Conversion of shares and the variation of class rights

The High Court has recently reviewed a company’s articles of association in the light of a claim from a private equity investor that the purported conversion by the company of preference shares into ordinary shares constituted a variation of the rights to which the preference shares were subject. The investor argued that the conversion was void, since it had not been carried out in accordance with the provisions of the company’s articles, and the court agreed. 

In the winter of 2021–22, DnaNudge Ltd, a medical and health technology company, raised equity capital from two investors, Ventura Capital and Sumitomo Mitsui Trust Bank, which were issued with preferred shares in the company.

The company’s articles of association provided that the preferred shares would have a liquidation preference amounting to a preferred payment. A shareholders’ agreement provided that the holders of preferred shares would have the benefit of a put option, requiring the company to purchase all their preferred shares for a price equal to the preferred payment, if the company did not undergo an initial public offering with an offer price of at least £900 million before November 2023.

Article 9.2 of the articles provided that all the preferred shares would automatically convert into ordinary shares on notice in writing from an Investor Majority. Notably, an Investor Majority was defined, not as the holders of some specified majority of the preferred shares, but as the holders of a majority of all the preferred and ordinary shares, as if they constituted a single class. Article 10.1 provided that the special rights attached to any class of shares could be varied or abrogated only with the consent of the holders of more than 75% of the shares at that class.

Seeking to avert the exercise of the put option, the company invited shareholders constituting an Investor Majority to serve notice effecting conversion of the preferred shares to ordinary shares. Such notice was given in June 2022, by a sufficient number of ordinary shareholders (who outnumbered the preferred shareholders), and the company’s lawyers wrote to the preferred shareholders informing them that, accordingly, their preferred shares had been converted to ordinary shares.

Ventura, acting on behalf of itself and Sumitomo, promptly brought a claim against the company, arguing that the purported conversion of the preferred shares was void, because the provisions of article 10.1, requiring a class consent for any variation or abrogation of class rights, had not been complied with. Alternatively, Ventura argued that the variation or abrogation of class rights effected by the conversion was unfairly prejudicial to the rights of the preferred shareholders and so should be disallowed under section 633 of the Companies Act 2006.

The company argued that the conversion did not constitute a variation of class rights, since the rights pertaining to the preferred shares were unchanged: it was simply that the preferred shareholders had been issued with ordinary shares in place of their preferred shares. In any event, the conversion was validly carried out under the provisions of article 9.2; and any prejudice suffered by the preferred shareholders was not unfair, since the conversion was carried out in accordance with the provisions of company’s articles.

Examining the articles, the court gave judgment in favour of Ventura, holding that the conversion of the preferred shares did indeed amount to a variation of class rights, and resolving the contradiction between article 9.2 and article 10.1 by holding that article 9.2 should be construed as if it included the words ‘subject always to having first obtained the consent required under article 10.1’. This conclusion – that the purported conversion was void, because class consent had not been given – made it unnecessary to decide the unfair prejudice point, but Hodge J added that, in that respect, he agreed with the company that (if the conversion had been validly carried out) any prejudice suffered by the preferred shareholders would not have been unfair.

A postscript to the judgment indicates that the company intends to seek permission to appeal, and so there may be further developments in due course. Whatever the eventual outcome, the High Court’s judgment is a useful reminder of the importance of class rights, both when drafting investment documents and when contemplating a corporate action that might have the effect of varying such rights.

For more information, please contact Brendan Biggs.