Background

• DnaNudge Ltd (DnaNudge) is a medical and health technology company founded in 2015. In late 2020, Ventura Capital Ltd (Ventura) and another investor invested over £40 million in the company through the purchase of preference shares. After the preference shares were issued, the ordinary shareholders retained an overall majority of approximately 87% of the company’s share capital, while the holders of the preference shares held approximately 13%.
• In connection with this funding round, DnaNudge adopted new Articles of Association in January 2021 (the ‘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.
  • 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.
• In May 2022, the ordinary shareholders purported to convert the preference shares into ordinary shares in reliance on Article 9.2(a) of the Articles, in effect stripping Ventura and its co-investor of the special rights (including 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; or
  • an order that the conversation should be set aside on the grounds that the ordinary shareholders’ attempt to force through the conversion of the preference shares under Article 9.2(a) was unfairly prejudicial (for the purposes of section 994 of the Companies Act 2006) to Ventura’s rights as a shareholder.

The Court of Appeal’s judgment

Did conversion of the preference shares “vary” or “abrogate” the rights attaching to those shares?

• DnaNudge’s first line of defence was to argue that Article 10.1 of the Articles was simply not engaged because:
  • Conversion of the preference shares involved an exchange of preference shares for ordinary shares, rather than a variation or abrogation of the rights attaching to the preference shares.
  • The majority shareholders’ right to convert the preference shares under Article 9.2(a) was part of the overall commercial bargain that governed the preference shares at the time they were issued. A conversion of the preference shares under Article 9.2(a) was simply the performance of one of the existing rights relating to the preference shares; it did not vary or abrogate the rights attaching to these shares.
• These lines of argument were firmly rejected by the judge at first instance, who emphasised 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).
• The Court of Appeal agreed. The conversion of the preference shares to ordinary shares clearly involved a variation or abrogation of the special rights attaching to these shares and therefore engaged Article 10.1. In circumstances where the conversion of the preference shares did not involve the performance of the special rights attaching to these shares (i.e. a priority payment to the holders) it could not be said that the conversion was simply the performance of the rights attaching to these shares.

Could the preference shares “automatically convert”, if conversion is subject to the consent of the holders?

• DnaNudge argued that the phrase “automatically convert” in Article 9.2(a) was clear and unambiguous: these words could only mean that once a conversion notice was served by a majority of the shareholders, conversion of the preference shares was automatic and could not be subject to any further conditions. It followed that Article 9.2(a) overrode Article 10.1 if there was an inconsistency between the two Articles.
• However, the Court of Appeal did not agree. It found that it was possible for the preference shares to convert “automatically” on service of a conversion notice, but subject to the consent of a 75% majority of the holders of the preference shares.
• Having concluded that the word “automatically” could be read in this way, the Court of Appeal found that, in determining the correct meaning of Articles 9.2(a) and Article 10.1, it was necessary to “investigate whether the rival meanings of Article 9.2(a) were consistent with the other provisions of the Articles and to ask whether they produced a coherent and commercially sensible scheme for the Articles as a whole” (paragraph 63).
• Having carried out this exercise, the Court of Appeal concluded that, when Article 9.2(a) was viewed in the context of the Articles generally, which attached special rights to the preference shares and provided for those rights to be protected, DnaNudge’s suggested meaning for Article 9.2(a) “would lead to an incoherent scheme and irrational results” (paragraph 64). If DnaNudge were right, the ordinary shareholders would have had an unrestricted right to deprive the holders of the preference shares of the special benefits attaching to those shares.
• The Court of Appeal concluded that “in order to make rational and coherent sense of the Articles”, Article 9.2(a) must be interpreted as being subject to the provisions of Article 10.1, or a term must be implied into the Articles to this effect.

Was the ordinary shareholders’ exercise of Article 9.2(a) unfairly prejudicial?

• The Court of Appeal rejected Ventura’s alternative case that, if the ordinary shareholders did have a contractual right under Article 9.2(a) to convert the preference shares into ordinary shares, the exercise of this right could nonetheless constitute unfairly prejudicial conduct for the purposes of section 994 of the Companies Act 2006.
• 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 of association governing a commercial association formed on an arm’s length basis.

Comment

• The courts will usually strive to interpret articles of association in a way that ensures a coherent and commercially rational outcome, and may even be willing to imply terms into articles in certain circumstances.
• However, companies will naturally look to avoid the intervention of the courts in the first place. Central to this is careful drafting of articles of association (and any other agreements between shareholders), especially those provisions that may be contentious, such as conversion mechanisms or put or call options.
• When drafting articles of association, it is important to be alive to actual or potential conflicts between the different provisions of the articles, and to ensure these are expressly addressed in the drafting.
• On the unfair prejudice issue, the Court of Appeal’s decision (which while not strictly binding) is it nonetheless a welcome indication that, where a shareholder exercises its contractual rights under a set of articles of association or a shareholders agreement which has been negotiated on a commercial arm’s length basis, it is highly unlikely that this will amount to “unfair” conduct for the purposes of section 994 of the Companies Act 2006, no matter how severe the prejudice may be to other shareholders.

Client Alert 2023-253