De Lorenzo v CXI Software Pty Ltd

The Issues

1. Mr De Lorenzo's case is that there has been no conversion of the obligation under the Deed from debt to equity, and as the "maturity date" has come and gone and certain monthly payments of interest were not made, sues for a debt, being the outstanding principle and unpaid interest.
2. CXI, who was represented capably by its sole director, Mr Seamus O Concheanainee, contends that the debt no longer exists because there was a conversion of the debt into equity on either 7 or 20 May 2020. Thus, he says that Term 7(c) of Schedule 1 of the Deed operates, so as to extinguish any debt obligation.
3. The case turns on a proper construction of the Deed and some findings of fact in the context of the Deed.
4. Resolution of the case boils down to answering the following questions: 1. Was there a "liquidity event" as that term is defined in the Deed? 2. If so, was there "shareholders' approval" for the issue of shares and the cancellation of the note as required under the Deed? And 3. If the answer to the first two questions is yes, what are the legal consequences in circumstances where it is an accepted fact that at no time were any of the mechanical steps required by CXI to cancel the notes and issue shares in their place carried out?

The Deed

1. I set out below what I consider to be the relevant defined terms in the Deed and the relevant provisions, in particular some of the defined words and phrases and Term 7 of Schedule 1 to the Deed. (I have emphasised those portions I think most relevant).
2. The following key terms are defined in Clause 1.1 of the Deed: "Conversion Shares means: (a) if the Liquidity Event is a subsequent capital raise of a sum in excess of Two Million Five Hundred Thousand Dollars, the Shares issued in accordance with Term 7(c); (b) if the Liquidity Event is an IPO of the Company, the Shares issued In accordance with Term 7(c); (a) If the Liquidity Event is an IPO via the acquisition of the Company by the Listed Entity, the ListCo Shares Issued In accordance with Term 7(c); (b) if the Liquidity Event Is a majority acquisition of the Company's share capital, the Shares Issued in accordance with Term 7(c); and (c) if there is no Liquidity Event, the Shares issued in accordance with Term 7(d). Convertible Notes means the convertible notes to be issued by the Company on the terms and conditions set out in Schedule 1 and under, and in accordance with, this Deed. Liquidity Event means the Company (CXI) (or its Shareholders, as applicable) completing a subsequent capital raise for a sum in excess of Two Million Five Hundred Thousand Dollars (A$2,500,000), an IPO or the majority acquisition of the Company's share capital. Maturity Date means, in relation to the Convertible Notes: (a) the first to occur of; (i) 36 months from the Subscription Date; and (ii) a Liquidity Event; or (b) such later date that the parties agree in writing. Monies Owing means, at any particular time in relation to the Convertible Notes, the amount of the Noteholder Subscription Amount plus any accrued interest payable on the Convertible Notes. Noteholder Subscription Amount means the amount calculated by multiplying the number of Convertible Notes stated in the Notes Application Form by $1.00. Shareholder Approvals means the approvals from Shareholders of the Company or the Listed Entity that are required to approve the Convertible Notes or convert the Convertible Notes into Conversion Shares in accordance with this Deed.
3. The following terms are found in Schedule 1 of the Deed: 5. Interest on Convertible Notes (a) The Convertible Notes will bear interest at 15.0% per annum. (b) The Interest will be payable quarterly and will accrue monthly in arrears. Interest may be capitalised on each payment date, at the option of the individual Noteholder. Interest is payable on the third business day at the end of each calendar quarter ("Payment Date"). (c) For the avoidance of doubt, interest shall cease to be payable in respect of any part of the Convertible Notes upon conversion of part or all of the Convertible Notes in accordance with this Deed. 7. Conversion (a) Shareholder Approval Unless and until the Shareholder Approvals are obtained to convert the Convertible Notes into Conversion Shares (If required), the Convertible Notes will be considered a debt instrument without rights of conversion. (b) Conversion in whole only Each Convertible Note may be converted in whole only. (c) Conversion on Liquidity Event (i) Subject to Term 7{a), on the occurrence of a Liquidity Event the Noteholder will be deemed to have agreed to the conversion of the Convertible Notes In accordance with this Term 7. (ii) As soon as practicable following a Liquidity Event (but subject to Term 7(h)), the Company will proceed to issue or procure the Listed Entity to issue (if applicable) to the Noteholder that number of Conversion Shares as calculated In accordance with Term 7(e) below. (iii) The number of Conversion Shares to which the Noteholder will be entitled on conversion of the Convertible Notes on the occurrence of the Liquidity Event will be equal to the Monies Owing divided by the Conversion Price. (d) Conversion without Liquidity Event (i) Subject to Term 7(a), on the occurrence of the Maturity Date without a Liquidity Event, the Noteholder will be deemed to have agreed to the conversion of the Convertible Notes in accordance with this Term 7. (ii) As soon as practicable following 36 months from the Subscription Date or such later date that the parties agreed in writing (as applicable) (but subject to Term 7(h)), the Company will proceed to issue to the Noteholder that number of Conversion Shares as calculated in accordance with Term 7(e) below. (iii) The number of Conversion Shares to which the Noteholder will be entitled on conversion of the Convertible Notes on the occurrence of the Maturity Date without a Liquidity Event will be equal to the Monies Owing divided by the Conversion Price… (f) Cancellation of Note Certificates (i) On the conversion of the Convertible Notes under this Term 7; (A) the Convertible Notes will be automatically cancelled; (B) the Noteholder must provide to the Company for cancellation, the Note Certificate relating to the Convertible Notes being converted: and (C) the Company must issue share certificate(s) to the Noteholder in respect of the Convertible Notes converted into Conversion Shares. (ii) Any issue of Conversion Shares on conversion will have the effect and be deemed to have been made on the Conversion Date. (iii) Conversion Shares Issued on conversion of Convertible Notes will; (A) rank equally in all respects with the Shares or the ListCo Shares on Issue in the capital of the Company or the Listed Entity (as applicable) on the Conversion Date; and (B) be entitled to receive any dividend payment on Shares or ListCo Shares (as applicable) where Shares or ListCo Shares on issue on the Conversion Date are or become entitled to a dividend… (h) Shareholders' Deed The Noteholder: (i) agrees that they will be bound by the terms of the Shareholders' Deed with effect from the Conversion Date and, until an accession deed poll in the form set out In Schedule 3 to the Shareholders' Deed {Accession Deed) is provided, that the Company may enforce the terms and conditions of the Shareholders* Deed against the Noteholder on behalf of all other parties to the Shareholders' Deed; and (ii) undertakes to provide an executed Accession Deed within two Business Days of the Conversion Date.

