As explained in our last tip, the stakes are high when it comes to pre-emption rights on a transfer of shares as the way the provisions operate can significantly impact the dynamics of the sale process, and can sometimes leave them open to manipulation. In this tip we highlight some issues to consider when drafting a pre-emption mechanic as well as a few common traps to avoid.
What… should I think about when drafting pre-emption rights?
There are a number of points to think about – many of which also arise in the context of drag and tag drafting, eg how conditionality required by a selling shareholder or a shareholder exercising its pre-emption rights will be dealt with (and how this may impact the timing of the process), whether non-cash consideration will be permitted (and, if so, how this will be valued), how indirect transfers are to be treated and whether powers of attorney are needed to ensure that shares required to be transferred as agreed are actually transferred. These and other points were discussed in an earlier tip April 2017 /Issue No.16. A few other points to think about (relevant to all Asian jurisdictions) include:
- Triggers. Carefully consider what is the appropriate trigger for a pre-emption process. The process will obviously need to be completed before an actual transfer of shares takes place. Provisions are sometimes drafted so that the pre-emption process must be initiated merely on a shareholder proposing or intending to sell. However, that is often considered to be too early or too vague a trigger. Consider whether to require that the process be completed before an agreement to sell to a third party is entered into or whether an agreement can be entered into first, provided it is conditional upon the pre-emption rights not being exercised. The decision will be influenced by what you are willing to allow a potentially selling shareholder to do before the process is triggered (including whether to allow any kind of pre-marketing exercise). This will, in part, depend upon the type of pre-emption right, ie a front-end or a back-end right (as explained in our last Legal Quick Tip on Pre-Emption Rights on Share Transfers April 2017 /Issue No.16.
- Co-sale. Remember that two or more shareholders may wish to sell some or all of their shares to the same third party in order to deliver a larger, or a strategically significant, stake (eg a 1% and a 9% stake that together deliver a 10% stake carrying a board appointment right). Ensure the pre-emption provisions work in this situation – in particular, so that the non-selling shareholders cannot frustrate the combined sale by acquiring only one shareholder’s shares (eg the 1% stake in the above example) or only part of the shareholder’s shares that are proposed to be sold.
- Price. Pre-emption provisions generally provide that if the offer is not taken up by the existing shareholders in respect of all of the proposed sale shares, the selling shareholder(s) may sell those shares to anyone at a price and on terms no more favourable than those offered to the other shareholders. Don’t forget to think about how other terms of an SPA to be entered into with a proposed purchaser might affect the price. For example, far-reaching indemnities which have a high chance of requiring a payment to be made or purchase price adjustments could allow a purchaser to acquire shares at a lower total price than the headline price offered to the other shareholders under the pre-emption process. From the viewpoint of the other shareholders, any potential for manipulation needs to be minimised.
- Timings. As well as addressing the timing implications of any regulatory or antitrust conditions that may be required by relevant shareholders, you should also consider whether shareholders who wish to exercise their pre emption rights are likely to have sufficient time to deal with the financing of the acquisition and to go through their own internal approval processes.
- Other terms. Depending on the size of shareholders’ stakes and their involvement in the joint venture, it may not be appropriate for the selling shareholder to offer business warranties (or other contractual protections) to the other shareholders. In that case, this should be addressed in the drafting so as to avoid the selling shareholder falling foul of the requirement not to sell to a purchaser on more favourable terms. Remember also that a selling shareholder may try to include some terms in the pre-emptive offer that are difficult for certain shareholders to accept.
- Conflicting rights. Sometimes, different pre-emption rights are granted to different shareholders. If this is the case, it is critical to ensure that the pre-emption mechanics work in parallel and do not conflict.
- Experts. Pre-emption rights are sometimes drafted with the price payable by the pre-empting shareholders to be determined by an independent expert. In that case, make sure the expert’s instructions are clear as to the basis of the valuation as this could have a significant
Yes – the pre-emption provision considered in Cosmetic Warriors Ltd v Gerrie and Hawksley  EWHC 3718 stated that the price was to be determined by two independent accountants ‘as being in their opinion the fair value thereof between a willing buyer and a willing seller valuing the company on a going concern basis’. A dispute arose as to whether the shares should be valued based on: (i) the price a purchaser would pay for a block of shares (ie discounted to reflect that it was a minority stake); or (ii) a per share price calculated from the value of the whole company. The court held that the accountants’ task was to fix a price per share (ie (ii)) because, at the time of calculation, they would not know the size of the block or blocks that would ultimately be transferred (or what significance they would have in the hands of the transferee). As well as any ambiguity in the draft impacting the value achievable on a sale, any uncertainty as to how a pre-emption mechanic operates in practice risks being exploited and may even prevent the provision being used at all.
Any… tips for ensuring the process works in practice?
Ensure you give sufficient consideration to the time periods and notice provisions in the shareholders’ agreement and constitutional documents, eg can notices be sent by email? When are notices deemed sent and received? Does the day a notice is sent or received count when calculating time periods? Don’t forget to check the relevant definitions (eg Business Day). Logistical issues can arise where shareholders are located in multiple jurisdictions and time zones as it may not be possible to deliver notices to all shareholders on the same day, leading to various time periods running in parallel. To avoid this, consider deeming the date of the notice as the date of delivery (subject to the notice being delivered in accordance with the agreement within an agreed number of days from the date of the notice). Also remember that, depending on the governing law of the agreement, there might be applicable statutory provisions which set out a default pre-emption mechanism (as explained in our last Legal Quick Tip on Pre-Emption Rights on Share Transfers April 2017 /Issue No.16).
Anything… else to think about?
Don’t forget that you can run into trouble even if the non-selling shareholders indicate they do not want to exercise their pre-emption rights and that there is no need to go through the process. In that case, ensure you properly document the shareholders’ waiver as a shareholder could be prevented from enforcing a pre-emption right in the future where the shareholders have, in the past, ignored or forgotten about (and therefore not formally waived) the pre-emption process (see Dixon v Blindley Heath Investments Limited  EWCA Civ 1023).
Do also consider whether you need any cooperation from non-selling shareholders. For example, if the joint venture is incorporated in Mainland China, you should include a provision in its articles of association and the joint venture agreement to require the non-selling shareholders to cooperate with the transfer process should they elect not to exercise their pre-emption rights by executing a written waiver for filing with the relevant department of the Administration for Industry and Commerce (which may otherwise refuse to register a transfer without a waiver). In respect of Chinese-foreign joint ventures, the non-selling shareholders’ consent is required by law.