Court Enforces Full Ratchet Anti-Dilution Provision Against Attempt to Evade Its Terms

A New York trial court recently enforced a “Full Ratchet” anti-dilution provision against a creative attempt to avoid its terms by using variable pricing for a later round of financing.  In Phoenix Motor Inc. v. JAK Opportunities II, LLC, Sadis & Goldberg won a motion to dismiss a claim seeking to avoid enforcement of a Full Ratchet anti-dilution provision, for which our client negotiated as a condition of making its initial investment.  This is an important ruling for private equity and venture capital investors, who commonly negotiate for Full Ratchet anti-dilution provisions to protect their investments from being diluted in a subsequent financing round.

Full Ratchet Anti-Dilution Provisions

A Full Ratchet is a common provision in early-stage investing that “offers … cost protection should the pricing of future” financing “rounds be lower than that of the initial round.”[1]  A Full Ratchet operates as “an anti-dilution provision that applies, for any shares of common stock sold by a company after the issuing of [a] convertible security[], the lowest sale price as the [new] adjusted … price … for existing shareholders.” (Id.)  Early-stage investors often use their leverage as an early investor to seek Full Ratchet provisions that will protect them against being diluted by later financing rounds.

For example, if, after initially issuing Stock (or Warrants) at $10 per share in Round 1, the Company later issues Stock (or Warrants) at $5 per share in Round 2, the Full Ratchet applies to compensate Round 1 investors by giving them the $5 per share lower price and also “additional shares sufficient to maintain” the same total value they had originally, i.e., twice as many shares.[2]  A Full Ratchet achieves this by automatically reducing the price downward “to reflect the … price of the shares issued in subsequent rounds,” and correspondingly adjusting the total number of … shares upwards, to achieve the same economic result.[3]
 

Phoenix Issues JAK a Warrant With a Full Ratchet Clause in 2023

In the Phoenix Motor case, Phoenix Motor Inc. (“Phoenix”) in 2023 obtained early-stage financing from JAK Opportunities II, LLC (“JAK”) in exchange for a warrant (“Warrant”) to purchase 1.5 million Phoenix shares at a $1.30 per share exercise price.[4]  The Warrant had a Full Ratchet anti-dilution provision to protect JAK from dilution by a later round of financing.  If Phoenix did a later round of financing at a lower price, JAK’s exercise price would be adjusted downward to the lowest price of the later financing round, and the number of shares would be adjusted upwards by the same proportion as the difference in price.

Importantly, JAK’s Full Ratchet provision addressed the possibility of a future financing round done at a variable price, which is adjusted based on factors like current stock trading price.  JAK’s Full Ratchet provision provided that JAK’s conversion price would be adjusted to the “lowest price per share” for which a share of Phoenix’s common stock “may become issuable assuming all possible market conditions” under an agreement for a new round of financing.[5]  Accordingly, JAK’s Full Ratchet provision required a new, lower price that is the lowest possible price at which stock could ever possibly be issued under a new round of financing, under any market condition.  In short, the Full Ratchet required using the lowest possible price in a later financing round.
 

Phoenix Does a Second Round of Financing in March 2025, Using Variable Pricing

A year and a half after issuing the Warrant to JAK, Phoenix entered into a new loan agreement with J.J. Astor & Co. (“J.J. Astor”), in which Phoenix agreed to borrow additional funds in two tranches (the “J.J. Astor Agreement”).[6]  In exchange, Phoenix agreed to issue J.J. Astor two promissory notes to secure each of the two tranches of debt.

Importantly, the new investment used a variable “Conversion Price” with no floor if either J.J. Astor or Phoenix elected to convert the second note (the “Additional Note”) into Phoenix common shares.  If either party converted, the Conversion Price would be tied to Phoenix’s stock price at the future “Funding Date” of the Additional Note.[7]  Phoenix’s stock price could be anything at that future time, and the J.J. Astor Agreement set no floor on the Conversion Price.

JAK Exercises its Warrant in March 2025, Using the Lowest Possible Exercise Price

As soon as Phoenix executed the J.J. Astor Agreement containing its floorless Conversion Price, Phoenix was “deemed” under the Warrant to have issued common shares for “the lowest price per share for which one share of Common Stock is at any time issuable” under the J.J. Astor Agreement.[8]  This triggered JAK’s Full Ratchet provision, to reduce the Warrant’s exercise price to the lowest possible issuance price under the J.J. Astor Agreement,[9] which contained no floor price.