"Liquidity Event"

1. The relevant "liquidity event" relied upon by CXI is a capital raise in an amount in excess of $2,500,000 caught by the provisions of subsection (a) of the defined term "liquidity event" which, if it occurs within the relevant time period, is deemed to have occurred immediately prior to the issuing of any new shares.
2. There is a question of fact as to whether such an amount was raised.
3. CXI relies on two sets of directors' minutes of CXI, where Mr O Concheanainee, as sole director of CXI, at meetings on 8 May 2020 and again on 20 May 2020, recorded resolutions to that effect: pp 213-14, 217, 218 of Exhibit A.
4. Within those resolutions there is a list of corporations and people from whom the relevant contributions of capital were received and a resolution to the effect that there had been a "liquidity event" for the purposes of the Deed, together with a resolution that CXI shall immediately issue new shares to the holder of the loan notes pro rata, at a particular conversion price, picking up the wording in Terms 7(c) and 7(f) of Schedule 1 of the Deed.
5. On behalf of Mr De Lorenzo, it is submitted that, notwithstanding the fact that on their face these resolutions appear to be business records and are some evidence of the facts stated therein, the Court ought not act on that evidence because it was open to CXI to prove the relevant matter, which is beyond the knowledge of Mr De Lorenzo, by more direct and better evidence.
6. That is a reasonable point, but it should be recorded that it was Mr De Lorenzo who put into evidence the director's resolutions and Mr O Concheanainee was cross-examined. It was not suggested to him that the minutes were anything other than contemporaneous and genuine.
7. In those circumstances, although the weight of the evidence is not great, it is the only evidence and was not challenged. I consider it is sufficient to prove the fact. I am satisfied that there was a relevant "liquidity event" in May 2020, which triggered the operation of the provisions of the Deed dependent on there being a "liquidity event".
8. It is not entirely clear to me why this matters, because if there was no "liquidity event" prior to the "maturity date", then the provisions of Term 7(d) of Schedule 1 of the Deed would apply, which for reasons I will explain would lead to the same overall result in this case because of the absence of "shareholders' approval". Nonetheless, the parties fought the case on the basis of a contested "liquidity event", without addressing what would happen if there was not one. I can put this to one side because I have concluded that there was a "liquidity event".

