A small number of family members, or perhaps a group of friends, decide to go into business together. The first question will usually be: ‘Who is to own what percentage of the equity?’ Having decided that, the next issue might be: ‘What happens when one of the shareholders wishes to dispose of their shares?’ It must be fairly evident that the existing shareholders may become rather upset if exiting members simply dispose of the shares to whomsoever they please. To avoid this situation there may be a shareholders’ agreement that sets out the respective rights and duties in such a case in even more detail than in standard articles of association.
Pre-emptive clauses oblige sellers of shares to offer them to existing shareholders first. The clauses are often found in the articles of association of private companies and have caused many shareholder disputes. If one of the shareholders wishes to sell part or all of their holdings, the remaining shareholders are normally keen to retain those shares within their ranks.
However, company law prefers to see shares as freely transferable pieces of personal property. Accordingly, any restriction on their transfer must be carefully worded to avoid conflict. It follows that shareholders who benefit from pre-emptive provisions have a right to protect those interests. Where a dispute arises because existing shareholders were not aware of their pre-emptive rights, it is usually necessary, if the outside buyer is to succeed, for the buyer to prove that the existing shareholders did have actual knowledge of their rights and waived them.
According to the wording of a pre-emptive clause, the directors must register a transfer of shares to an outsider, so long as the seller has first offered the shares to existing members in accordance with the prescribed procedure. Typically, the shares must first be offered to existing members at the same price at which the seller proposes to sell them to the outsider.
If purchasers for all the shares are not found among the existing members at this price, within a specified time limit, and the seller does not withdraw the shares from sale, the shares must be independently valued at a ‘fair price’ and re-offered to existing members at the ‘fair price’. Any shares still unsold may then be sold to the outsider.
Many boards and many more shareholders have little familiarity with their company’s pre-emptive clauses, let alone how they would work if activated. So what happens if the terms of a pre-emptive clause are breached? It is possible that a shareholder may sell their shares in breach of a pre-emptive provision. This could be because the shareholder deliberately ignored the pre- emptive provision or was unaware of it.
Clash of contracts
In some situations, it may be possible for the other shareholders to go to court before the sale contract has been signed and have an injunction granted to prevent the sale taking place. In most cases, however, the first time the shareholders or the company find out about the sale of the shares is when the transfer documents are sent to the company.
This situation can cause problems because there are now two valid but conflicting contracts, namely a pre-emptive clause in a company’s constitution that is part of a contract between all of the existing shareholders, and the contract for the sale of shares between one of those shareholders and a third party. How does the court decide which contract should take precedence?
There have been varying decisions. It has been held that the outside purchaser may not have the purchase registered by the company if there are existing shareholders who are willing to take the shares under the pre-emptive rights. On the other hand, if the selling shareholder gets a higher price under the pre-emptive provisions than under the contract to sell to the outsider, the outsider has been entitled to that ‘profit’.
What is clear is that at the consulting stage, before incorporation, professional legal advice should be taken. Courts are not inclined to enforce restrictions where the intention of the parties is other than absolutely unambiguous.