be “automatic” if consent was required. The effect of the articles was the conversion took place immediately when a notice was served and the company was obliged to take actions to reflect that conversion. There was no room in the wording of article 9.2(a) to make conversion conditional on the preferred shareholders’ consent.

The preferred shareholders argued that this could not have been the intention of the conversion clause. If the ordinary shareholders could convert the preferred shares without the preferred shareholders’ consent, this would effectively allow them unilaterally to strip the preferred shareholders of their valuable rights, potentially even the very moment after the preferred shares were issued.

The preferred shareholders’ case (paraphrased by the judge) was that it would be “complete nonsense to bargain for special rights [that] can only be varied … with the consent of 75% of the class members, yet to agree a trapdoor … that can be pulled open at any stage by the ordinary shareholders.”

The court agreed that consent was required. In analysing the articles, the judge employed the usual tests of contractual interpretation. This included what a reasonable person reading the articles would understand them to mean and what was necessary to give “business efficacy” to the articles.

In the judge’s view, this meant that the conversion mechanism had to be conditional on the preferred shareholders giving consent to the variation of their rights. This was “so obvious that it [went] without saying”. No reasonable person reading the company’s articles and knowing how much the investors had paid for their preferred shares would regard the articles as allowing a majority of ordinary shareholders to remove the special rights enjoyed by the preferred shares.

The only way to give business efficacy and “integrity” to the articles was to insert, at the end of article 9.2(a), the words: “subject always to having first obtained the consent required under article 10.1.”

As a result, the court declared the purported variation of rights and, therefore, the conversion null and void.

Was the purported variation unfairly prejudicial?

Having declared the variation void, the court did not need to consider whether it was unfairly prejudicial to the preferred shareholders. This was because there could not be unfair prejudice if there had been no variation as a matter of law.

However, the court explored this question anyway. The judge’s comments in this respect are purely persuasive, not authoritative, but they give an interesting insight into a provision of law that is not tested very often.

The preferred shareholders argued that the variation was prejudicial to them because it stripped them of valuable rights, namely the right to a preferential return, and that this was unfair because:

• they had specifically negotiated those rights and a shareholder majority should not be able to extinguish them without consent or compensation;
• none of the preferred shareholders had voted in favour of the variation; and
• the ordinary shareholders were simply seeking to improve their own financial position at the expense of the preferred shareholders.

The court disagreed. The judge agreed that, if the variation had been effective, the preferred shareholders would have been prejudiced. But that prejudice was not unfair.

If it had been effective, the conversion would simply have followed the provisions of the articles and the terms of the agreement between the parties. There would have been nothing unfair about holding the parties to their commercial bargain.

The fact that no preferred shareholders voted in favour of the variation was irrelevant. If article 9.2(a) had been effective without the consent of the preferred shareholders, it would not have mattered whether they voted for or against the variation. Likewise, provided the ordinary shareholders had not been acting with an improper motive, there would have been nothing unfair in them improving their financial position.

The court also rejected arguments that the variation would have been unfair because it would have deprived the preferred shareholders of the benefit of the put options or it would have in some other way breached a shareholders’ agreement with the company. These were separate contractual arrangements that did not concern rights attached to the shares.

What does this mean for me?

It seems from the judgment that the court was never going to allow the preferred shareholders to lose their enhanced rights easily. The very first paragraph of the judgment reads:

“From the perspective of common sense and simple fairness, the answer to [the question of whether the special rights attached to a class of preferred shares can be extinguished by the simple procedure of converting those shares into ordinary shares without the consent of the preferred shareholders, who had invested some £44m in the company in reliance on those special rights] should be fairly straightforward; but the resolution of contested legal issues is seldom an easy process.”

In a case that turned first and foremost on ambiguities in the drafting of the articles, this will no doubt have been present in the judge’s mind from the outset.

The key lesson from the case is to ensure the drafting of any conversion mechanism is clear and unambiguous. In this respect, it is worth bearing certain points in mind.

• Set out the trigger(s) for conversion. This could be automatic (for example, on an exit or when a person leaves the company) or voluntary (for example, by notice to the company, perhaps within a particular period of time). There is no default method for converting shares under company law, so any mechanism will need to be set out in the articles.
• If possible, the conversion provisions should detail how the conversion is to take place. This might be through a redesignation of shares (which will usually amount to a variation of class rights) or an alteration of capital, depending on whether the nominal value of the shares will change. Any alteration of capital may well require shareholder approval.
• If conversion will involve varying class rights, clarify how the conversion intersects with any class consent rights. If the conversion mechanism is to apply – and class rights are to be varied – without the consent of the affected shareholders, the articles should make this crystal clear.