Approvals from Shareholders

1. As can be seen from the above relevant provisions, any conversion of the debt to equity under Term 7 is by virtue of Term 7(a) of the Schedule, conditional on shareholders approvals.
2. To put it in the terms of the Deed: "Unless and until the shareholders approvals are obtained… (if required), the convertible notes will be considered a debt instrument without rights of conversion". (Term 7(f))
3. "Shareholders approvals" is a defined term and means: "The approvals from shareholders of the company or the listed entity that are required to approve the convertible notes… In accordance with this deed".
4. There is no evidence of any approval by any particular group of shareholders, whether formal or informal. The only evidence of any approval by anyone is the directors' minutes to which I have referred. That of course is evidence of the approval of the Director of CXI, but nothing more other than perhaps his approval in his capacity as one of the shareholders.
5. There was some debate before me as to the proper construction of the phrase "approvals from shareholders" as defined. The issue being, was it the party's intention that there be unanimous approval by shareholders, or perhaps a special resolution, or perhaps a simple majority, or something else?
6. Mr De Lorenzo's submission is that the literal meaning of the phrase ought be applied and that what needs to happen is for each and every shareholder of the company at the time to give approval for the conversion. On the other hand, CXI contends that the Constitution of the company (which is not in evidence before me) can be used as an aid to construe the parties' intention as to the requirements for approval and it grants the directors an unfettered discretion to issue shares. As CXI is unrepresented, I am prepared to proceed upon the basis that the Constitution provides for something to that effect. CXI submits that a requirement of unanimity is commercially unlikely, as it is likely to be difficult to obtain at any particular time. On the other hand, Mr De Lorenzo submits that it is not commercially unusual in a tightly held company to find a requirement that all the present shareholders approve the entry into the shareholders register of a new shareholder.
7. On balance, and the matter is by no means clear and the drafting poor, I prefer Mr De Lorenzo's construction of "shareholders' approvals", that is I think what was required was a unanimous resolution of all shareholders.
8. The question of construction as to unanimity probably does not matter because, other than Mr O Concheanainn's, there is no evidence of any actual shareholder approvals at all. CXI's submission is that is not necessary because, by reference to the Constitution of CXI, it is observed that the directors of that company from time to time had full and unfettered authority and discretion to issue shares without the approval of shareholders. So, the submission goes, because the only director of the company resolved as a director, in the way he did in May 2020, "shareholders' approval" as is required under the Deed was achieved because the mechanism for approval by shareholders in relation to the issue of shares was short-circuited by the operation of the Constitution.
9. I do not accept that submission. Whilst I am prepared to infer that some holders of notes at the relevant time might already have been shareholders (again I do not think there is any evidence of this), it is equally plausible that some were not. Indeed, that is likely. The Deed contemplates noteholders on conversion to shareholders signing up to the current shareholders' agreement. In other words, it contemplates that noteholders may not already be shareholders. Whilst the Deed itself does contemplate becoming a shareholder in the company and does expressly require that there will be an accession deed poll to a shareholder's agreement in existence at the time by new shareholders, it is silent as to the Constitution. Of course, there is nothing surprising about that, because a person who becomes a shareholder of the company becomes bound by that Constitution by operation of law.
10. I do not accept the submission that the requirement for "shareholders' approval" in the Deed ought be read to mean shareholders' approval given by the directors because they have a general discretion to issue shares, thus creating some sort of authority to give approval under the Deed. To the contrary, the fact that the Deed expressly refers to shareholders approval in the commercial context to which I have referred almost compels the contrary construction. I do not think it is at all commercially surprising that shareholders in a tightly held company might want a veto over the identity of new shareholders.
11. CXI's final submission in answer to this aspect of the case, is that the words in brackets, "(if required)", in Term 7(a) relate to "shareholders' approval" and again, read down the requirement for approval in circumstances where the Constitution allows for directors to issue shares. I do not think that is right. It is not a sensible commercial construction and, in any event, as a matter of grammar, I think the "(if required)" relates to circumstances where there is a requirement to convert the convertible notes into conversion shares and does not relate to the approval at all.
12. I am not satisfied that there has been "shareholders' approval" as defined. In those circumstances, the express words of Term 7(a) provide that there has been no deemed acceptance of conversion by Mr De Lorenzo and the Deed continues to be a debt instrument.
13. On those findings, Mr De Lorenzo's case must succeed because, whilst I have concluded in favour of CXI that there was a relevant "liquidity event", I have also found that the express requirement for "shareholders' approval" was never obtained and so there was no conversion, nor even any right to call for shares. The consequence being that the debt instrument component of the note continues and is enforceable.
14. Against the possibility that I am wrong, I will deal with the final issue.

what is the legal consequence if there has been a "liquidity event" and "shareholders' approval"?