Accordingly, JAK exercised its Warrant at $0.12 per share, a price well below the Warrant’s original exercise price (and well below the $0.60 per share market price).  The $0.12 price per share was proper, assuming the Full Ratchet provision applied.  Phoenix disputed JAK’s exercise price, and argued that the Full Ratchet provision did not apply.  Phoenix then sued to recover the difference between the original exercise price and the far lower price JAK paid for the shares.
 

The Court Holds Phoenix to the Plain Terms of the Full Ratchet it Granted to JAK

JAK retained Sadis to handle this case, and JAK immediately moved to dismiss the complaint.  JAK argued that the Full Ratchet’s plain terms required using the lowest possible price under the J.J. Astor Agreement.  The J.J. Astor Agreement used variable prices, including as low as $0.01 per share.  Accordingly, JAK argued that it was entitled under the Full Ratchet provision to buy shares for as low $0.12 per share – which made its conduct proper under the Warrant’s plain terms.
In response, Phoenix argued that (i) the J.J. Astor Agreement did not trigger the Full Ratchet provision re-setting the conversion price as low as $0.12 per share, and (ii) JAK would get a windfall if it used an exercise price at $0.12, which was well below JAK’s $0.60 per share market price.

The Court agreed with JAK and dismissed Phoenix’s complaint.[10]  It held that the J.J. Astor Agreement triggered the Warrant’s Full Ratchet provision.  It emphasized that the Warrant directs the use of the “lowest” price at which a share “may become issuable assuming all possible market conditions.”[11]  That language captured the J.J. Astor Agreement’s Conversion Price, which was tied to whatever Phoenix’s share price might be on the future date when J.J. Astor would be required to provide additional financing, which future price could be anything, without any specified price floor.  Accordingly, the Court held that JAK’s purchase of shares at a $0.12 per share price was permissible under the Full Ratchet provision.

The Court rejected Phoenix’s attempts to avoid the consequences of the full ratchet it had granted to JAK.  Phoenix took issue with the variable future Funding Date of the Additional Note, arguing that JAK had “to wait for an actual agreement” to fund the Additional Note, and use the market price on the date of that agreement.[12]  The Court disagreed, because that interpretation “doesn’t give any significance” to the Warrant’s language that the exercise price is tied to the price that a convertible security “may become issuable assuming all possible market conditions.”[13]  The J.J. Astor Agreement contained the “option” that there “could be a second round” of financing,” and that sufficed to trigger the Warrant’s full ratchet.[14]

Nor was the contemplation of the Additional Note Funding Date an unenforceable “agreement to agree.”[15]  The fact that “the exact terms of how [the Additional Note] will be invoked [were] unclear” at the time the J.J. Astor Agreement was signed “doesn’t make it any less of an agreement.”[16]
In addition to dismissing the complaint, the Court awarded JAK its attorneys’ fees pursuant to the fee-shifting clause in the parties’ shareholder agreements.[17]  This gave JAK a full victory.
 

Implications

Phoenix Motor Inc. v. JAK Opportunities II LLC, is an important victory for private equity and venture capital investors who invest using agreements with Full Ratchet provisions.  This ruling stands out as one of a very few New York or Delaware decisions ruling on the enforcement a Full Ratchet anti-dilution provision, against a counterparty who seeks to avoid the clause’s dramatic effect on price.  Courts had long recognized that a “full-ratchet protection” is among the “most common” forms of anti-dilution protection in securities purchase and lending agreements.[18]  But few recent decisions had actually applied a Full Ratchet provision to a later financing providing for a floorless conversion price, and enforced the clause over an issuer’s attempt to limit the clause to a higher price.  The case therefore provides rare, concrete guidance that courts will enforce negotiated Full Ratchet protections against investment dilution, and will reject issuer attempts to avoid their obligations under Full Ratchet provisions.

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Samuel J. Lieberman and Frank S. Restagno defended JAK in this matter.  For further information regarding distressed financing disputes, please contact Sam at (212) 573-8164 (slieberman@sadis.com) or Frank at (212) 573-8145 (frestagno@sadis.com