The term “shareholder right of first refusal” – or preemptive right – means that when a shareholder of a limited liability company wishes to transfer any of his equity to a third party, the other shareholders have, all things being equal, the preemptive right to purchase such equity. The main legal basis for this is article 71 of the Company Law (amended in 2013).
The main purpose of the preemptive right is to assure the “personalized nature” of limited liability companies and safeguard trust between the shareholders. It has a positive effect on the corporate system. However, limited liability companies are characterized both by their “personalized nature” and “profit seeking”, and if the former were to be overemphasized at the expense of the latter, the realization of market trading efficiency and liberty would be compromised, as would the protection and realization of the lawful rights and interests of transferring shareholders and acquirers. In practice, serious difficulties can arise because the legal provisions are sometimes too general and the procedure is complicated. An entire equity transaction may occasionally become null and void due to flaws in the preemptive right procedure.
The Company Law divides shareholder rights into inherent and non-inherent rights. The criterion for the division is whether a right can be restricted or deprived by the company’s articles of association, or a resolution of the shareholders’ meeting. Room for adjustment and configuration of inherent rights by corporate contracts is limited, with the large majority of such rights either immune to restriction or requiring the unanimous consent of all of the shareholders before any restrictions can be placed.
The great majority of the relatively important or core rights comprising shareholders’ rights fall into the category of inherent rights, including the preemptive right. Accordingly, in practice, bypassing the preemptive right requires consideration from a different vein in the company system.
BYPASSING PREEMPTIVE RIGHT
Create a state in which all things are not equal. The preemptive right is not absolute, as it is predicated on the principle “all things being equal”. Theoretical studies and judicial practice indicate that “all things being equal” does not solely refer to the transfer price for the specific equity, but also includes other pricing conditions such as the payment deadline, payment method, etc., and additional conditions like liability for breach of contract, employee resettlement, engagement of senior officers, etc., that have a substantive impact on the transferor’s rights, or that impose additional burdens.
Therefore, by setting reasonable transaction conditions, it is possible to lawfully and compliantly bypass the preemptive right. For example, the acquirer may, in addition to the specified price, agree to other secondary payment obligations to make up for a low price, e.g. by the payment of a certain thing. Furthermore, such payment obligation must be one that the other shareholders of the target company cannot perform, or that they are unable to substitute with an equivalent benefit. In this way, the other shareholders of the target company are unable to satisfy the condition of “all things being equal”, thus bypassing the preemptive right.
Substitute method of acquisition. The preemptive right applies only when an equity is transferred to a third party, whereas corporate acquisitions with different legal conditions come in many forms. Under the existing legal framework they include equity transfers, registered capital increases, company mergers, complete asset transfers and proxy solicitations. Taking equity transfers and capital increases as examples, the Company Law requires the consent of a simple majority of the other shareholders in the former, whereas the votes of shareholders representing at least two-thirds of the voting rights is required in the latter. Clearly, in different company acquisition fields, it is possible to opt for a transfer of equity or a capital increase.
Be a shareholder. Pursuant to the Company Law, shareholders of limited liability companies may transfer all or part of their equity among themselves, and the preemptive right applies only when a shareholder wishes to transfer any of his equity to someone other than another shareholder. Accordingly, an acquirer can first become a shareholder of the company and then achieve his or her objective of a complete buyout.
In a corporate acquisition recently handled by the author’s firm, the acquirer wished to buy an 87% stake of a certain company held by a number of its shareholders, but the remaining shareholders wished to exercise their preemptive right. Accordingly, the lawyers recommended that the client first acquire, bit by bit, 1% of the equity at a relatively high price, until such time as it became a shareholder of the company, from where it could proceed to acquire the remainder of the equity.
Of course, the preemptive right procedure was still operative for the acquisition of the 1% of equity by this method, but, through co-operation, the transferor and acquirer were able to jointly procure the voluntary waiving by the other shareholders of their exercise of this right. Formally, this use of financial strengths to buy shares and become a shareholder, and then acquire equity in the capacity of a shareholder, does not bypass the preemptive right, but in essence, it has the bypassing effect. Use of a capital increase can also cause the acquirer to become a shareholder of the company, who can then continuously and freely further acquire equity in the company.
Indirect acquisition. This means, in a situation where there are multiple layers of parent and subsidiary companies, securing the control and property of a company at a lower level through acquisition of equity in a company at a higher level. Since it does not involve an acquisition between the shareholders of the target company, these shareholders cannot assert the right of first refusal. In practice, such indirect acquisitions are frequently employed and recognized by judicial rulings and judgments.
However, in the “Shanghai Diwang” case on which the author acted as counsel, the court at first instance held that the indirect acquisition involved in the case was an instance of an illegal objective wrapped up in a legal form, and clearly violated the provisions of the Company Law on the preemptive right. Accordingly, it ruled that the corresponding equity transfer contract was invalid. This outcome only has significance in this particular case and does not negate the lawfulness and validity of all indirect acquisitions, but it nonetheless reminds us that indirect acquisitions still need to be carried out lawfully.
Xi Qing is a senior partner at AllBright Law Offices in Nanjing
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