1. The stark fact is that CXI, at no time, issued the noteholders with any conversion shares as required by Term 7(c)(ii) (or for that matter, Term 7(d)(ii)). There was no issue of any new share certificates to the noteholders, as provided for under Term 7(f). This was deliberate.
2. CXI explains that this is because it was agreed between the parties that, until what was a contested question surrounding the "liquidity event" was somehow resolved, the parties would do nothing. This aspect of the case is not pleaded and confronts numerous hurdles, including that there is no sufficient evidence to make such a finding, let alone that it was intended to be legally binding, or to operate as some sort of variation of the Deed. In my opinion, if that be the explanation, the fact remains that CXI has not issued any shares, in breach of its obligation to do so under the Deed.
3. CXI's submission is that, if there has been a "liquidity event" and "shareholders' approval", then beneficially the shares that have not issued are to be taken to have issued and therefore, the automatic cancellation of the notes provided for under clause Term 7(f)(A) has taken place. Therefore, so the submission goes, the debt instrument has ceased to operate, and Mr De Lorenzo's claim must fail.
4. This argument is heavily dependent on a proper understanding of what Austin J said in Basis Capital Funds Management Ltd v BT Portfolio Services Ltd [2008] NSWSC 766 at [75] - [105], but, in particular, paragraphs [98] - [105].
5. Austin J in that matter was dealing with a convertible note type instrument relating to units in a unit trust which, of course, are "a financial product", as defined in s 764A(1)(b)(i)-(ii) of the Corporations Act 2001 (Cth) ("the Corporations Act"). I think that legal context is an important distinction. Where his Honour is discussing the notion of a beneficial interest he was talking of an interest in the underlying assets of the trust, which is a very different concept to the arrangement between shareholders and the assets of the company.
6. The submission of CXI is that there are, on proper analysis, two contracts. The first is a subscription agreement, which is the Deed. Thereafter, there is a second contract, being a contract which requires the issue of new shares and the cancellation and the automatic cancellation of notes, also created by the Deed.
7. There is nothing for a noteholder to do once a shareholder approved "liquidity event" has taken place, and thus the subscription agreement has been fully performed by the noteholder, and so the argument goes that the noteholder has an interest created by the contract which, at the very least, can be enforced by an order for specific performance or damages in lieu, or perhaps creates a beneficial interest itself, although this last argument overlooks the critical importance of shares being issued and recorded on the register of the company before a person becomes a shareholder.
8. I think there are number of problems with this argument, as ingenious as it is. They include: 1. This argument was not flagged at all in any pleading and is of some legal and factual complexity. I do not consider it fair on Mr De Lorenzo to have to deal with it on the run. 2. It has, as its starting point, the fact that it is CXI who has failed to perform its obligations under the contract. Whilst under Term 7(c)(1), the noteholder will be deemed to have agreed to the conversion, it was CXI who was contractually bound to issue the new shares which it did not do. CXI in those circumstances makes a submission to the effect that equity would compel it to perform its part of the bargain which it has never performed so as to relieve it from the legal consequences of its own breach of contract. I find that a surprising outcome. 3. Most fundamentally, the argument simply does not work within the four corners of the Deed itself, which makes it abundantly plain that unless and until there is an issue of shares, a conversion has not taken place, and the debt instrument remains on foot. To put it another way, until such time as there is actual performance of the obligations under the debt instrument by the issue of shares, the debt instrument remains the enforceable arrangement between the parties. Any other result may well lead to the bizarre outcome of no shares having been issued by CXI through its own breach-of-contract, nonetheless CXI is also relieved of its obligation to pay the debt. I do not think the parties intended such a result.

Some miscellaneous matters

1. I should record that in the event CXI was successful in answering Mr De Lorenzo's claim, CXI accepts that it has a liability of approximately $9102.74 plus interest. This represents interest payments which CXI concedes were not paid prior to the date of the alleged conversion.
2. As to interest generally, Mr De Lorenzo has calculated interest at the amount prescribed under the contract until the "maturity date", and thereafter on pre-judgement rates as prescribed by the Court rules up to the date of this judgment. I am satisfied as to that calculation. The amount is $25,576.21.
3. Finally, the Deed is silent as to repayment of the debt in circumstances where the debt has not converted to equity by the time of the "maturity date". Mr De Lorenzo has submitted that there must be an implied term that the full amount of any principle and any interest unpaid at that time must become payable at that time and CXI accepts such a term forms part of the Deed. That concession was appropriate. Without such a term, the Contract just does not work and would result in a windfall to CXI.

Conclusion

1. In relation to the issues I have identified, I have determined: 1. There was a "liquidity event" as defined by the Deed in May 2020. 2. There has been no "shareholders' approval" of any conversion of the note to equity, and therefore the Deed remains the operative instrument between the parties. 3. Therefore, Mr De Lorenzo is entitled to recover the "monies owing" as defined in the Deed being the principal, all payments of interest that were not paid up to the "maturity date", together with interest thereafter at the Court rates.

Orders

1. My orders are: 1. Judgment for the Plaintiff in the sum of $151,795.39, inclusive of interest up to 23 August 2024. 2. The Defendant pay the Plaintiff's costs.

DISCLAIMER - Every effort has been made to comply with suppression orders or statutory provisions prohibiting publication that may apply to this judgment or decision. The onus remains on any person using material in the judgment or decision to ensure that the intended use of that material does not breach any such order or provision. Further enquiries may be directed to the Registry of the Court or Tribunal in which it was generated. Decision last updated: 23 August 2024