I was facilitating a workshop recently at the University of Law in London on pre-emption rights on share transfers and was brought back to a situation, a few years back, when a client contacted me who needed to urgently dispose of its shares in a successful Dubai subsidiary as the client was facing financial challenges at home and needed to raise cash. The subsidiary was not wholly owned by the client and the shareholders’ agreement (and possibly also the constitutional documents) contained pre-emption rights in favour of the other shareholder. In basic terms, if an offer was received for a shareholders’ shares from a bona fide third-party buyer, then the other shareholder was entitled to buy the shares at the same price (pre-empt the sale) before the sale to the third-party buyer could proceed.
The client went into liquidation before it could complete the sale. Would a more seller friendly exit mechanism have saved the day in providing the client with a more expedient route for disposing its shares in the subsidiary and realising the much needed cash? Probably not in that instance, as the financial woes of the client were substantial. Certainly, the pre-emption mechanism was a hindrance to the client because it put-off potential buyers, meaning that the client could not even initiate a sale process.
The above pre-emption rights structure is common enough. It is also not unreasonable as it provides the continuing shareholder the opportunity to buy-out the selling shareholder and avoid the participation of a new shareholder, which might disrupt the dynamics of the joint venture company’s business. The challenge is that the process is triggered by the third-party offer, and a potential third-party buyer may not be inclined to make an offer (and spend the time and costs on valuations, due diligence and integration plans) in the knowledge that the continuing shareholder might then exercise its rights of pre-emption and trump the process. This situation creates a major hurdle for the shareholder wishing to initiate a sale.
A solution might be for the proposed seller to indemnify the potential buyer for its professional costs if the deal aborts because of the continuing shareholder exercising its pre-emption rights. But that could be expensive for the seller, and may still not be attractive to a potential buyer as it does not compensate the buyer for its wasted management time and costs spent in considering the deal, and the uncertainty that would underpin such a deal from the start. The other shareholder could agree to waive its pre-emption rights in advance, but it may not have much incentive to do so, particularly if it sees an opportunity to buy the selling shareholders’ shares at a discounted price due to the absence of a potential third-party buyer (a situation possibly precipitated by the existence of the restrictive pre-emption rights).
Pre-emption mechanisms can be long winded (they are the type of clause that you often need to read more than once, and even then, you do not have a totally clear grasp of the situation) meaning that even if the seller can find a third-party buyer, the deal might still not complete for several months once all the hurdles have been gone through. As mentioned in my real-life example, the proposed seller went into liquidation before a solution could be found in respect of selling the shares in its subsidiary. I do not know what became of the subsidiary but possibly the insolvency would have triggered a deemed transfer notice by the insolvent shareholder pursuant to the terms of the shareholders’ agreement, entitling the continuing shareholder to buy the shares of the insolvent shareholder at a discounted price, a fairly common provision in a shareholders’ agreement (and not really providing much incentive for the ongoing shareholder to assist a struggling shareholder with a sale process.)
Whilst explaining the typical pre-emption clause structure in class, I began thinking about structures in shareholders’ agreements and articles of association more favourable to a shareholder who may need to exit (expediently) from a successful joint venture. Perhaps to raise cash or because of a change in direction of its business. One structure I have seen is where the shareholder wishing to sell its shares notifies the company and specifies the price per share it is willing to sell its shares at. There is no requirement for a third-party offer. The other shareholder(s) then has X business days to consider the offer and if it does not accept the offer, then the shareholder wishing to sell its shares is able to sell them to a third party at not less than the price per share notified to the company. There is usually a specified period during which the sale must take place (perhaps up to three or six months) and there might be a list of persons to whom the shares cannot be sold (prohibited persons, perhaps certain competitors and/or persons subject to international sanctions), thereby giving the continuing shareholder some comfort in respect of the integrity of any new proposed investor/shareholder. These mechanics are sometimes referred to as a ‘right of first refusal’ to differentiate them from the more traditional pre-emption structure triggered by a third-party buyer.
This right of first refusal is arguably a better pathway for a party who might, at some point in time, need to exit the successful corporate joint venture.
I have seen some variations in the right of first refusal where, on the company’s receipt of the notice from the shareholder wishing to sell, a ‘fair value’ valuation of the shares is performed with the continuing shareholder then able to buy the selling shareholder’s shares at that valuation only (or the seller can withdraw from the sale process if it is unhappy with the price). In my view this is too favourable towards the continuing shareholder and could add complications to the deal process (and lead to an extended timetable), and it would be better to allow market forces to prevail, with the seller able to specify the price it wishes to receive (perhaps because it has received an indicative offer at that price). I have also seen precedents that allow the remaining shareholder(s) to take-up part of the shares on offer only. Again, in my view, perhaps too accommodating to the continuing shareholder, complicating the deal process and making it harder for a shareholder wishing to exit to dispose of all of its shares due to it being unable to sell the shares in one batch.
The focus of this article is on pre-emptions rights. In practice, pre-emptions clauses will need to dovetail in the relevant agreements with other share transfer provisions such as lock-in periods, drag and tag along rights, put and call options, compulsory share transfer provisions (often on insolvency, change in control and material breach) and deadlock provisions resulting in share transfers (for example Russian Roulette clauses).
Arrangements in joint ventures in respect of share transfers are complicated and should be tailored in the joint venture/shareholders’/investment agreement and articles of association to suit a client’s specific needs. The share transfer clauses may never need be applied, but if they are then this is likely to be a pivotal moment for all concerned and the relevant clauses will need to stand up to scrutiny and be practical in application. The danger when preparing joint venture agreements or tailoring articles of association is to gloss over the complicated precedent pre-emption language, in the belief (or hope) that it is boiler plate, possibly encouraged by Heads of Terms focusing on the union of the joint venture rather than the terms of a separation, and not give the clauses the full consideration that they require in the context of the parties’ particular circumstances and what might transpire beyond the horizon.
Disclaimer
This communication has been prepared for general information only and you should not rely on its contents as legal advice.