A recent UK Court of Appeal decision has cast doubt on the effectiveness of a common mechanism for the “automatic” conversion of shares. Corporate partner, Conall Geraghty, examines the impact of this development and why founders and investors should check their investment agreements.

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Minority shareholders may have new leverage to derail future investment rounds and to attack an unwanted “automatic” conversion of their shares. This follows a recent UK court of appeal decision which has cast doubt on whether an automatic conversion, using one of the most common industry templates, is truly automatic or whether a separate class consent is still required.

Successful challenge

An investor in a UK company has successfully challenged a purported “automatic” conversion of its Series A Shares into Ordinary Shares.

On its face, this decision is both surprising and concerning. The conversion mechanism in the company’s articles of association appeared to be clear and unambiguous. It stated that the shares would “automatically convert” on a written notice “without further authority than is contained in these Articles”. However, the UK court of appeal determined that the conversion was void in the absence of a separate class consent from the holders of the converting shares.

A common Series A investment

Two investors invested about £42 million into a UK company in exchange for Series A Shares.

The company adopted new articles of association as part of the investment, which were based on the widely-used model documents published by the British Private Equity & Venture Capital Association (BVCA). The new articles included a provision specifically dealing with the conversion of the Series A Shares and another provision dealing with the variation of class rights:

• Article 9 (Conversion of Series A Shares) stated that all Series A Shares shall automatically convert into Ordinary Shares upon notice in writing from an ‘Investor Majority’.
• Article 10 (Variation of Rights) was of general application. It stated that special rights attached to any class of share may only be varied with the written consent of a specified majority, or more than 75%, of holders of shares of that class.

However, as the key issue in this case, the articles did not expressly state whether or not a class consent under Article 10 was needed to give effect to an automatic conversion under Article 9.

An unusual “Investor Majority” threshold

Somewhat unusually, the Investor Majority was defined as the holders of a majority of the Ordinary Shares and the Series A Shares together.

The Ordinary Shares were about 87% of the issued shares and the Series A Shares were only about 13% of the issued shares in the Company. Therefore, it would have been obvious that holders of Ordinary Shares alone could collude to trigger a conversion of the Series A Shares.

Request for more Working Capital

About 18 months after the investment, the company sent a circular to all its shareholders indicating that it was running very short of cash. It also set out a proposal to raise additional working capital by way of an issue of between £7 million and £25 million of convertible loan notes.

The circular flagged some risk factors for the company. This included the fact that the Series A investors had an option to allow them to redeem their Series A Shares if an IPO had not occurred by a particular date.

The circular went on to say that an “Investor Majority” might seek to nullify the put option by converting the Series A Shares into Ordinary Shares in accordance with Article 9, but warned that this action would likely be challenged by the investors.

When various Ordinary Shareholders signed a notice to automatically convert the Series A Shares into Ordinary Shares, the Series A investors challenged this action.

What did the court decide?

The court found in favour of the Series A investors. It noted the conflict between Articles 9 and 10 and found that the only way to make rational and coherent sense of them was if the “automatic” conversion mechanism was subject to a requirement for a class consent.

The court went on to state that it would have been valid for the articles to expressly exclude a requirement for a class consent. The company may have won if the articles had included this clarity.

What action should you take?

Companies and investors should review their investment documents to check if they are silent on this question. If any “automatic” share conversion mechanism does not expressly exclude a requirement to obtain a separate class right approval, it may be prudent to make this change now.

Minority shareholders who have had shares converted without their consent may want to review historic documents to assess whether there are grounds to challenge the validity of that conversion.

For more information and expert advice, please contact a member of our Corporate team.

The content of this article is provided for information purposes only and does not constitute legal or other advice.

People Also Ask

What does it mean to convert shares?

Except for the limited circumstance of converting shares to make them redeemable shares which has a statutory basis, the process of “conversion” of preferred shares into ordinary shares is not a process that is prescribed by Irish company law and is not dealt with under the Companies Act 2014. There is debate about the nature of conversion, but courts have commented that a process to convert Series A shares into Ordinary shares involved the Series A Shares continuing in existence and being redesignated as Ordinary Shares on the Company’s register of members.