Shareholders’ Agreements and Pre-emptive rights
A company must have articles of incorporation (“articles”). The articles will apply to all persons who are members of the company, without any requirement for persons, other than the original subscribers, to sign confirming their agreement to the articles. Where the company will have more than one member or shareholder, the shareholders often wish to put in place a shareholders’ agreement to be agreed expressly by all of the company’s shareholders.
The shareholders’ agreement generally describes the way the company is to be operated and the rights and obligations of the shareholders in and to the company and its business and as between each of the shareholders and the shareholders and the company. The shareholders’ agreements, therefore, will work together with the articles to govern the relationship between shareholders but will usually provide that where there is a conflict between the shareholders’ agreement and the articles, the shareholders’ agreement will prevail.
Section 61 of the Companies Act provides that:
- If the articles so provide, no shares or a class of shares may be issued unless the shares have first been offered to the shareholders of the company holding shares of that class.
- The shareholders mentioned in subsection (1) have a pre-emptive right to acquire the offered shares in proportion to their holding at such price and on such terms as those shares are to be offered to others.
- Notwithstanding that the articles provide the pre-emptive right referred to in subsection (1), the shareholders of the company have no pre-emptive right in respect of shares to be issued by the company—
(a) for consideration other than cash;
(b) pursuant to the exercise of conversion privileges, options or rights previously granted by the company.
These are known as “pre-emptive rights”. These statutory pre-emptive rights, however, only apply if the articles of the company make provision for them. Whether or not the statutory pre-emptive rights apply, shareholders’ agreements will usually contain a clause granting pre-emptive rights to the existing shareholders. This will mean that if one of the original shareholders wishes to transfer his/her interest in the company, he/she must give the other existing shareholders the option to acquire his/her interest before offering that interest to a third party.
The shareholders are the owners of a company and are usually free to deal and dispose of their shares in any way they see fit. The law recognizes that a key feature of “ownership” is the ability to deal freely with that property concerned and therefore, any fetters on that ability must be expressly provided for. In recognition of this principle, courts have taken a strict view when interpreting pre-emption provisions in shareholders’ agreements or the articles, with the result being that commonly used phrases in pre-emption provisions have distinct legal meanings. This means that superficial or small variations may have significant legal effects. This is an important consideration when drafting pre-emption provisions, particularly when they are complex.
In law, ownership can be divided into two main interests: legal title and beneficial interest. Legal title will include the right to be identified as the owner, the right to possess the property, and the right to take action to enforce the ownership rights against other people. Beneficial interest, on the other hand, is the right to benefit from the property and the right to take enforcement action against the legal title holder when deprived of that benefit. When dealing with shares, beneficial interest will also include the right to dividends, the right to vote at company meetings, and/or the right to have the legal title in the shares transferred to the beneficial owner at some point in the future. So, a properly drafted pre-emption provision in a shareholders’ agreement should address both the transfer of legal title and the transfer of beneficial interest.
Why is this important when thinking about pre-emptive rights? Pre-emptive rights are a way to protect shareholders from losing voting power and influence in decision making and limit the ability of an unknown third party becoming involved in the company. When thinking, for example, of a scenario in which a third party may become involved in the company, consider the situation in which securities, such as shares, are often used … as security or collateral for a debt! A person may be willing to extend funds to the owner of shares who relies on their shareholding in a company as security, placing a charge over those shares. Should the owner default on his/her loan and the bank (or other person) chooses to enforce its security a company may find itself with a brand-new shareholder. This new shareholder may have a different vision for the company than that shared by the existing shareholders and may even have the resources to attempt a takeover of the business.
The use of the shares as security for a loan will usually not require an immediate transfer of legal title but may nevertheless amount to a transfer of beneficial interest. When placed before a court, pre-emptive rights provisions will be strictly construed. A transfer of beneficial interest must therefore be expressly prohibited or restricted. If a clause granting pre-emptive rights is worded generally then it is likely that the clause may be interpreted so strictly as to limit the infringement on the rights of ownership. The likely result being that the clause will be interpreted to apply only to the transfer of legal title and not the transfer of beneficial interest. It is important to draft pre-emptive rights clauses and other provisions of a shareholders’ agreements carefully so that loopholes like this may be closed.
Luke Phillips is an Associate at Myers, Fletcher and Gordon. He may be contacted at email@example.com or through the firm's website www.myersfletcher.com. This article is for general information purposes only and does not constitute legal advice.