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Pre-emption right in share transfer transactions

23.05.2004

The Law of Obligations Act, which took effect on July 1 2002, introduced a pre-emption right that applies to the shareholders of limited liability companies. The concept differs from its predecessor and its interpretation has proved troublesome, particularly in relation to share transfer transactions.

Shareholder Rights of Pre-emption

A key issue is whether the pre-emption right is created on the basis of a transaction or on the basis of law. The issue is significant, since it affects the protection of shareholders' interests.

In relation to private limited companies, the Commercial Code provides that where shares are transferred to a third party, the other shareholders have a pre-emption right. However, it also provides that the right may be waived if the articles of association so provide.

In relation to public limited companies, the code provides that the articles of association may prescribe that, upon the transfer of shares to a third party, other shareholders have a pre-emptive right to acquire those shares.

Effectively, it is thus left to shareholders to decide and to provide adequately in the articles of association as to whether they shall enjoy the pre-emption right. Thus, the right may be considered to be created on the basis of a transaction. However, no court ruling exists on this issue and it is arguable that the right is law-based for private limited companies (because it can be waived by the articles of association) and transaction-based for public limited companies (since it will apply only if expressly included in the articles of association).

The issue is significant given that, as of December 27 2003, the disposition of something to which a pre-emption right created on the basis of law applies is void if (i) it is made after the right to exercise the pre-emption right arose, and (ii) it would prejudice or restrict the exercise of the pre-emption right.

Exercising the Pre-emption Right

The Commercial Code provides that the Law of Obligations Act provisions on the pre-emption right apply to a shareholder's pre-emption right.

The right is deemed to create a contract of sale that grants all rights arising from a standard contract of sale to the shareholder, including the right to demand transfer of the shares.

According to the Law of Property Act, which provided for the pre-emption right before the Law of Obligations Act took effect, an individual who enjoys a pre-emption right takes precedence over the original buyer under a sale-purchase contract so that no competing sale contracts are created. At the moment once the pre-emption right has been exercised with respect to the shares, the seller is bound by two similar contracts of sale (ie, a contract of sale with the buyer and a contract of sale with the shareholder who has the pre-emption right). Given that the seller can perform only one of the two contracts, he should allow for the possible exercise of the pre-emption right at the time of signing the original contract of sale, notifying the buyer of the pre-emption right and signing the contract of sale either provisionally or retaining a right of withdrawal from it.

The most problematic situation has proved to be that in which the seller has not considered the aforementioned possibilities and has transferred title to the shares to the original buyer, with the effect that he cannot perform obligations arising from the contract of sale to the shareholder who has the pre-emption right.

Where the shareholder's pre-emption right is considered to be transaction-based, the transfer of title of shares to the original buyer (made after the right to exercise the pre-emption right has arisen) is not void. The seller has violated the sale contract and the shareholder with the pre-emption right can only demand the relevant legal remedies. The shareholder cannot demand performance of the sale contract from the seller, as the latter has transferred the title and, according to the Law of Obligations Act, performance is impossible. Thus, such shareholder may file a claim for damages against the seller as in the event of a pre-emption right under the Law of Obligations the shareholder with the right cannot have any claim against the original buyer.

Thus, the shareholder's pre-emptive right, which should grant him the right to exclude third parties from becoming shareholders, may be quite weak if the pre-emption right is indeed based on a transaction rather than on the law.

Exercise of the Right by Several Individuals

The regulations on the exercise of the pre-emption right by several individuals in relation to the transfer of shares are somewhat vague.

The Law of Obligations Act applies if a company's articles of association do not provide a procedure for the transfer of shares and more than one shareholder wishes to exercise the right. The law provides that if the pre-emption right is enjoyed by several individuals separately and they wish to exercise the right, lots should be drawn unless otherwise provided by law or agreement. Therefore, it is advisable for the articles of association to state that where several individuals wish to avail of the pre-emptive right, each individual shall have the right to acquire the shares proportionate to his or her current holding in the company's share capital.

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