A class apart – Court of Appeal considers class rights and automatic conversions of shares

The Court of Appeal has recently given guidance on the interpretation of a company’s articles of association where the Court found a conflict between provisions dealing with the conversion of preferred shares to ordinary shares and the requirements for class consent.

In a rare case, the Court of Appeal upheld the first instance judgment that, on their proper construction, there was an implied term in the articles – despite certain words being “clear and unambiguous” – that class consent was required to convert preferred shares to ordinary shares and that the purported conversion by the company was void and of no effect in the absence of that consent. The Court of Appeal also provided further insight into what constitutes unfair prejudice in shareholder disputes.

Background

DnaNudge Ltd v Ventura Capital GP Ltd [2023] EWCA Civ 1142 concerned a dispute between DnaNudge Limited (the “Company”), a medical and health technology company, and one of its shareholders, Ventura Capital GP Limited (“Ventura”). 

In 2021, Ventura invested around £40m to acquire shares in the Company, as part of an external fund-raising by the Company. 

Under its articles of association (the “Articles”), the Company had two classes of shares. Series A shares, around 13% of the total, entitled their owners to certain enhanced rights to company distributions. The remaining 87% of shares were ordinary shares. Ventura held Series A shares.  

However, Article 9.2 of the Articles provided that upon “written notice” from a majority of all shareholders, Series A shares would automatically convert into ordinary shares. This, argued Ventura, conflicted with Article 10.1, which stated that “special rights attached to” a class of shares “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.”

A separate shareholders’ agreement also granted Ventura a put option whereby, after a certain date, the Company could be required to purchase Ventura’s Series A shares at a rate that reflected their enhanced distribution rights (the “Put Option”). In May 2022, the Company was running out of cash and sent a circular to all its shareholders proposing to raise additional working capital through issuing convertible loan notes. In that circular the Company explained that a risk factor was Ventura exercising the Put Option, which would materially and adversely affect the business.   

Six months before Ventura’s Put Option vested, the ordinary shareholders unilaterally purported to trigger the automatic conversion process for the Series A shares under Article 9.2. None of the Series A shareholders had provided written consent to the conversion.

Basis of the proceedings

Ventura issued a claim against the Company seeking a declaration that the conversion abrogated its enhanced distribution rights and was invalid, as Ventura had not given the consent required by Article 10.1. In the alternative, Ventura asked the court to disallow the conversion under section 633 of the Companies Act 2006, which allows the court to set aside “variations of class rights” where the class of shareholders has been “unfairly prejudiced”.

The Company argued that the right to convert was expressly made automatic and was a facet of the bundle of rights comprising the Series A shares; conversion amounted to giving effect to the terms of issue and therefore was not a variation or abrogation of the rights. Therefore there was no conflict with Article 10.1.

First instance judgment

Hodge KC, sitting as a Judge of the High Court, agreed with the Company that Article 9.2 was “clear and unambiguous” and, as written, gave ordinary shareholders the right to convert the shares without the Series A shareholders’ consent. However, in the High Court’s view, it made no commercial sense for Series A shareholders, who held only 13% of the issued shares, to agree a provision that permitted the ordinary shareholders opportunistically to remove their preferential rights without their consent. The Judge also found that the conversion appeared to trigger Article 10.1, as it extinguished the special rights enjoyed by Series A shareholders. To resolve this “clear tension” between Articles 9 and 10, and in order to “give business efficacy, and integrity to the Articles as a whole”, the High Court held that Article 9.2 contained an “implied limitation” that any conversion of Series A shares into ordinary shares could only happen after the Series A shareholders provided written consent under Article 10.1.

On the issue of the section 633 challenge, the High Court held that, should the conversion have been permissible under the Articles (which the Court ruled it was not), there was no unfair prejudice to Ventura. While obviously prejudicial to Ventura, the conversion could not be considered unfair. This was because Ventura had agreed to the Articles and “there is nothing inherently unfair in holding [Series A shareholders] to their bargain.” 

Court of Appeal

Lord Justice Snowden, delivering the unanimous judgment of the Court of Appeal, agreed with the High Court and dismissed the Company’s appeal. On the issue of interpreting the Articles, the Court of Appeal stated that when “what is contended to be the natural and ordinary meaning” of articles of association “produces an incoherent or irrational result” a judge is permitted to provide a “corrective construction” that may include an implied term. It further agreed that, on the case before it, the High Court had taken “a logical alternative approach” that “to make rational and coherent sense of the Articles, either Article 9.2(a) must be interpreted as being subject to Article 10.1, or a term must be implied to that effect.” Otherwise, on the Company’s argument, Article 9.2 would give an investor majority comprising only ordinary shareholders an unrestricted power to deprive the holders of the Series A Shares of the particular benefits conferred by those special rights, at any time chosen by the ordinary shareholders. The Court of Appeal regarded that outcome as “a bizarre conclusion which makes no commercial sense given the very creation of the Series A Shares as a separate class...”

In reaching its decision, the Court of Appeal applied the well-known principles of contractual interpretation derived from the leading Supreme Court authorities on the subject, including Arnold v Britton [2015] AC 1619, given that those principles were equally applicable to the interpretation of the Articles as a contract by reason of section 33 of the Companies Act 2006 (except that the factual matrix against which the meaning is assessed is narrower for documents such as articles of association, reflecting the fact that they can bind persons who did not negotiate them and are made available on the public register at Companies House for the use of readers with limited knowledge of the background). The Court applied the so-called iterative approach, by which alternative readings are tested against the document as a whole. On that basis, the Court was entitled to find that the position adopted by the Company – that the special rights could be abolished opportunistically by the other shareholders – made no sense in the context of the nature of the special rights.

The Court of Appeal expressed no view on a technical point as to whether section 633 applies to consent provisions in articles of association, as the challenge on that point was withdrawn. However, the Court of Appeal went on to state in dicta that, given the evidence that the Articles were negotiated at arm’s length and there appeared to be no equitable considerations in play, it would be difficult to say that the majority shareholders were acting unfairly “when they simply gave effect to the agreed terms.” 

Comment

This was an unusual case where there was an obvious error in the drafting of the Articles, resulting in a clear conflict between the ability to change fundamentally the respective rights of differing classes of shareholders. This judgment provides a useful overview of the principles that a court will apply when seeking to reconcile such conflicts, and how the courts remain willing to imply terms into articles of association, where necessary, in order to make rational or coherent sense of them. Obviously a dispute could have been avoided had the Articles been drafted in a clearer way, but the judgment also serves as a reminder that the court will seek to give effect to agreed terms and that it will be challenging for a disaffected party to complain that the result is unfairly prejudicial to their interests where they have readily agreed to contract on that basis.