Precision matters when drafting articles of association: Lessons from DnaNudge Ltd v Ventura Capital GP Ltd [2023]

Posted Thursday 7th December 2023

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. The case 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 (DnaNudge), a medical and health technology company undertook a funding round with Ventura Capital Ltd (Ventura) and another investor. Ventura invested over £40 million in the company through the purchase of preference shares.
In connection with this funding round, DnaNudge adopted new Articles of Association in January 2021 (Articles). These included the following provisions:
- Article 9.2(a), which stated that the preference shares would “automatically convert” into ordinary shares, upon notice in writing from a majority of all shareholders (Investor Majority).
- Article 10.1, which stated that a class of shares with special rights attached to them (e.g. the preference shares) could only have those rights “varied” or “abrogated” with the consent of the holders of more than 75% of the relevant share class.
After the preference shares were issued, the ordinary shareholders retained an overall majority of approximately 87% of the DnaNudge’s share capital, while the holders of the preference shares held approximately 13%.
In May 2022, the ordinary shareholders attempted to convert the preference shares into ordinary shares in reliance on Article 9.2(a) of the Articles, in effect stripping Ventura of a right to payment in priority over the ordinary shareholders in certain circumstances that they enjoyed as holders of preference shares.
Ventura commenced court proceedings seeking a declaration that the purported conversion of the preference shares was null and void because it varied or abrogated the rights attaching to those shares, and therefore required the consent of a 75% majority of the holders of the preference shares under Article 10.1;

The Court of Appeal’s ruling

Automatic conversion provision was invalid

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 holders of preference shares of the benefits conferred by the special rights attaching to the preference shares, at any time chosen by the ordinary shareholders.

Conversion of preference shares did “vary or “abrogate” the rights attaching to those shares

The Judge’s view was that it was necessary to “look at the reality of the situation”, and concluded 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” (paragraph 105 of the Judgement) – and therefore engaged Article 10.1

The Court of Appeal said that the word “automatic” in the share conversion provision did not exclude the possibility that other conditions – such as the requirements of Article 10.1 – 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.

Separate claim from Ventura – unfair prejudice against ordinary shareholders for exercise of Article 9.2(a)?

The Court of Appeal concluded that, while the exercise by the ordinary shareholders of such a right would certainly have caused “prejudice” to the holders of the preference shares, there would have been nothing “unfair” about the ordinary shareholders exercising a right conferred on them in a set of articles governing a commercial agreement formed on an arm’s length basis. The Court therefore rejected this element of the claim.

Comment:

Automatic share conversion and share right variation provisions are a common occurrence in venture capital transactions. When drafting articles, it is important to be aware of actual or potential conflicts between the different provisions of the articles, and to ensure these are clearly addressed in the drafting, for example, that automatic share conversion mechanisms of this type are not to be subject to class consent.

If you would like to discuss amending your articles ahead of any fundraise to protect your/your Company’s interests, please feel free to reach out to Rajiv Samani in our Corporate team who will be very happy to assist you.

This article is for reference purposes only. It does not constitute legal advice and should not be relied upon as such. Specific legal advice about your specific circumstances should always be sought separately before taking or deciding not to take any action.