The High Court has interpreted that a right for preferred shares to be converted to ordinary shares is subject to class right approval by the preferred shareholders.
In the case of Ventura Capital GP Ltd (Ventura) v DnaNudge Ltd (the Company)  EWHC 437 the High Court held that a conversion of preferred shares constituted a variation or abrogation of the special rights attaching to the preferred shares since the consent of the preferred shareholders was not obtained. Ventura had invested £42m into the Company in return for preferred shares and, together with Sumitomo Mitsui Trust Bank, held all of the preferred shares in the Company.
The preferred shareholders had negotiated valuable rights attached to the preferred shares, reflected in the Company's new articles of association and an amended shareholders' agreement, including a right to a cumulative preferred return on any dividend or capital distribution and a contractual put option pursuant to which they could require the Company to buy back some or all of their preferred shares if the Company did not IPO before November 2023.
In May 2022, the Company wanted to raise more capital and issued a circular to all shareholders, in which it warned that the potential exercise of the put option by the preferred shareholders could negatively impact the Company’s business. The circular also stated that an Investor Majority (being the holders of a majority of the ordinary shares and preferred shares in aggregate as if such shares constituted one class of shares) could nullify the put option by converting the preferred shares into ordinary shares. Given the number of ordinary shares in issue, ordinary shareholders could constitute an Investor Majority without the need for any preferred shareholders. In June 2022, an Investor Majority comprised of ordinary shareholders informed the preferred shareholders that their preferred shares had been converted into ordinary shares.
What did the Articles say?
This case hinged on the interplay between the conversion right in Article 9.2(a) and the protections afforded to the preferred shareholders in Article 10.2.
Article 9.2 (a) provided that:
'All Series A [preferred] Shares shall automatically convert into Ordinary Shares:
(a) upon notice in writing from an Investor Majority at the date of such notice'
Article 10.1 provided that:
'Whenever the share capital of the Company is divided into different classes of shares, 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.'
Ventura argued that the conversion constituted a variation or abrogation of the rights attaching to their preferred shares and that Article 9.2 (a) should therefore be read in conjunction with Article 10.1, requiring the written consent of the preferred shareholders. As this consent was not obtained, the conversion should be declared void.
The Company's principal submission was that the exercise of the conversion right under Article 9.2(a) was not a variation or abrogation but instead an 'exchange' of preferred shares for ordinary shares on a one for one basis. This meant that the rights attached to the preferred shares were not extinguished and, whilst the preferred shares were no longer in issue following the conversion, the Company still could issue shares of this class in the future. The correct question to consider was therefore whether the rights attaching to the class of share had changed, not whether the rights of the holder of the shares had changed. Hence, Article 9.2 (a) should not be subject to Article 10.1 because there had been no abrogation or variation of the rights attaching to the class of preferred shares under the articles.
High Court's Decision
The court agreed with Ventura's submission that there had been an attempted variation or abrogation of the preferred share rights. Firstly, the court noted the premium paid for the shares, and stated that it would have been 'apparent' that the premium paid was for the special rights attached to those preferred shares.
Secondly, in assessing the true meaning of the words in Article 9.2 (a), the court stated that it must look at the 'reality of the situation'. The reality here was that the conversion sought to extinguish the special rights of the preferred shares and was therefore an attempted variation or abrogation of the preferred share rights. It was immaterial that shares of the same class could still be issued after the conversion. The court rejected the Company's submission that the conversion could have taken effect without the consent of the preferred shareholders and stated that it was 'so obvious that it goes without saying' that no reasonable person reading the articles and knowing how much the preferred shareholders had paid for their shares would interpret the articles as allowing a majority of ordinary shareholders to remove the special rights attaching to the preferred shares.
As a result of the above conclusions, Judge Hodge KC agreed with Ventura that the following words should be read as inserted at the end of Article 9.2 (a): ‘… subject always to having first obtained the consent required under article 10.1’
Judge Hodge KC was clear that the implied insertion of the above phrase did not reverse the deal struck by the parties originally. Instead, it was giving business efficacy and integrity to the articles as a whole and giving effect to the 'true bargain made between the company and all its shareholders, whereby they always intended that the special rights attached to the preferred shares should enjoy effective protection from any attempt to vary or abrogate them'.
The court therefore declared the purported variation or abrogation of rights attaching to the preferred shares, and hence the conversion, null and void.
The key takeaway from this case is that a company's articles should be clear and unambiguous in setting out when and how a conversion right occurs since there is no default conversion mechanism under UK company law. In particular, there should a clear process where a conversion will constitute a variation of class rights and how the conversion right will interact with class consent rights under the articles or section 630 of the Companies Act 2006. If the intention is for a conversion not to require class consent, this should be expressly stated in the articles so as to avoid any potential claims from shareholders who may be impacted. Prospective investors should also be mindful of any of any automatic conversion rights in a company's articles and ensure that any such rights are subject to appropriate class consents.